Regulation for Competition: Understanding the Relationship between Law and Economics, Lecture notes of Law

Download Regulation for Competition: Understanding the Relationship between Law and Economics and more Lecture notes Law in PDF only on Docsity! REVISTA DE LA MAESTRÍA EN DERECHO ECONÓMICO 175 PUBLICATION THEORIES OF REGULATION A DIANA FRANCO* ABSTRACT This article examines the relationships between regulation and competition, and thus, between law and economy. As part of this debate, the notion of ‘reflexive law’ is of particular importance. This idea, which is not found within Law and Economics, but which is derived from systems theory, denotes a new form of law that captures the concept that the role of law is to stimulate self-regulation within society rather than prescribing rigid solutions for it. This article shed lights on the need for a broader theoretical category capable of explaining both the law and the economy as well as the prospects for these orders to come into alignment with one another. The potential reconciliation, as this article suggests, lies in seeing both ‘law’ and the ‘market order’ as forms of information and knowledge transmission, with their own distinctive logic. These concepts, already to be found both within systems theory and the Austrian/neoinstitutional economics, must be further articulated so as to create a functional language through which both sets of theories, economic and legal, can converge. * Abogada de la Universidad del Rosario, LL.M. de la universidad de Exeter, M.Phill, y Ph.D. en Derecho de la Universidad de Oxford. Profesora de la Universidad Javeriana y de la Universidad de la Sabana. 176 PUBLICATION THEORIES OF REGULATION INTRODUCTION Since the late 1970s, economic reforms have been undertaken across the world with the purpose of stimulating the development of competition in the provision of utility services which, until then, were the domain of vertically-integrated and state-owned companies. This process, labelled by some as ‘marketisation’, either began as a consequence of privatisation reforms, as for instance, in the UK, or was complemented ex post by privatisation programmes, as in the case of Chile. (DEAKIN and PRATTEN, 1999: 1). These processes of marketisation rest on the apparent paradox that competition can be instituted and articulated via regulation. (ibid.: 1). Hence, as Prosser remarks, [r]egulation does not cease with the end of monopoly … Moreover, market creation also involves creating a substructure of rules and other institutional and normative devices. Some of these are market-constitutive in the sense that we cannot envisage a functioning market without them; others are designed to create the proverbial level playing field, such as the continuing prohibitions of undue preference or undue discrimination by a dominant firm. Regulation thus has an important role in market creation; and it is not merely temporary, for these rules and other pro-competitive norms need continuing policing. (PROSSER, 1999: 197). In utilities, the sources of contemporary regulation are varied, including legislation abolishing entry barriers as well as providing for the vertical and horizontal separation between activities within the chain of supply; price control mechanisms, such as RPI-X rate-of return regulation or a combination of them; and finally, quality control standards. While price controls and quality standards are typically used to mimic competition in the face of activities traditionally operated as natural monopolies, legislation abolishing entry barriers and providing for vertical and horizontal separation are typical examples of a new form of regulation labelled by some as “regulating for competition”1 and by others as a “new type of competition policy or economic law”2 whose task, rather than mimicking competition, is to foster and steer it in such a way as to meet a number of often potentially disparate policy objectives: enhancing efficiency in the allocation of resources at the same time as achieving certain social goals. 1 See PROSSER, 1997; HELM, 1994: 27-28. 2 DEAKIN and PRATTEN, 1999: 2. REVISTA DE LA MAESTRÍA EN DERECHO ECONÓMICO 179 that is, individuals are conceived as self-interest egoists seeking to maximise their utilities. (ibid.: 23). Thirdly, it is assumed that information and resources flow freely in response to price variations. Individuals, then, posses the necessary information to take their utility-maximizing choices. (ibid.: 23). Given these assumptions, under conditions of ‘perfect competition’ (no market failures impeding the transaction), price alone brings about ‘perfect allocative efficiency’, that is, a state of equilibrium in which all potential gains from trade are made. This situation is associated with an example of Pareto optimal allocation of resources, that is, with a distribution which cannot be altered in favour of any one without making any other worse off.4 Allocative efficiency is, then, a necessary and tautological outcome of free exchange under conditions of perfect competition. However, as market failures are capable of obstructing the preconditions of competitive equilibrium required to deliver perfect allocative efficiency, thus causing negative effects on welfare outcomes, the normative public interest theory of regulation justifies state intervention as a means to protect the public interest against the undesirable consequences of markets operating unimpeded5 . The state, as prescribed in welfare economics, in the face of perceived defects in the working of the economic system intervenes to correct the deficiency, that is, enters the scene to restore the lost equilibrium. This, in addition to being seen as a desirable action, is seen as costless, as it is assumed that “a government policy, once decided upon, is correctly and efficiently carried out.” (LITTLECHILD, 1978: 21). In practice, the public interest theory of regulation and the neoclassical mainstream economic ideology played an important role in the nationalisation and regulation processes, including those in the UK and the United States, between the late Nineteenth and the mid Twentieth centuries6. In the view of public interest theory, governmental intervention in utility industries is, then, a desirable response in light of a particular type of market failure, namely, natural or technical monopoly (PIGOU, 1912: 180), which, with more or less emphasis depending on the utility industry in question (water is the natural monopoly par excellence as opposed to telecommunications which among utilities is the industry that admits more competition7 ) and on the specific segment within each industry (natural monopoly 4 For an introduction to the concept of Pareto efficiency, see SLOMAN, 1994, s. 11.1; LAYARD and WALTERS, 1997. 