COURSE 7A

REGULATION IN SERVICES
The nature of regulation in services
'Economic distance' can be defined as the sum of the costs arising from
geographic distance (transport as well as transaction costs of various kinds,
including differences in culture, language, etc.) and regulatory barriers to the
exchange of products and factors of production across frontiers.
Technological limitations to the tradability of services often require providers to
establish a physical presence in individual markets.
The combination of non-tradability of many services and government policies
restricting access to service market by foreign providers increases the 'economic
distance' between agents in different countries.
Reductions in economic distance may occur because of technological improvements
that reduce the cost and enhance the quality of transport, communications and/or
information.
It may increase or decrease because of changes in regulatory regimes, whether of
policies, laws and regulations that discriminate against foreign products and
producers, or that apply equally to domestic and foreign producers.
The production of services tends in most countries to be more thoroughly regulated
than the production of goods.
Governments have found it difficult to control the flow of services across borders,
and instead have focused their controls on the domestic sale of services. Since
services are extensively regulated, most governments use the domestic regulatory
machinery to control the sale of services to foreign suppliers.
Because you cannot see services crossing the border, governments tend to impose
regulations on trade in services at points where such trade leads to verifiable
transactions.
There are four types of transactions or activities associated with trade in services
that lend themselves to government controls:
1. Sales of imported services within the domestic borders of the importing
country, provided the government regulates the sale of all such services,
those produced by both domestic and foreign enterprises
2. Consumption of imported services, provided the government regulates the
consumption of all such services, those produced by both domestic and
foreign enterprises
3. Purchases of foreign exchange in order to pay for imported services, provided
the government controls all foreign currency transactions
4. Movements of goods, people, and informational materials that carry services
across the border, provided the government controls all such movements
indiscriminately
The basic rationale of the underlying control mechanisms usually has nothing to do
with trying to control trade-in services per se.

Controls on the sale and consumption of imported services are usually attached to
domestic regulatory programs that are aimed at domestic objectives.
Controls on the purchase of foreign exchange used to pay for imported services are
usually a part of a broader currency control program designed to solve a balance of
payments problem.
Controls on people moving across the border are usually designed to control the flow
of new immigrants who want to settle permanently.
Controls on imports of services embedded in goods rarely serve the exclusive
purpose of restricting trade and are usually feasible only to the extent that the
government regulates or controls all transactions in a particular category, whether
they relate to trade in services or not.
This means that trade policy objectives and other regulatory objectives are usually
completely intertwined, and this inevitably leads to considerable confusion over the
objectives of government policy measures that create barriers to trade in services.
Consequently, the main difference between international trade with goods and trade
in services is that, for the latter, the great majority of barriers take the form of
internal regulatory measures, some taking a protectionist stance.
Government measures that inhibit the movement of money, information, people, or
goods create barriers to trade in services by limiting the means for transferring
services internationally.
Controls on the transfer of money thus can create impediments to
international trade in banking, insurance, and brokerage services, which depends on
the international flow of money. Money, of course, is not only a means for
transferring financial services, but also a means of payment. Restrictions on the
transfer of money thus create a barrier to all trade in services by limiting the extent
to which sales proceeds can be transferred home
Barriers to the international flow of information create barriers to international
trade in data processing and information services that depend on an international
flow of information. Similarly, information flows are not only a means for transferring
information services but also a means for providing information about trade
opportunities in services. Impediments to the transfer of information can reduce the
information available to banks about foreign exchange or securities markets,
information available to travel agents and airlines about foreign bookings, and
information available to credit card companies about stolen cards. Barriers to
international information flows also can make it more difficult for construction
companies to coordinate the timely procurement and transportation of cement,
bulldozers, building permits, architectural drawings, construction workers, and
supervising engineers.
Travel restrictions create barriers to trade in tourism, education, and
professional services that depend on the international movement of people. Barriers
to movement of people create a barrier to trade in any service that requires frequent
face-to-face contacts between an exporter and a foreign client, or between a
manager in the, home office and a local sales manager in the importing country.
Business contracts still depend on personal trust and confidence, which can only be
achieved through face-to-face contacts.

