Property rights and economic regulation

For organizations of supply, economic or rate regulation replaces market pricing. Often economic regulation is imposed under conditions of mar- ket failure where competition is absent or creates inefficiencies, such as in situations of natural monopoly brought about by significant real or pecu- niary economies of scale. This has occurred in certain circumstances for electricity generation and telecommunications, for example. Whether or not regulators are ‘captured,’ they are subject to cost and revenue data supplied primarily by the regulated organization(s). Thus, there is clearly asymmetric information in the regulatory process. In addition, the prop- erty rights structure inherent in the regulatory process, whereby regula- tors cannot legally appropriate returns from regulatory outcomes or monitoring, enhances the economic property rights of the regulated organization’s decision maker. This, coupled with the economic property rights of the organization’s decision maker, affects the efficiency of regu- latory policy.

1. Economic regulation in for-profit firms

There are many forms that economic regulation may take. To illustrate the effect of property rights on the outcome of regulation, I consider rate-of-return regulation, where the price charged is based on an allowed rate of return on the firm’s invested capital. In the neoclassical model of the firm, the firm responds to economic regulation as a revenue or profit constraint. Whether regulators are ‘captured’ or because they seek to avoid the costs of excessive and frequent rate reviews, there is a predicted tendency for the allowed rate of return to be set higher than the true cost of capital. Therefore, in a profit-maximizing firm, one of the predicted results of rate-of-return regulation is overinvestment in capital relative to other inputs, the well known Averch–Johnson, or A–J effect (Averch and Johnson, 1962). The implication of this form of regulation is inefficient production at a higher than minimum cost with an inefficient input mix in the form of a higher than optimal capital–labor ratio.

In the managerial model of the firm, profit maximization is the objec- tive of the shareholders but not the decision maker, who  maximizes utility. Separation of ownership and control in a large regulated corpo- ration creates a property rights structure that permits the decision maker to expropriate some of the shareholders’ returns to instead increase managerial utility. How might this affect the outcome of rate-of-return regulation? Managerial utility is derived from prestige, authority, and income which are articulated through discretionary profit, staff and other amenities. As shown in Chapter 5, discretionary profit may be increased by increasing actual profit (wA) above profit reported to shareholders (wR). Regulation is designed to allow a normal profit, which is the expected profit that would be reported to shareholders. The A–J capital bias results from the rate of return being set higher than the true opportunity cost of capital. An additional capital bias could result from managerial oppor- tunism as a way to increase the actual rate of return (profit) and therefore increase managerial discretionary profit. In this case the predicted results of the managerial model and the neoclassical model would be the same: above minimum production cost and  an  inefficient  input  mix  in  the form of a higher than optimal capital–labor ratio.

The utility maximizing manager of the regulated firm also has a preference for staff, however, which has a direct positive effect on man- agerial utility. Increased capital has a relatively smaller effect on managerial satisfaction for two reasons. First, increased capital only indi- rectly increases managerial utility through its effect on discretionary profit. Second, although increasing capital increases revenue through a higher allowed rate of return, it also increases costs. The increase in costs results from the A–J effect, where the manager overinvests in capital because the higher allowed rate of return causes the manager to perceive the cost of capital to be lower than its true cost. Its true cost, being higher than the manager perceives, lowers the firm’s actual profitability (wA) and therefore also the discretionary profit available to the manager. Utility maximizing behavior on the part of the manager predicts a greater bias in favor of staff relative to capital. Thus, the managerial model predicts a smaller A–J effect of regulation than would occur in the neoclassical firm.

The outcome of regulation is still inefficient,  for  cost  is  still  higher than the minimum level. The input mix may or may not be inefficient, however. If the managerial bias toward staff offsets the A–J type capital bias from the regulatory process, then  the  input  mix  will  be  efficient and the same as if there were no regulation. In this case there is both too much staff and too much capital,  so  cost  is  above  minimum,  but their proportionate increase keeps the capital–labor ratio at the efficient pre-regulation level. If the managerial bias toward staff is significantly greater than the capital bias  from  regulation,  then  the  input  mix  will not be efficient. The resulting capital–labor ratio will be too low, as it would be in the unregulated managerial model.

In any case, regulation reduces efficiency. The property rights struc-tures facing both the regulated firms and the regulators provide no clear incentives for either party to reduce costs. The inefficiencies in the out-comes differ in terms of the level of cost and the input mix predicted by the managerial model as compared to those predicted by the neoclassi- cal model.

