electricity). By setting the compensations for quality change at the social value of this change, the regulator internalises the trade-off between cost and quality of the service provision. This is possible as long as quality is contractible. However, the situation is more complex if quality is non-contractible. Laffont and Tirole (1991) analyse a regulation model with non-contractible quality. They distinguish between the case of a ‘search good’, in which quality can be observable to consumers so that their demand for a good to quality changes, and the case of an ‘experience good’, which quality can be observed only after buying the good. It appears that the search-good case is close to the situation with contractible quality. There high powered incentive schemes can be designed in such a way that prevents a detrimental effect on quality, while this is not the case for an experience good. In addition to information asymmetry between the firm and the regulator, there are other factors that can limit the effectiveness of regulation. Short time horizons constitute a source for government failure. Some economists claim that politicians have a time horizon as short as the next elections (e.g. Wolf, 1978). Although this extreme stance is debated by other economists, some agreement and empirical evidence on the existence of political business cycles exists (e.g. Reid, 1998; Price, 1997). Another problem with government officials regulating industries is that of regulatory capture. These officials may be influenced (ranging from bribed to misinformed) by the industry in order to have them make decisions that are favourable to the industry. See Chapter 11 in Laffont and Tirole (1993) for an extensive overview of the literature, as well as a formal game theoretic model.
30 4.4 Internalization of external costs The government in our villages has several options to combat external effects. Pricing, the obvious solution in the eyes of an economist, is treated further on. Let us first return to the example of the farmer experiencing inconvenience from the road passing his farm (see section 0). 10 Government may force road owners to build noise walls and a pedestrian bridge near his farm, or it may restrict capacity expansion near the farm, more or less forcing them to create a bypass when capacity expansion is required. Instruments to internalise external costs Environmental and safety norms can affect the design and location of the roads. For example, norms on noise, how far the road should be from the residential houses, safety norms and so on. Such norms may are likely to lower the private efficiency of the road owner and increase costs. This is likely because the road owner would have chosen the private optimum if left unrestricted. Any change imposed by rules is therefore a deviation from this optimum, but can improve total welfare, as long as the decrease in external costs outweighs the decrease in the road owner’s benefits (Lijesen et al., 2006)
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