5 This theory is more often assumed that articulated. For representative works see BONBRIGHT, 1961. 6 See FOSTER, 1992: ch. 11; JARELL, 1978: 273-275. 7 See LITTLECHILD, 1983, 1986a. 180 PUBLICATION THEORIES OF REGULATION conditions certainly apply to power transmission but are less obvious in electricity generation and supply8 ), characterise these sectors9. It was once commonplace to argue that under natural monopoly conditions, it is inefficient to have competition, as resources are necessarily wasted if more than one firm engages in production given the extensive scale of economies relative to the size of the market. According to this theory, monopoly should prevail for the sake of efficiency, rather than being remedied by market forces, and should be subjected to utility regulation to protect the public from services being “overpriced and under-produced relative to their true social value” (OGUS, 1994: 30). Typical utility regulatory instruments put in place to attain these purposes included entry controls (i.e. authorisation, concessions, licences) as well as price control mechanisms10 (ie. rate-or-return, sliding scale) and quality service standards. In addition to the condition of natural monopoly, there are other examples of market failures capable of obstructing the preconditions of competitive equilibrium including “… transaction costs (understood in a narrow sense as the costs of negotiating, monitoring and enforcing contracts), barriers to contractual cooperation (such as ‘opportunism’ or self seeking behaviour on the part of contracting parties), and externalities (which arise where various costs and benefits of activities are not fully captured by market prices, with the result that third parties incur losses or gains which are not fully contracted for).” (DEAKIN and PRATTEN, 1999: 4). The modern economic analysis of law is full of examples of legal intervention which, in the presence of these conditions, are considered to enhance economic efficiency. Typical forms of this type of legal intervention include property rights,11 contractual legislation12 , liability rules13 and criminal punishment14. All of these forms of legal intervention exist in parallel to regulation, and are “said to ‘mimic the market’ by allocating rights to the parties who would have acquired them but for the presence of transaction costs” (ibid.: 8 See Department of Energy, 1988. 9 For views that support natural monopoly as a justification for state intervention, see MEADE, 1975. For a critical view, see DEMSETZ, 1968; POSNER, 1969. 10 For an overview of price controls as regulatory instruments, see OGUS, 1994: ch. 14; FOSTER, 1992: ch. 6. 11 See COOTER and ULEN, 2000: Ch. 4, 5. 12 Ibid.: Ch. 6, 7. 13 Ibid.: Ch. 8, 9. 14 Ibid.: Ch. 11, 12. REVISTA DE LA MAESTRÍA EN DERECHO ECONÓMICO 181 4). In other words, law, under the modern analysis of law, is seen to act as a set of implicit prices to which agents respond accordingly. We may, then, emphasise that under the postulates of neoclassical economics, the purpose of law, including regulation, “is to bring about particular states or allocations which can be viewed as superior, in terms of allocative efficiency, to alternative situations in which no legal intervention takes place.” (ibid.: 5). It is in this sense that authors have attributed to law a ‘market-perfecting’ or ‘market completing’ character. (ibid.: 6). Precisely on this basis, authors attribute to regulators the following goal with regard to the implementation of contemporary utility regulation: “… the task of the utility regulators is to apply economic criteria with the goal of increasing efficiency in the sense of Pareto efficiency with its goal of a state of the economy in which no reallocation of resources could make anyone better off without making someone else worse off”15. Both neoclassical mainstream economics and the public interest theory of regulation have been subjected to severe criticisms. While neoclassical economics has been criticised for “increasingly proving embarrassing, mainly because it is unable to analyse phenomena in the real world of incomplete knowledge and uncertainty” (LITTLECHILD, 1978: 9), the regulatory orthodoxy has been contested by arguments that indicate that regulation, in practice, seldom works as a deus ex machina eliminating unfortunate allocative consequences of market failure, but rather that it may even have even engendered more resource misallocation than it cured. (PELTZMAN, 1976: 211). In fact, the emerging argument was that the inefficiencies of ‘market failures’, far from being corrected by regulation, were exacerbated by ‘regulatory failure’. This prompted a search for new theoretical explanations. The answers came in various forms, including the private interest theory of regulation and wider economic perspectives provided by the Austrian school of economics and the neoinstitutional economics or transaction cost economics16. Critically, the neoclassical theory and the public interest theory, useful 15 Prosser attributes this view to FOSTER, 1992: ch. 9. 