Restrictions on the movement of goods create barriers to trade in services

that add value to material things-repair of equipment or printing of books.
Barriers to the movement of goods create barriers to trade in any service that
requires the international transfer of a physical information medium. Accountants
often need to carry audit tapes, engineers often need to carry technical drawings,
computer services companies often need to carry software tapes, and musicians
have to carry their instruments. International trade in services also frequently
depends on access to compatible equipment in the importing country-a customized
crane to unload a special kind of ship, or telecom equipment designed to handle
information transmitted in a unique code or requiring transformation into a unique
medium in the importing country.
Thus, regulatory measures in the services sector, conceived to serve
internal regulatory objectives aimed at correcting market failures have, in
their vast majority, a restrictive effect on trade, assuming a protectionist
role and acting as real barriers to trade and investment in services.
The case for regulation in services
The economic case for regulation in services, as in goods, arises essentially
from market failure attributable to three kinds of problems:
1. natural monopoly or oligopoly,
2. asymmetric information,
3. externalities.
The social case for regulation is based primarily on considerations of equity.
1.) The existence of natural monopoly or oligopoly is a feature of the so-called
locational services. Such services require, first of all, specialized distribution
networks: roads and rails for land transport, cables and satellites for
communications, and pipes for water supply and sanitation and for energy
distribution. They may also require specialized equipment for transmitting or
receiving the service: railway stations and bus terminals, seaports, airports,
telephone exchanges.
One reason for the tendency toward monopoly or oligopoly is the difficulty of
duplicating networks and terminals, given space constraints.
A second reason is the high barriers to entry associated with large initial
investments.
It must, however, be kept in mind that recent technological developments in areas
such as telecommunications are leading to the emergence of relatively small
optimal scales of production and are overturning conventional wisdom about the
inevitability of monopoly.
Liberalization in locational services could imply two types of change.
First, the monopoly itself needs to be delineated as narrowly as possible so that
competition is introduced where feasible. For instance, in railways a monopoly track
owner could sell track services to separate, competing operators of trains. Second,
competition could be introduced for the right to provide the remaining monopoly
services. Thus, the right to provide track services could be auctioned off to the firm
that commits to supply the services at the lowest price.
In the current context, the interesting issue arises when services that can be
provided competitively must rely on services provided monopolisticallyeither by

governments or by private firms. The challenge is to ensure that all service

providers, domestic and foreign, have access to the essential facilities that continue
to be monopolistically controlled.
2.) The problem of asymmetric information occurs in a wide range of intermediation
and knowledge-based services.
Buyers are often inadequately informed about the true attributes of sellers. Thus,
consumers cannot easily assess the competence of professionals such as doctors
and lawyers, the safety of transport services, or the soundness of banks and
insurance companies.
In principle, the adequate dissemination of information could remedy the problem,
but it may be too expensive to communicate the necessary information to individual
buyers.
In such situations, it may be easier to regulate suppliers than to educate consumers.
The imposition of minimum regulatory conditions on suppliers reflects a certain
uniformity of preferences among consumers about the quality of services. Thus,
regulators ensure that all banks meet a certain threshold of financial soundness and
professionals a certain threshold of competence.
Regulating the output of a services industry, which is often invisible and customized,
is usually more difficult than regulating inputs. Such regulation of inputs, however,
often amounts to restrictions on entry into the market.
The difficulty in imposing border restrictions on services, which rarely take a visible
form, makes regulation a particularly attractive means of protecting domestic
suppliers from foreign competition.
3.) The problem of externalities arises when market prices do not fully capture the
costs and benefits of the associated transactions. Typical examples are the negative
environmental externalities generated by providers of transport services, tourism
services or externalities generated by financial services through the effect of the
collapse of institutions on the entire market - failure of one institution can have an
impact on others. Prevention of such situations imposes the promotion by national
authorities of prudential regulation (authorization and licensing procedures).
There are, also, for some services, positive externalities in the telecommunications
sector, for example, the benefits of consumers are higher with the increase in the
number of consumers. In this situation, government intervention should be oriented
towards insuring interconnection, network compatibility and effective market entry.
4.) Ensuring Universal Service. Achieving the desirable social objective of
universal service in an economically efficient way is a major challenge for national
policymakers. The manner in which they pursue this objective is likely to have a
profound effect on trade in a variety of areas, including financial, transport,
telecommunications, health, and education services. The government can choose
from a spectrum of policies that range from completely replacing the market to
installing supportive policies that affect the market outcome.
Historically, governments have frequently relied on public monopolies to pursue
(often unsuccessfully) the goal of universal service, either through crosssubsidization across segments of the market or through transfers from the
government or from government-controlled banks.
In addition to the inefficiencies created by monopolistic market structures, the
burdens these obligations imposed on existing national suppliers are even now a