In addition, the monitoring role of shareholders who hold legal prop- erty rights is mitigated by the regulatory process and its equity (fairness) objective. This objective requires that rates must be equitable to share- holders as well as to consumers. Rates set at a low level may appear to be equitable to consumers, but if costs are not covered, these rates will not be equitable to the firm’s shareholders who must earn a normal profit. Such a situation could result in a selloff of shares that endangers the viability of the firm and, ultimately, consumer access to the service. Costs must be covered by the regulated price. The decision maker for the regulated firm is in the position of determining costs with some dis- cretionary ability. The implication of this is that the regulatory process promotes managerial opportunism, that is, utility-maximizing behavior rather than profit-maximizing behavior. In situations of real natural monopoly it is therefore more difficult for regulators to assess the true value of costs and thus monitor this behavior.

Economic regulation also is imposed at times on working competitive markets, ostensibly for distributional purposes although in some cases for the purpose of correcting a perceived (but not real) market failure. This has taken place in markets for natural gas, housing, labor, agricul- tural commodities, and hospital and health services, for example, as well as those parts of the electricity generation and telecommunications industries that have become more competitive due to technological innovations. In the natural gas and housing markets regulated prices have been set low to correct perceived market failures and to promote consumer access. Given legal and economic property rights of suppliers, however, the impact of these low regulated prices was to create short- ages in both the short run when production became less profitable and in the long run as investment in natural gas wells and housing fell through lack of maintenance and abandonment. In labor and agricul- tural markets, high floor prices create surpluses as fewer buyers partici- pate and more suppliers are attracted by the higher regulated prices.

2. Economic regulation in nonprofit organizations

Some markets where economic regulation is applied are either mixed, including both for-profit and nonprofit organizations, or consist essentially of only nonprofit organizations. One such industry is the hospital and health care services industry. I discuss regulation in this industry below.

In the neoclassical model of a nonprofit organization that assumes pure revenue maximization, rate or price regulation has the likely effect of constraining revenue below the maximum possible. The A–J capital bias effect would occur if the nonprofit was subject to a breakeven con- straint. The effect of rate-of-return regulation on a revenue maximizing nonprofit organization would be to either reduce nonprofit output or to keep its output unchanged, depending on its initial situation.

If the nonprofit were  producing  the  revenue  maximizing  output  in the pre-regulation period, and cost were below revenue, then output would likely fall. Rates would be regulated so that revenue  would  be lower and equal to cost. This would occur at  a  lower  level  of  output along the cost function. If the nonprofit had been breaking even at its revenue maximizing output, the A–J effect  would  be  more  likely  to occur. The nonprofit, being cost constrained,  would  invest  in  more  of the input that is perceived to be relatively cheaper (that is, capital) as a way to continue to break even.

In the neoclassical model of a nonprofit that assumes output maxi- mization, the nonprofit will produce at its breakeven point. The A–J effect would be predicted under rate-of-return regulation in this type of nonprofit. In the nonprofit property rights system associated with the nondistribution constraint, all residual is allocated to the production of services. Under regulation, the nonprofit manager perceives the cost of capital to be lower than its true cost. The regulation encourages a capi- tal bias by the nonprofit that seeks to lower its costs so that its breakeven point occurs at a higher level of output. The outcome is per- verse, for the nonprofit manager, attempting to minimize costs, incurs actual costs that are higher than the minimum level. In addition, the nonprofit operates with an inefficient input mix in the form of a capital– labor ratio that is too high. The output maximizing nonprofit is less efficient under rate-of-return regulation than it would be in the absence of regulation.

In a managerial model of a nonprofit, the investors (donors and grantors) seek to maximize their pecuniary and/or nonpecuniary return from services provided by the nonprofit. The manager maximizes util- ity, derived from prestige and social standing, obtained typically from staff size, discretionary profit, income, and quality of services provided to the community. Both investors and the manager have a preference for quality in the managerial model. Donors and grantors benefit from having provided funds to an organization that provides services recog- nized for their quality, and the manager is granted greater prestige from his or her responsibility for having quality services provided. Increased quality can be obtained through a larger staff or a higher quality staff, or in some cases (such as research institutions and hospitals), through the use of more sophisticated capital equipment. Both investors and the manager would have some preference for output as well, as a larger number of services provided increases the size of the nonprofit and its community profile.