16 In addition to these theories the validity of the public interest theory of regulation has been contested on other grounds. For instance, it has been claimed that the presence of regulation is not correlated with the presence of market failures, as regulation has been found in industries that can be typically competitive sectors, such as airlines, trucking, taxis, and ocean shipping. (See POSNER, 1974a: 336-337; GRAY, 1942: 280). At the same time, the notion of “technical failure” arguing that the disappointing performance of regulation is a consequence of the weakness of personnel (lack of expertise, adoption of passive or compromising attitudes, reluctance of court to intervene) or procedures (rigidity of legal frameworks, insufficient resources), has been advanced to explain the gap between the professed public interest objectives of regulation and their poor achievement. (See POSNER, 1974a: 336-337; OGUS, 1994: 54-56). 184 PUBLICATION THEORIES OF REGULATION Importantly, capture theory, as originally formulated, predicts that the outcome, regulatory capture, may be economically efficient. As FOSTER explains, “[w]hether the regulator or the legislature received a cut or not, the output and prices of a regulated industry would be virtually the same. The difference would be in the distribution of income between the parties only.” (FOSTER, 1992: 372). It cannot be otherwise, as “all interested parties – the monopoly, the legislators, the regulators, even the consumers – are assumed to be pure examples of economic man.” (ibid.: 372). Under this perspective, it is possible to construct a role for law as an instrument to channel distribution of wealth through the hands of those able to organise themselves and exert pressure on the regulatory function, rather that as a means to correct market failures. Nevertheless, followers of the theory have campaigned for economic deregulation. Allies of this ideology explicitly have opposed restrictions on entry and control over profits under the conviction that the abolition of these regulatory devices increases, even optimises, economic efficiency24. As POSNER puts it, “we might do better to allow natural economic forces to determine business conduct and performance subject only to the constraints of antitrust policy.” (POSNER, 1969: 549). This argument, which necessarily implies that the recognised deficiencies of the market are preferable to the deficiencies of state intervention, has played a central role in the liberalisation, privatisation and re-regulation processes of the last three decades. In this task, the theory of economic regulation, however, was not alone. The theory of public choice coupled with the theory of private property rights contributed to offer support for the beneficial effects of ownership changes from the public to the private sector, and also, from monopoly to competition. While public choice theory served to discredit public ownership by arguing that politicians and managers, rather than maximising economic efficiency, and thus society’s economic welfare, ran public enterprise on the basis of their own personal interests, the theory of property rights emphasised the ‘goods’ of the private over the ‘bads’ of the public by arguing that the concentration of ownership into fewer and private hands served to reduce the principal- 24 See POSNER, 1969, 1975. REVISTA DE LA MAESTRÍA EN DERECHO ECONÓMICO 185 agent problems, which were particularly severe in the management of the public enterprises 25 . 1.1.3. OVERCOMING REGULATORY CAPTURE The private interest theory of regulation, despite offering an explanation for the divergence between the promise and the reality of regulation, has been criticised on the grounds that it does not provide a concluding explanation for the evolution of regulation, or better of deregulation. As FOSTER indicates, “In every industry that was deregulated, almost every regulated firm was opposed to deregulation. Thus, it is implausible that the regulated firms could not have outbid the resources of other interests to avoid deregulation if whether or not deregulation occurred depended on such an auction. They had much more at stake. Yet their undoubted lobbying was ineffective. What then is left of the original prediction? The deregulation of American public utilities that occurred after 1975 seems a genuine counter-example to the theory of regulatory capture – as were the contemporary privatisations in Britain – and as a result falsified the Stigler-Peltzman version of the Chicago theory. (FOSTER, 1992: 384). At the same time, capture theory has been contested on the grounds that it is unable to fully explain the costs which the regulatees have to incur to achieve capture, an element which might well deter regulatory capture26. Equally, this theory along with the public choice approach, has been challenged by theories which argue that they ignore broader desires such as altruism or ideology27. At the same time, the theory has been criticised on the basis that it frames economic regulation within a bilateral relation between public regulators, on the one side, and private regulatees, on the other, a conception that is far from the practice of contemporary regulation. Theories developed within the political science framework propose the ‘regulatory space’ (HANCHER and MORAN, 1989) and the ‘stakeholder’ (SOUTER, 1994) approaches as alternative theoretical models to understand utility regulation. 25 See VICKERS and YARROW, 1988. 26 In particular STIGLER treated these costs as small and negligible. For a critical response to this assumption, see NOLL, 1989: 1258-1259. 27 See FARBER and FRICKEY, 1991; KELMAN, 1988. 