significant impediment to liberalization in many countries. For instance, domestic

banks saddled with bad debts because of past directed-lending programs are ill
equipped to deal with foreign competition.
The current handicap of universal service obligations can in principle be imposed on
new entrants, as well, in a nondiscriminatory way. Thus, such obligations were part
of the license conditions for new entrants into fixed-network telephony and transport
in several countries. Recourse to fiscal instruments, however, has proved more
successful than direct regulation. For instance, in Chile government subsidies
equivalent to less than 0.5 percent of total telecommunications revenue, allocated
through competitive bidding in 1995, mobilized 20 times that amount of private
investment for extending basic telephone services to rural areas.
A third method is to fund the consumer rather than the provider.
Governments have experimented with various forms of vouchers in such areas as
education and energy services. This last instrument has at least three advantages: it
can be targeted more directly at those who need the service and cannot afford it; it
avoids the distortions that arise from pricing services artificially low to ensure
access; and it does not discriminate among providers.
Consequently, the reasons for government intervention through the
regulatory mechanism is the attempt to correct market imperfections caused by
negative effects of unregulated competition or by inadequate access to information
of consumers.
However, while a market failure problem might be apparent, it is not necessarily the
case that government intervention in the market is appropriate. This depends on a
ranking of the instruments available and an assessment of the costs and benefits of
their application.
In many cases, market mechanisms will emerge or market processes will develop to
solve the problem (eg eventually entry occurs to solve a market power problem or
new ways of providing information to consumers are developed). Simply proposing
to do something about market failures can invite a rent-seeking response from
incumbents already in the market, thereby making intervention more likely, and
increasing the risk of regulatory capture and even worse outcomes occurring.
Therefore, in considering the choice and design of regulatory instruments, it is
important to retain the option of leaving the problem to the market to resolve.
Theories of regulation
Much of the case for regulation is based on reducing the ill effects of unrestricted
competition in the provision of services when buyers are misinformed.
There are two major theories of regulation:
1. public interest theory promoted by Stigler regulations serve the public
interest
2. captured interest theory promoted by Peltzman regulations are applied in
the interest of private groups that are capturing the regulatory process.
1. The public interest theory of regulation sees the existence of ill effects as a
justification for regulation. The public interest case for service sector regulation is to
solve market failure problems.

But service providers are also likely to see ways in which they can benefit from the
regulation of purely competitive services they are likely to prefer the higher
incomes that result from the control of entry into their occupation, or from
restrictions on competition between those who are admitted to it.
Once regulators are given powers to avoid the outcome of unrestricted competition,
conflict is likely to arise over how those powers will be used.
Regulatory powers can be used as easily to achieve anti-competitive goals of the
providers of a service as to protect buyers of the service from lazy or predatory
providers.
In this conflict, service providers have several clear advantages:
- they are likely to be better able to assess the effects of regulatory actions
than users
- they will usually be fewer in number than users
- they will have a greater interest in the conditions of their occupation.
It will thus be easier for them to organize themselves and press for the adoption of
their views by regulators or by the government.
Since effective regulation of an industry is likely to require a detailed knowledge of
that industry, such knowledge will be often found only among practitioners or
potential practitioners. Regulators therefore may have an inherent sympathy with
the views of those they are ostensibly regulating. These insights form the basis for
the so called capture theory of regulation.
The public interest theory of regulation points to possible defects in the
outcome of unrestricted competition in the provision of services and
concludes that the situation will be improved by giving powers to regulate
competition to knowledgeable persons who will act in the public interest.
2. In contrast, the capture theory of regulation questions the ready
availability of knowledgeable persons who will act in the public interest.
Those who promote the capture theory believe that the members of a regulated
industry will often succeed in diverting the powers of regulators to their own
purposes.
Hence, the capture theory suggests that regulation will often be good for the profits
of providers of a service, but bad for users of that service. Users, in fact, might be
better off with no regulation at all, than to have the provision of the service
controlled by captured regulators.
The capture theory of regulation also applies to regulatory powers designed to
control the activities of private operators of a natural monopoly. It cannot
legitimately be assumed, without knowledge of the motivations, and incentives of
regulators, that they will automatically act in the public interest.
Services can, thus, also be regulated in the interest of private interest groups
that exercise pressure over regulatory bodies, having as outcome:
- forced introduction of regulation where it is not the case
- adoption of less efficient regulatory instruments
It is important to stress that regulation introduced in favor of private interest groups
may be more costly and more limitative than the optimal ones asymmetric
information, or, on the contrary, less restrictive and costly the case of negative
externalities

