It is widely accepted that countries’ institutions play a major role in their economic development. Yet, the way they affect, and are affected by, development, and how to reform them are still poorly understood. In this companion volume, State and Business in Tanzania diagnoses the main weaknesses, root causes, and developmental consequences of Tanzania’s institutions, and shows that the uncertainty surrounding its development paths and its difficulty in truly ‘taking off’ are related to institutional challenges. Based on a thorough account of the economic, social, and political development of the country, this diagnostic offers evidence on the quality of its institutions and a detailed analysis of critical institution- and development-sensitive areas among which state-business relations rank high, even though the institutional features of land management, civil service and the power sector are shown to be also of prime importance. This title is also available as Open Access.

Modern regulation theory is anchored into two canonical models of regulation under the benchmark case of full information. Baron– Myerson (1982) is useful to analyse the optimal regulation of efficiently run private monopolies for which maximization of profit, and therefore cost control, is paramount, while Laffont– Tirole (1986) is useful to design the regulation of any type of monopoly for which institutional or management characteristics are just as important as technological ones. This typically includes SOEs in addition to private enterprises, since SOEs tend to be much more subject to political interference than their private alternatives. To alleviate this problem, many governments have created separate regulatory agencies but political interference largely persists. Optimal regulation also needs to consider the constraints on the fiscal capacity of the sector. In countries with highly distorted tax systems, user fees may impose lower costs on society than subsidies. Combined with the need to recognize that without subsidies monopolies have to enjoy financial autonomy to be able to cover their costs and deliver the services, it leads to an upgraded Lerner index formula: Ramsey pricing. The optimal price level, when costs can be observed, depends on the elasticity of demand and on the opportunity cost of public funds.

Underinvestment, overinvestment or mistargeted investment are common across sectors at all development stages. They penalize the poorest when it slows down increase in access rates, all users when it leads to congestion, environmental impacts or low quality, and taxpayers as their costs are passed on to final prices or subsidies. These failures are due to poorly designed processes, corruption and capture of politicians or civil servants, and collusion between service providers. Regulation is often part of the problem because cost-plus/rate-of-return regulation tends to stimulate overinvestment, price/revenue cap regulation tends to result in underinvestment, regulated firms can underinvest to exclude potential entrants, regulatory designs omitting to include service obligations and/or access rules lessen incentives to invest, and some regulatory commitments are unrealistic or non-credible. Regulatory failures and uncertainties increase the risk premia built into the financing cost of investment, contributing to further investment mismatch. Regulation can be part of the solution with the adoption of hybrid price regulation approaches and well-designed access prices and rules.

Regulated services represent between 14% and 26% of households’ expenditures in all economies and are costly to operate and maintain. They demand heavy investments for extensive periods of time. Funding them is a challenge: investment needs in infrastructure average 1– 2% of GDP, and 4– 8% of GDP in developing economies. The technological characteristics of these services justify their production by monopolies or quasi-monopolies. Moreover, their demand being inelastic, there is a risk of abuse of market power, which drives the original case for the regulation of the price of these services. When setting them, the regulator needs to address multiple goals: financial or fiscal viability, efficiency, equity, institutional viability and political viability. It implies trade-offs, which reflects the fact that regulation is not only an economic decision but also a political one. It needs to account for the specific institutional context in which the decision is taken. For many of the key decisions, economic theory provides useful guidelines, but in some dimensions, theory still has some way to go to become fully operational in the practice of regulation. This book aims to bridge part of this gap.

Understanding the details of the way public service providers get their market power and use is essential to the design of regulatory supervision. The Lerner index is one of the most basic indicators available to assess the risks of abuses from market power. It measures the percentage of extra profit the firm can earn per unit sold on top of the marginal cost. A laissez-faire monopoly chooses its price to equate this Lerner index to the inverse of demand elasticity. When demand is inelastic, the firm can raise its price without cutting into sales. Prices’ regulation aims to alleviate this problem of rent extraction. But all financially viable pricing strategies delivering financial viability create deadweight losses as compared to marginal cost pricing. The only way in which marginal cost pricing and the financial sustainability of the operator can be reconciled is through subsidies. To compensate for the lack of competition in the market, regulators have tried to introduce competition for the market, but implementation failures have resulted in high prices and low quality. Welfare losses of regulatory failures in the public utilities sector range from 1% to 1.5% of GDP.

The average price is essentially set to ensure a fair rate of return to the regulated firm, but it is also the weighted average of the various prices faced by the various types of users. Which specific prices and which specific weight the average price reflects depends on the forms of price discrimination and price differentiation adopted by the firm. Full price discrimination is unrealistic under current consumption measurement technologies and political constraints. Most firms providing public services rely on second- and third-degree price discrimination or some combination of the two. From a regulated firm’s perspective, price discrimination is an effective way of maximizing its share of the surplus produced by its activities. From a social welfare perspective, price discrimination can have both positive and negative effects as it can improve or worsen both efficiency and equity: the net effect depends on the specific market analysed and the specific form of price discrimination adopted by the firm. Rapid improvements in the technologies available to measure consumption such as smart meters imply that firms can implement increasingly precise forms of price discrimination.