186 PUBLICATION THEORIES OF REGULATION Under the ‘regulatory space’ approach the proposition is that regulatory capture falsely betrays the assumption “that ‘private’ influence over the regulatory process is illegitimate.” (HANCHER and MORAN, 1989: 273). This false belief is the consequence of the capture theory assumption that there are two distinct spheres, the private and the public, and that the distinctive interests of the former ought to be controlled by the sovereign authority of the latter. Hence, “evidence that private interests benefit from regulation, or that they exercise a strong influence over the regulatory process, is naturally treated as a sign that the purpose of the activity has been distorted.” (ibid.: 273-274). It is the acceptance of this traditional private-public dichotomy, which in the opinion of HANCHER and MORAN, “obscures perhaps the single most important feature of economic regulation under advanced capitalism: that the most important actors in the process are organizations, and organizations which, regardless of their formal status, have acquired important attributes of public status.” (ibid.: 274). Under the ‘regulatory space’ approach “understanding economic regulation, then, means understanding a process of intermediation and bargaining between large and powerful organisations spanning what are conventionally termed the public and the private domains of decision- making.” (ibid.: 272). Hence, this approach proposes to frame the regulatory process within an analytical construct named ‘regulatory space’, where “[i]ts occupants are involved in an often ferocious struggle for advantage.” (ibid.: 277). Alternatively, stakeholder theory, advocated, in the case of Britain, under the auspices of the leading think-tank, the Institute for Public Policy Research, assumes a pluralistic view of the regulatory function, as opposed to the bilateral conception of capture theory. However unlike the regulatory space approach which is primarily concerned with vindicating the role of firms as active actors of the regulatory process, this approach goes further in viewing regulation as a network of relations involving customers, shareholders, utility managers, market entrants, suppliers, employees, and the government. (SOUTER, 1994: 10). Hence, REVISTA DE LA MAESTRÍA EN DERECHO ECONÓMICO 189 “[n]eoclassical economics finds it appropriate to view the economy as if it were in or near a state of equilibrium. Austrian economics sees the economy as involved in a continual process of discovery, co-ordination and change.” (ibid.: 10). Hence, general welfare is achieved, not via the realisation of allocatively efficient states as put forward by neoclassical thought, but through a process of market discovery based on competition. On this basis, Austrian economists, as a rule, are opposed to normative prescriptions since they are likely to impede the process of economic co-ordination. This happens because, as Austrians emphasise, social institutions, among them markets, are the result of human action rather than of human design. Thus, regulatory failures, in the view of the Austrians, are the result of using law for specific instrumental purposes, when this, in the words of HAYEK, is merely a “sypnotic delusion, that is…the fiction that all the relevant facts are known to some one mind, and that it is possible to construct from this knowledge of the particulars a desirable social order.” (HAYEK, 1973-79: Vol. 1, 14). Hence, as OGUS points out, “the centralized pool of information on which rulers must rely for regulatory measures could never replicate the widely dispersed fragments of knowledge which individuals use in pursuance of their own ends and therefore could never be adequate to anticipate all the variety of circumstances to which specific regulations must be applied.” (OGUS, 1994: 57). Let us examine in more detail the relation between the law and the economy under the work of Professor Friedrich Hayek, the leader of this school of thought. 1.1.4.1. Hayek’s theory of market order The market or catallaxy, in Hayek’s language, is a type of ‘order’ in the sense of being a “state of affairs in which a multiplicity of elements of various kinds are so related to each other that we may learn from our acquaintance with some spatial or temporal part of the whole to form correct expectations concerning the rest, or at least expectations which have a good chance of proving correct.” (HAYEK, 1973-79: vol. 1, 36). 190 PUBLICATION THEORIES OF REGULATION More specifically, the market is a special kind of ‘spontaneous order’, or cosmos, as opposed to a ‘made’ or ‘imposed’ order, taxis. As a spontaneous order, the market is an endogenous order, a self-generating order, whose equilibrium is set from within; it is an order that consists of “a system of abstract relations between elements which are also defined only by abstract properties, and for this reason will not be intuitively perceivable and not recognizable except on the basis of a theory accounting for [its] character.” (ibid.: vol. 1, 39). It is also an order not made by humans, though a product of the action of many agents; not being made, the market order cannot legitimately be said to have a particular purpose. By contrast, taxis is an exogenous order, artificially established, often concrete, in the sense that it can be perceived by inspection, and having been deliberately made, it invariably serves a purpose of the maker29. The distinction between these orders, which coexist in every society, corresponds to the distinction between two types of rules, namely, the rules of conduct, nomos, and the rules of organisation, thesis. While cosmos rests upon nomos, taxis relies upon thesis. Despite cosmos not being deliberately established, it nevertheless rests upon rules of conduct, in the sense that it “is the result of their elements following certain rules in their responses to their immediate environment.” (ibid.: vol. 1, 43). The rules of conduct, also named by HAYEK the “law of liberty” (ibid.: vol. 1, 94), are characterised firstly by being “observed in action without being known to the acting person in articulated (‘verbalized’ or explicit) form.” (ibid.: vol. 1, 19). This happens because the observance of these rules gives the group in which they are practised “superior strength, and not because this effect is known to those who are guided by them.” (ibid.: vol. 1, 19). Secondly, they are purpose-independent. (ibid.: vol. 1, 50, 85). Thirdly, they are applicable to an unknown and indeterminable number of persons and instances whose nature cannot be known in advance. (ibid.: vol. 1, 86). Fourthly, they define “a protected domain of each, [so as to enable] an order of actions to form itself wherein the individuals can make feasible plans.” (ibid.: vol. 1, 86). And finally, it is the prime task of judges to discover and gradually perfect the rules of conduct. (ibid.: vol. 1, 94-100). 