In short, while it cannot successfully be argued that economic efficiency

always requires a complete absence of regulation, whenever regulation is
judged necessary, a major concern must be to ensure that regulatory
powers are not captured by the existing providers of a service and used to
further their interests.
Types of regulation
There are four broad types or tiers of regulation:
1. Primary legislation - comprises Acts of parliaments.
While they can contain highly specific provisions, they are often expressed in quite
general terms, setting down overall guidelines as to what the legislation is intended
to do and delegating the implementation detail to the second tier delegated
legislation.
2. Delegated legislation can take many forms.
The first two, statutory rules and disallowable instruments, are subject to limited
parliamentary scrutiny, but considerably less so than for primary legislation.
The other element of delegated legislation, non-disallowable instruments, is the
responsibility of Ministers, relevant boards and officials.
3. The third tier is referred to as quasi-regulation.
It covers those rules or arrangements where governments influence people to
comply, but which do not form part of explicit government regulation. Note, that
each of the three elements of quasi-regulation may be embedded in primary or
delegated legislation, thereby transforming them into explicit government
regulation.
4. The fourth tier is about how regulatory officials actually implement the
regulation.
Surveys of businesses often point to general acceptance of regulations, but highlight
concerns about the difficulties with the way they are administered and with the
associated compliance costs.
These tiers of regulation highlight three points pertinent to achieving good quality
regulation:
the lower one goes down through the regulatory tiers, the fewer parliamentary
and other quality control mechanisms there are;
if more quality control is applied at the higher tiers, there will be pressure to shift
more and more of the regulatory function to lower tiers; and
the magnitude of economic impact does not necessarily diminish at lower tiers;
indeed, administrative or quasi-regulatory arrangements may have substantially
more economic impact than primary legislation.
What forms should government action take?
There is a variety of factors relevant to deciding what form of action government
should take to address a problem:
the extent of risk;
the severity of the problem;
the nature of the industry concerned; and
the need for flexibility or certainty in any regulatory arrangement.

Relatively light-handed regulation, such as industry agreed codes of practice, is

likely to have fairly low economic costs, as they do not change the fundamentals of
how an industry operates.
In contrast, heavy-handed regulation, such as restricting entry to markets, may
substantially alter the structure and operation of an industry, and is likely to incur
relatively large economic costs. It is an important principle, therefore, that
regulation should be the minimum necessary to achieve the stated objectives.
In general:
matters where the potential damage is minimal might best be left to the market
or industry itself to correct;
matters with moderate probability and/or moderate impact may best be handled
by a relatively light-handed regulatory approach; and
matters with high probability and/or high impacts may warrant highly
interventionist regulation.
The following figure illustrates tradeoffs between risks and impacts and what form of
government action might be appropriate.