Rate-of-return regulation would be applied to those nonprofits that charge a fee for at least some of their services, such as hospitals and nurs- ing homes. The regulation of fees would affect revenue and, accordingly, managerial discretionary profit, which would reduce managerial utility, other things equal. The utility maximizing manager could respond to this additional constraint in a number of ways. One is to seek additional donations and grants to make up for revenue lost as a result of the regulatory constraint on fees. This would require a closer alignment of preferences of the manager to nonprofit investors. If the manager emphasizes quality of service, an A–J capital bias effect could occur if greater investment in capital equipment would be a means to increasing quality. Alternatively, increased quality could be achieved through either larger staff or more specialized staff, which would result in less or no A–J capital bias effect.

An alternative response by nonprofit managers faced with a rate of return regulation that reduces revenue is to minimize cost in order to either expand output or to increase discretionary profit. This would be more likely if the regulated fee took into  account  additional  revenues that would be obtained from donations and grants. In this case, the reg- ulation again encourages a capital bias, this time because the nonprofit manager seeks to reduce nonprofit costs so that either its  breakeven point occurs at a higher level of output or there is greater discretionary profit available. As before, the outcome is perverse, for the nonprofit manager, attempting to minimize costs, incurs actual costs that are higher than the minimum level. In addition, the  nonprofit  again  oper- ates with an inefficient input mix in the  form  of  a  capital–labor  ratio that is too high. The output maximizing nonprofit is less efficient under rate-of-return regulation than it would be in the absence of regulation. In the US, economic regulation  of  fee-based  nonprofits,  such  as hospitals, is rare even at the state level. An exception is the state of Maryland, which has a unique hospital rate regulation system that has been in place since 1974. The Maryland system is based on a federal government waiver from Medicare that permits Maryland’s Health Services Cost Review Commission (HSCRC) to set rates for all payers regardless of insurance status. A feature of the HSCRC rate system is that it provides for coverage of services provided to those who cannot pay, known as uncompensated care (Health Services Cost Review Commission, 2003). Therefore there are no public hospitals in Maryland; all but one hospital is nonprofit (The Association of Maryland Hospitals and Health Systems, 2002). The rates are designed to ensure consumer access and a rate of return sufficient to cover patient (variable) costs and allow for investment (fixed costs) by hospitals.

HSCRC’s regulatory system includes regular reviews of each hospital’s costs and budget. Thus the regulatory system adds a layer of monitor- ing that imposes accountability on managers and therefore limits man- agerial discretionary ability and the economic property rights of the hospital decision maker. The Maryland revised regulated rate system is based on the number of patients treated rather than on invested capi- tal, either through its Charge per Case (CPC) Targeting System or Total Patient Revenue (TPR). The rates depend on the nature of the cases treated, that is, the case mix; more complicated cases are allowed higher costs. Revenue can be increased through either more cases (increased output) or through altering the case mix to include more complicated cases (increased quality) (Maryland Hospital Association, 1994 and Health Services Cost Review Commission, 2003). Increasing revenue through more cases or admissions is consistent with either the neoclas- sical or the managerial model of a nonprofit hospital. Increasing rev- enue by altering the case mix to include more complicated cases is consistent with the managerial model because this practice is likely to increase the prestige of the institution and the manager.

3. Implications of property rights for economic regulation

Economic regulation, by setting prices directly, effectively  alters  the rights structure facing the decision maker. Under conditions of natural monopoly and in some competitive market situations, economic regu- lation limits the return to shareholders. In situations of other types of market failure, such as imperfect information of suppliers, economic regulation may correct this problem by increasing the returns to share- holders. Under natural monopoly or situations of other types of market failure this increases efficiency while under conditions of working (that is, effective) competitive markets regulation reduces efficiency.

In any case, if the regulatory policy allows costs to be covered by the regulated price and true costs are not known to the regulators, then this policy expands economic rights of the decision maker and  thus  pro- motes  managerial  discretionary  behavior  and  related  inefficiency.  If the regulatory policy sets an allowed rate of return that approximates normal (expected) profit based on industry conditions, then this policy limits the economic rights of the decision maker and the corresponding managerial discretionary behavior, increasing efficiency. This latter sys- tem is the policy applied by Maryland’s HSCRC to both nonprofit and for-profit hospitals  where  asymmetric  information  in  conjunction  with a third-party payment system results in market failure.

Source: Carroll Kathleen A. (2004), Property Rights and Managerial Decisions in For-Profit, Nonprofit, and Public Organizations: Comparative Theory and Policy, Palgrave Macmillan; 2004th edition.

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