29 For detailed description of the features of these two orders, see HAYEK, 1973-79: Vol. 1, 35-48. REVISTA DE LA MAESTRÍA EN DERECHO ECONÓMICO 191 By contrast, the rules of organisation, also described by HAYEK as the “law of legislation” (ibid.: vol. 1, 124) constitute the deliberate making of law by representative assemblies. (ibid.: vol. 1, 72-73). Accordingly, they are “designed to achieve particular ends, to supplement positive orders that something should be done or that particular results should be achieved, and to set up for these purposes the various agencies through which government operates.” (ibid.: vol. 1, 125). The differentiation between rules of conduct and rules of organisation “is closely related to, and sometimes equated with, the distinction between private and public law.” (ibid.: vol. 1, 132). This distinction, which HAYEK explicitly accepts as valid (ibid.: vol. 1, 132), is of fundamental importance given that public law cannot substitute private law as the foundation of a spontaneous order. Nor can they be combined without perverse effects on the spontaneous order. This happens since the rules of just conduct, and thus private law, are not a means to any purpose, but merely a condition for the successful pursuit of a great variety of individual purposes. Private law is a “multi-purpose instrument” (ibid.: vol. 2, 4), “securing [the] conditions in which the individuals and smaller groups will have favourable opportunities of mutually providing for their respective needs.” (ibid.: vol. 2: 2). Since it is only “due to the freedom of choosing the ends of one’s activities that the utilization of the knowledge dispersed through society is achieved” (ibid.: vol. 2, 9), only this type of law, and no other, “serves, or is the necessary condition for, the formation of a spontaneous order of actions ….” (ibid.: vol. 1, 112). Likewise it is private law that can most appropriately support spontaneous order since at the same time as respecting the autonomy and capacity of action of individuals, it prevents conflict and enhances the compatibility of individual’s actions by appropriately delimiting the range of permitted actions towards others, in particular by delimiting protected domains. Precisely this explains Hayek’s definition of the market, as “the special kind of spontaneous order produced by the market through people acting within the rules of the law of property, tort and contract.” (ibid.: vol. 2, 109). 194 PUBLICATION THEORIES OF REGULATION about in a spontaneous process by particular acts of interference can never be just in the sense of satisfying a rule equally applicable to all. Every single act of this kind will give rise to demands by others to be treated on the same principle; and these demands can be satisfied only if all incomes are thus allocated. The current endeavour to rely on a spontaneous order corrected according to principles of justice amounts to an attempt to have the best of two worlds which are mutually incompatible. … (ibid.: vol. 2, 142). It is undesirable because the advantages of competition, in the view of the Austrians, do not depend upon it being perfect. Indeed, “competition is of value precisely because it constitutes a discovery procedure which we would not need if we could predict its results.” (ibid.: vol. 3, 69). Imperfections and disequilibria are inducements to operate in the market. It is precisely the possibility of capturing ‘supra-competitive rents’ or surpluses representing a temporal advantage over others which motivates entrepreneurship, thereby ensuring long-term innovation on technology and organisation31. Hence, ex-post reallocation of resources, as proposed by neoclassical economists, simply blunts incentives for individuals to channel efforts in such a way as to pursue their expectations. Summing up, in opposition to the neoclassical mainstream economics which puts aside the relation of law to the economy, Austrians place it at the centre of the discussion, though heavily confining the role of public law to the margins of the economy. This approach to regulation, like the ‘market perfecting’ rules we looked at before, are also exemplified in the modern debate over utility regulation, in particular in the rationale put forward for re-regulation in the UK, and more specifically in the notions of utility regulation as a temporary device with a ‘light rein’ put forward by LITTLECHILD32. The expectation was that once competition was mature, regulation would become redundant. It was partly on these grounds (and also to avoid the over legalistic approach to regulatory decision-making) that the RPI-X formula was put in place as a more simple and less interventionist alternative to rate-of-return regulation33. 31 See KIRZNER, 1997. 32 See in particular, LITTLECHILD, 1983. For a further and more recent articulation of Littlechild’s view of regulation within the context of Austrian economics, see LITTLECHILD, 1999. 33 The degree to which RPI-X is regarded as simpler form of regulation with stronger incentives than the traditional rate-of-return has been criticised. See STELZER, 1988. For a view of the operation of rate-of- regulation in US, see STELZER, 1991. For a view of the operation of RPI-X in Britain, see REES and VICKERS, 1995. REVISTA DE LA MAESTRÍA EN DERECHO ECONÓMICO 195 1.1.5. NEOINSTITUTIONAL ECONOMICS OR COST-TRANSACTION ECONOMICS: THE LAW, THE MARKET OR THE FIRM? Neoinstitutional economics shares with the Austrian approach the rejection or at least the severe questioning of neoclassical economic theory. Hence, neoinstitutional economics sees economic phenomena as the result of learning over time, as a dynamic exercise best understood as evolutionary34. Likewise, neoinstitutional economics, in opposition to neoclassical economics, sees “the coordination of economic activity … not merely [as] a matter of price- mediated transactions in markets, but [as] supported by a wide range of economic and social institutions that are themselves an important topic of theoretical economic inquiry.” (LANGLOIS, 1986: 6). In fact, as COASE emphasises, this approach does not “reject existing economic theory, which … embodies the logic of choice and is of wide applicability, but [employs] this economic theory to examine the role which the firm, the market, and the law play in the working of the economic system.” (COASE, 1988: 5). By offering a functional theory of institutions within a market economy, this economic school of thought provides useful lens to help determine when the different modes of economic coordination, ‘the firm’, ‘the market’ or ‘law’ including regulation, are appropriate for particular circumstances. It is by understanding transaction costs economics that it is possible to understand institutions and organisations, and therefore when the option for one rather than the other is more efficient. In other words, neoinstitutional economics claims that forms are matched to their environment, thereby implying that there is some kind of social adaptation of forms to specific environmental pressures35 . The observed pattern of variety of governance mechanisms is indicative of the external reality in which these forms emerge. This explains why on occasions it is the market that emerges, but on others, it is the firm. Under yet other circumstances, it is regulation. The most distinctive contribution of neoinstitutional economics has been its explanation of when, of the two coordinating mechanisms par excellence, the firm and the market, 34 Historically the development of a theory of institutions is closely linked to the evolution of the view of competition as a process. See in particular LANGLOIS, 1986: 7-15 and O’DRISCOLL, 1986: 153-156. 35 For an illustration of work of functionalism of neoinstitutional econonomics, see in particular WILLIAMSON, 1993, 1986; JOSKOW, 1989; JOSKOW and ROSE, 1989; JOSKOW and SCHMALENSEE 1986. 196 PUBLICATION THEORIES OF REGULATION the former is preferred over the latter. It is not our intention to rehearse in full the ‘Coase Theorem’36. It is enough to refer to Coase’s formulation that “if rights to perform certain actions can be bought or sold, they will tend to be acquired by those for whom they are the most valuable either for production or enjoyment.” (COASE, 1988: 12). Hence, “a rearrangement of rights will only be undertaken when the increase in the value of production consequent upon the rearrangement is greater than the costs which would be involved in bringing it about.” (ibid.: 115). In a world of positive transaction costs which, as COASE insists, is the real world that economic agents encounter, law, in particular property rights, play a crucial role, as by amending rights and duties which people are allowed to acquire or are deemed to posses, transactions become less or more expensive37. As COASE indicates, “[e]conomic policy involves a choice among alternative social institutions, and these are created by law or are dependent on it.” (ibid.: 28). On this basis, authors have constructed a role for law of overcoming barriers to exchange. Indeed, one of the functions of law, in particular of property rights, as COOTER and Ulen put it, is to act as ‘lubricators’ of bargaining processes by removing the impediments to private agreements. In other words, law acts as a lubricator of bargaining processes by internalising certain transaction costs. (COOTER and ULEN, 2000: 93). On the basis that the decision to opt for one or the other coordinating mechanisms can be influenced by law, COASE notes that modern exchange processes are regulated in great detail, despite often being cited by economists as examples of perfect markets and perfect competition. As COASE puts it, contrary to the general perception of economics that “observing the regulation of exchanges often assume[s] that they represent an attempt to exercise monopoly power and aim to restrain competition” (COASE, 1988: 9), the truth is that 36 The theorem is discussed in COASE’s article, ‘The problem of social cost’, (1960), reprinted in COASE, 1988: 95-156. For alternative analysis of the COASE theorem, see COOTER and ULEN, 2000: 81- 98. 37 In a scenario of zero transaction costs, (an unrealistic approach under COASE’s perceptions) “it does not matter what the law is, since people can always renegotiate without cost to acquire, subdivide and combine rights whenever this would increase the value of production.” COASE, 1988: 14. REVISTA DE LA MAESTRÍA EN DERECHO ECONÓMICO 199 in purpose-oriented rules, and into regulatory law, aimed at bringing about certain social outcomes. (ibid.: 15-19). As such, materialised law is conceived as capable of directly acting on political, economic and social spheres. The major critique of this type of regulatory collectivist framework from the legal angle comes from the juridification debate. This debate, particularly exemplified by TEUBNER39 and HABERMAS40 , condemns the role of law of the welfare state not just for the disquieting effects resulting in a ‘legal explosion’ or in a ‘flood of norms’ (BARTON, 1975: 567), but most importantly, for being over-prescriptive and over-regulatory up to the point that “human conflicts are torn through formalization out of their living context and distorted by being subjected to legal processes” (ibid.: 7-9) or to the extreme that social conflicts are depoliticised restricting the room for manoeuvre of social movement and interest groups. (ibid.: 9-10). Furthermore, juridification, identified “with the type of modern ‘regulatory law’ in which law, in a peculiar fashion, seems to be both politicised and socialized” (ibid.: 5) results in the dysfunctional problem of law being caught in what Teubner describes as the ‘regulatory trilemma’, that is, “[e]very regulatory intervention which goes beyond [the limits of the respective self-reproduction] is either irrelevant or produces disintegrating effects on the social area of life or else disintegrating effects on regulatory law itself.” (ibid.: 21). In other words, “the trilemma exists in three forms: first, as a problem of mutual indifference; second, as a problem of social disintegration through law; and third, as a problem of legal disintegration through society.” (ibid.: 22). On the basis of systems theory or autopoiesis (only a brief account of which can be presented here), this occurs due the fragmentation of modern societies into differentiated functional systems and sub-systems, including law, politics and the economy. These systems are autopoietic, that is, they are self-organising, self-producing and self- referential; in other words, they spontaneously give rise to an autonomous order, 39 See TEUBNER, 1987a. 40 See HABERMAS, 1985. 