For example, the probability of a mid-air collision between two aircraft might be very
low, but, should it eventuate, the consequences are likely to be great. Such a matter
is likely to justify explicit government regulation.
In contrast, the risk of someone being overcharged for a supermarket item may
have a moderate probability, but the impact is quite low the diagram suggests
such an event should be left to the industry and not be addressed by government
regulation.
As is particularly relevant to the provision of many services, recent rapid
developments in electronic commerce and related technological advances add
another dimension to the relationships illustrated above. Government regulation is
inherently slow to be developed and subsequently to be changed, and typically is
inflexible. As a general rule, therefore, explicit government regulation is likely to be
less effective in sectors experiencing rapid rates of technological development or
other changes.

Paradoxically, the uncertainty associated with such rapid change may result in
strident demands for more regulation. For example, rapid growth in many different
forms of electronic transactions has raised demands for governments to regulate for
protection of the privacy of information on individuals.

The box above sets out nine different forms that a government response to a
problem might take, ranging from no action all the way to explicit government
regulation.
There are many potential intermediate steps.
The first three are non-regulatory. The fourth is industry self-regulation. Items five
and six cover industry codes of practice or standards and are typical examples of
quasi-regulation. Moving further along the regulatory spectrum are government
guidelines (item seven). Finally, items eight and nine are explicit government
regulation.
Choosing from the regulatory spectrum
From an economic perspective, some forms of self-regulation may be an inferior
option to explicit government regulation. For example, if a group of service
providers, such as migration agents or medical specialists, were to self-regulate in
order to provide clients with assurance of a good quality service, there may be a
temptation for them to set standards which effectively exclude potential new
entrants to the industry.
Another more general example is that small businesses typically prefer the certainty
of explicit government regulation, rather than the higher transaction costs often
associated with other forms of regulation.
Further, the last category black letter law has a wide range of different
regulatory forms, some of which are much more interventionist than others, and
thus more likely to be relatively costly.
At the lighter end of this group may be taxes, fees and fines, business registrations
etc. At the heavy-handed end would be prohibitions on any particular business
activity, barriers to entry into certain industries, price controls and other operational
restrictions on business, all of which constitute restrictions on competition.
A related consideration, which applies right across the regulatory spectrum, is the
distinction between prescriptive (command and control) regulation and

performance/outcome-oriented regulation. Performance-based regulation is widely

seen as appropriate for building flexibility into regulation and for encouraging
innovation. By focusing on the outcomes required, rather than prescribing the
precise means of achieving those outcomes, this approach gives business the
opportunity to achieve regulatory objectives in ways that suit their needs and
minimize compliance costs.
Clearly, the process of choosing the best form of action or regulation to address a
particular problem is not straightforward. There are, still, some general guidelines:
Self regulation should be considered where:
there is no strong public interest concern, in particular, no major public health and
safety concern;
the problem is a low risk event of low impact/significance; and
the market can fix the problem itself for example, there may be an incentive
for individuals and groups to develop and comply with self-regulatory arrangements
(eg for industry survival or market advantage).
The likelihood of self-regulatory industry schemes being successful is increased if:
there is adequate coverage of the industry concerned;
there is a viable industry association;
there is a cohesive industry with like minded/motivated participants committed to
achieving the goals; and
there is evidence that voluntary participation can work effective sanctions and
incentives can be applied with limited scope for the benefits to be shared by nonparticipants.
Quasi-regulation should be considered where:
there is a public interest in some government involvement in regulatory
arrangements and the issue is unlikely to be addressed by self-regulation;
government is not convinced of the need to develop or mandate a code for the
whole industry;
there are cost advantages from flexible, tailor-made solutions and less formal
mechanisms, such as access to speedy, low cost complaints handling and redress
mechanisms; and
there are advantages in the government engaging in a collaborative approach
with industry and industry having substantial ownership of the scheme.
Explicit government regulation should be considered where:
the problem is a high risk event of high impact/significance (eg a major public
health and safety issue);
the government requires the certainty provided by legal sanctions;
universal application is required;
there is a systemic compliance problem with a history of intractable disputes and
repeated or flagrant breaches of fair trading principles and no possibility of effective
sanctions being applied; and
existing industry bodies lack adequate coverage of industry participants, are
inadequately resourced or do not have a strong regulatory commitment.

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All these guidelines should be complementary to a formal testing of the

effectiveness and the likely costs and benefits of the different regulatory options.

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