Institutional weaknesses can be attributed to limited human and/or financial capacity, limited accountability, limited commitment and limited fiscal capacity. Ignoring institutional limitations increases the odds of inefficient regulation, undesirable social side effects and excessive fiscal burdens. To address some of the limitations, most countries have created specialized separate regulatory agencies (SRA). The SRA model has been less popular for water and transport regulation, which continues to be largely managed by units within ministries or agencies directly controlled by the ministries, than for telecoms and electricity. Countries with overlapping and interconnected network facilities are increasingly considering moving part of the regulatory responsibilities to supranational agencies. In contrast to the theoretical predictions, the empirical evidence on the effectiveness of SRAs in terms of efficiency, equity, financial/fiscal viability and accountability is mixed. There is no single perfect institutional solution that applies to all sectors and all countries. The existence of an agency is neither a necessary nor a sufficient condition for performance improvements of a public utility. Hybrid models that combine traditional visions with more modern approaches, which include a role for civil society and for expert panels, can be better to match the local country context.

The ability to appreciate and account for the magnitude and complexity of the interactions of efficiency and viability, on the one hand, and social concerns (including equity), on the other, continues to be a major regulatory challenges. One of the keys to effective targeting is to distinguish between lack of access and lack of affordability. For both challenges, regulators can rely on large menu of pricing, direct and cross-subsidies, technological or quality options or service obligations to reduce or eliminate the undesirable social biases. The optimal choice depends on the local preference, on the local fiscal capacity and on the implementation capacity of the regulators. And this requires a specific institutional diagnostic. Regulators should pay more attention to the costly default options often found in menus of service levels, and push for these to be reset so as to maximize the odds of helping those who need it most. To ensure that regulation delivers on the social goals to be addressed, regulators must make the most of the growing volume of data available and use it with more rigour to refine the social targeting efforts.

The environmental concern and its social side effects will be at the core of regulatory authorities’ agenda on top of short-term efficiency objectives in the foreseeable future. The steady growth of ‘big data’, of digitalization and of the new data-processing technologies will change the way firms and governments use and share information in the design, compliance and enforcement of regulation. The institutional environment of regulation will need to evolve to correct institutional mistakes of the past and to internalize the impact of the data revolution on the distribution of regulatory mandates across agencies and across sectors within countries and across countries. Non-traditional financial actors will press regulators to internalize more systematically financial markets’ concerns in the design of regulation in exchange for their willingness to help close the financing gap of many regulated industries. Keeping the right balance between the return-on-investment objectives of non-traditional financial actors, investment targets, users’ needs and taxpayers’ benefit is a challenge for the regulators of the future. Tools emerging from applied research in behavioural economics will offer new alternative regulatory tools to improve the effectiveness and targeting of regulation.

Regulated industries increasingly look like multi-product monopolies or oligopolies, which necessitates adaptations in the design of regulation. An oligopolistic market structure will be preferred if it allows information rents to be cut and shared and if these gains offset lost scale economies. Rent cuts come from sampling effects, yardstick competition and complementarity effects. In mixed oligopolies, differences in the objectives and constraints of public and private competitors make the regulation tasks more complex and limit the possibility of implementing yardstick competition. If the costs are relatively well known (standardized technologies), a monopoly may be a better choice as there is no variance in production costs and so dual sourcing is inefficient. Otherwise, when the firms’ costs are correlated, a duopoly leads to lower marginal costs despite the need to duplicate the R&D costs. In mixed oligopolies, regulation must be adapted to the differences in the objectives and institutional constraints of private and public operators. In oligopolistic industries, self-regulation and regulation by contract offer alternatives to regulation by a specialized regulatory agency. For a multi-product monopolist, the regulatory challenge is to decide whether to set a rate of return for each product sold by the regulated firm or for its overall business.

The optimal form of regulation of the average price depends on the relative importance of the various sources of information asymmetry influencing the cost levels. Theory provides two main insights that hold, irrespective of the main source of distortion. The first is that the average regulated price needs to include a temporary payment to cover the price the regulator must pay to get the missing information and this price should be seen as an additional cost. The second is that the regulators should set up a menu of desirable contracts and allow the firms to self-select the contract type that best matches their capacity and risk-taking preferences; good firms (low costs) tend to prefer fixed-price contracts and bad firms (high costs) tend to prefer cost-plus. There are three main approaches to set the average price in practice: cost-plus, price caps and hybrids. Various forms of performance benchmarking can be useful complements to close the informational gap on costs and to shame poor performance (sunshine regulation). In practice, most countries are evolving towards hybrid forms of regulation emphasizing the need to account for the multiplicity of regulatory goals and informational constraints.

Finance theory and practice drive the translation of the theoretical approaches to regulation into operational guidelines. The guidelines define a financial model to assess the net present value of all allowed costs and demand-related variables and the resulting allowed rate of return. The cost component accounts for the expenditures needed to meet all services, investments and quality obligations, net of any possible subsidies. Costs can be assessed at either their observed or their efficient level depending on the regulatory guidelines adopted.The demand forecast is typically based on long-term needs to be able to identify the investment requirements of the sector.The discount rate used to assess the net present value of costs and revenue is the cost of capital allowed by the regulator.The cost of capital is estimated as a weighted average cost of capital (WACC) of equity and of debt, with the weights reflecting the relative importance of the two sources of financing. This cost of capital is used to set the upper bound for the allowed rate of return. The average price for the regulated service should be set to ensure that the allowed rate of return is consistent with the allowed cost of capital.