200 PUBLICATION THEORIES OF REGULATION producing and reproducing their own elements through the interaction of those elements and evolving in accordance with their own definition of themselves and their function41 . These systems are ‘cognitively open’ but ‘operatively closed’. By being cognitively open, the sub-systems are open to the environment and adaptive to it; they can receive communications from other systems, that is, be indirectly affected by them. Nonetheless they are operatively closed, by which it is implied that they recognise no norms other than those which they themselves produce as valid. This implies, for example, that in the legal system, social events derived their meaning through the law’s unique binary code: legal/illegal. (KING, 1993: 223). Likewise, the economic system will recognise as valid only economic and not legal norms. Legal norms are merely external ‘noise’ which the economic system must internalise and reconstruct in accordance with its own rationality. Reception of communication between sub-systems, then, “presupposes a process of translation or internalisation as part of which the original communication is, necessarily, subject to re-interpretation.” (DEAKIN and PRATTEN, 1994: 14). In the legal context, this means that, as KING phrases it, “[t]he normative communications of other systems cannot simply be reproduced by law as legal communication. They have to be reconstructed as law if they are to become accepted as law, and this reconstruction process may well give rise to unforeseen distortions and reductions to the meaning of the original communications as they were formulated in the political or economic systems.” (KING, 1993: 227). On this basis, the root of the failure of command-and-control regulation and of the resulting dysfunctional problem of modern juridification, the regulatory trilemma, lies in the fact that direct intervention by one system or sub-system on the other is impossible given the existence of internal, recursive processes of self-reproduction in each sub- system. Command-and-control regulation fails precisely because it oversteps the limits of self-reproduction of the involved sub-systems, that is, because it attempts to impose “modes of functioning, criteria of rationality and forms of organisation which are not appropriate to the ‘life word’ structures of the regulated social areas and which therefore fail to achieve the desired results or do so at the cost of destroying these structures.” (BLACK, 1996: 47). It further follows, as Teubner concludes, that 41 See TEUBNER, 1993: Ch. 2, 3, 4. REVISTA DE LA MAESTRÍA EN DERECHO ECONÓMICO 201 “[o]ne is …forced to abandon ideas of effective outside regulation, the notion that law or politics could have a direct goal oriented controlling influence on sectors of society.” (TEUBNER, 1987a: 21). RATHER, regulatory law “must be described in far more modest terms as the mere triggering of self- regulatory processes, the direction and effect of which can scarcely be predicted.” (ibid.: 21). In fact, “[i]f we adopt this perspective and regard juridification processes as complex relations between three self-regulating social systems, we begin to grasp why ‘regulatory failures’ must in fact be the rule rather than the exception and that this is not merely a problem of human inadequacy or social power structures but above all one of inadequate structural coupling of politics, law and the area of social life.” (ibid.: 21). 1.2.2. REFLEXIVE LAW: THE RESPONSE OF SYSTEMS THEORY TO OVERCOME REGULATORY FAILURE The proposed solution of systems theory to the regulatory dilemma of the welfare state is ‘reflexive law’. Reflexive law42, as TEUBNER remarks, is an ‘alternative within law’ rather than ‘an alternative to law’ to solve the crisis of prescriptive regulation, diagnosed by systems theory “as a social-immune reaction to legal interventions.” (ibid.: 33). Systems theory is not concerned with dismantling regulation but with shifting its emphasis. As BÜHL puts it “[a]utopoiesis does mean simply letting things run their course. What autopoietic control in fact means is arranging the interaction and the systems which are to be controlled and developed in such a way that they can more or less regulate themselves and control each other”43. 42 There are numerous conceptions that, like the notion of reflexive law, address the problem of regulatory failure by proposing a more abstract, more indirect control by law. Different terms have then been developed including ‘thick proceduralization’. (BLACK, 2001); and ‘responsive law’ (AYRES, and BRAITHWAITE, 1992); ); ‘neo-corporatist law’ (STREECK and SCHMITTER, 1985); ‘proceduralisation of law’ (WIETHÖLTER, 1985); ‘negotiated regulation’ (HARTER, 1982); and ‘semi-autonomous social fields’ (MOORE, 1973). 43 TEUBNER, 1993: 68 citing BÜLH, W., 1987 GREZEN der Autopoiesis, 39, KÖLNER ZEITSCHRIFT für Soziologie und Sozialpsychologie. 