Regulation is typically used where there is market failure, such as the natural monopolies in energy distribution, or asymmetric market power such as between banks and individual account holders. In these instances, governments try to restore the market by restricting prices or actions. For example, in order to overcome monopolies in the postal sector, the regulator may set the price at a level that would be expected to be seen in perfect competition – price set according to a marginal cost (often calculated using a Long-Run Incremental Cost, or LRIC, model).
The reason for regulation is that there is a high incentive for the regulated industry to act in a harmful way. this causes further problems – there is a high incentive for the regulated industry to try to find ways around the regulation, while not breaching it directly. Regulators are forever playing catch-up by getting rid of loopholes or rewording legislation to prevent companies acting against the spirit of the regulation, if not the letter.
A good example was reported on by The Independent around this time last year. In their report they examine a number of railways where the stations have very few passengers. This has arisen because train operating companies are specifically not allowed to cut services, but the regulations did not prevent them from reducing the frequency of service. In order to reduce costs, trains now serve these stations once a week, and of course this is going to mean that every passenger makes alternative arrangements.
This is a clear example of where regulations have been set up in an overly specific way. A greater use of economist input – to understand what incentives the operating companies would have had, and how these could be mitigated against in a more general sense – may have had better results!