204 PUBLICATION THEORIES OF REGULATION participation, pluralism, collectivity of players and bargaining are fundamental elements of the regulatory task. Likewise they converge in rejecting the idea put forward by the theory of regulatory capture, that the intervention of the subjects of the regulation is pervasive per se. Hence, they all share the idea of abandoning the model of hierarchical and bilateral control relations and of replacing it with one based on interaction in which the multiple sub-orders (in the language of systems theory), or the multiplicity of participants and interests (in the language of the regulatory space and stakeholder approaches), communicate as equals. Nevertheless, reflexive law differs from regulatory space and stakeholder approaches in that its main goal is not the mere increase of participation, but “[t]he creation of structural conditions for an ‘organizational conscience’ which would reflect the balance between function and performance of the social system … .” (TEUBNER, 1987a: 38). Secondly, reflexive law is not confined to “the ‘foundational’ function identified by HAYEK for the abstract rules of just conduct, namely that of supporting the purely competitive and rivalrous behaviour of self-interested agents.” (DEAKIN and PRATTEN, 1999: 16). RATHER, reflexive law extends well beyond the boundaries of the sphere of private law in its attempt “to encourage a wider range of responses within self-organising systems.” (ibid.: 17). Indeed, reflexive law is aimed at co-ordinating the rationalities of different self-regulating systems with one another (TEUBNER, 1983: 273), rather than the mere preservation of self-generating structures, as conceived by Hayek. Nevertheless, systems theory shares with Austrian economics an emphasis on procedure and process, rather than on substantive outcomes. 1.3. CONCLUSIONS AND THE NEED FOR A LARGER CATEGORY OF THEORETICAL EXPLANATION The different discourses between the economic and the legal regulatory theories which we have just reviewed are quite diverse both in their nature and in their policy regulatory implications. While systems theory sheds fundamental light on the nature of law and on the difficulties that this order has in communicating with others, it has less to say on how to conceptualise the economic order46. Within economic theories, markets and 46 This is particularly true in the case of TEUBNER’s work. However the work of LUHMANN has more to offer in this respect. See i.e. LUHMANN, 1990, 1988. REVISTA DE LA MAESTRÍA EN DERECHO ECONÓMICO 205 competition occupy a central place. However, the same cannot be said about the relationship between competition and the legal system. Coase presents some preliminary thoughts on how the law may alter economic behaviour, in particular in the sphere of private law. HAYEK goes further by suggesting that markets rest upon rules of just conduct. In other words, the closest economic theories come to conceptualising a relationship between law and the economy is accepting that markets rest on non-market foundations, but such theories are far from spelling out how the law operates in this sense. In addition, while systems theory portrays a defence of regulation in the particular form of reflexive law, the followers of the economic analysis of law, along with the Austrian school, attack the role of regulation within the economy, since in the view of the former, regulation is acquired for the private benefit of regulatees, and in the opinion of the latter, regulation interferes with the process of economic discovery and coordination of the market. The implication is that none of these theories alone is adequate for understanding the law-economy relation. Thus, there is a need for a larger category where both legal and economic approaches can converge. Indeed there is a need to theorise law within the context of the economy. In the particular context of utilities, we need to understand how pricing mechanisms, the coordination mechanism par excellence of information in the context of markets, but also the many forms in which regulation functions, operate as means of generating information, of creating knowledge and also of operating learning and adaptation. Although it is not the purpose of this opening article to offer a comprehensive theory on the matter, a way forward may be suggested. This lies in seeing both ‘law’ and the ‘market order’ as forms of information and knowledge transmission, each with their own distinctive logic. Concepts which are already found within systems theory, in particular in the notion of reflexive law, as well as in the Austrian/neoinstitutional economics, must be further articulated as to create a functional language where both sets of theories can come together. Then, the next step would be to understand how the process of learning unfolds in each category, the law and the economy, and how structural coupling can happen. Let us further articulate this idea. Under the Austrian/neoinstitutional conceptions, the market creates means by which people engage in a search process, and in this manner the market mobilises knowledge. Essentially, the price mechanism allows this by coding information. This codification of information embodies a process by which the ‘price’ takes in information from what is going on in the market, scarcity, preferences, innovation, etc, and sends it back, disseminates it, to economic agents. What is contained in the price is coded knowledge about enormously complex events that are going on everywhere. Importantly, the motive why there is transmission of information of knowledge in the markets is that it 206 PUBLICATION THEORIES OF REGULATION “… is supplied by individual self-interest – we might say by the desire to buy cheap and sell dear” (SUGDEN, 1998: 490). The price mechanism is also path-dependent, that is, at any time it depends on the history of the system. (ibid.: 488). If compared to the legal system, it is possible to conclude that legal system does the same: it draws into itself information about society, either via litigation, legislation or contractual forms, and then transmits the information out again through its unique legal/illegal code. Both in the case of the market and of the law a process of information reception, coding, packaging and retransmission to society, under the logic of each system is being undertaking. In this sense, it can be argued that these systems are both autopoeitic. 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