Why Five Prisms?
By Lynne KieslingMar 25, 2021
Economic regulation in a changing world faces multiple challenges — economic change, technological innovation, and evolving policy priorities. Since its origins in 2004, the IRLE has focused on examining the fundamental principles of regulatory legitimacy and sound regulatory decision-making in the context of technological dynamism. The analytical framework we developed to organize these principles is called the Five Prisms of Law & Economics Analysis.
Neoclassical Economics: Microeconomic price theory and market process economics, grounded in basic market (supply/demand) models, provide the intellectual foundation for both the theory of economic regulation and critiques of that theory and its application in public utility regulation. Neoclassical economics enables us to evaluate and weigh tradeoffs when making decisions and to understand why and how markets enable people to create value through mutually-beneficial exchange. It also helps us understand the cost structure underlying the vertically-integrated natural monopoly model.
Innovation & Dynamism: Much of the neoclassical economics that’s embedded in utility regulation through the natural monopoly model is very static, and doesn’t take into account the fact that societies and economies are constantly changing. Indeed, over the past 40 years digitization has accelerated change. Building on economist Joseph Schumpeter’s work on the dynamics of economic change and the “perennial gale of creative destruction”, this prism provides an analytical lens for thinking about the effects of technological change on the utility business model, on potential consumer outcomes, and on the scope and role of economic regulation.
Institutional & Organizational Economics: Economic activity always occurs within an institutional context. Institutions are the “rules” that shape our incentives and influence our decisions and behavior. These rules can be long-term cultural conventions, social norms, or formal laws and regulations. Another aspect of the institutional context is the organization of production into firms, or through contracts. The traditional vertical integration of electric utilities is an example of organizing the electricity supply chain into a single firm (driven largely by the cost structure analyzed using neoclassical economics), and technological changes, from the combined-cycle gas turbine in the 1980s to solar PV and digital consumer devices today, create economic pressures to unbundle that vertically-integrated structure. This prism enables us to analyze effects of the economic, technological, and social change on organizational structure and regulation.
Public Choice Economics: Electricity production, consumption, and regulation also occurs in a political context. Public choice economics uses economic theory frameworks and tools to analyze political decision-making and the choices people make in their roles as political actors: voters, elected representatives, regulators, agency leaders, lobbyists. The public choice economics prism provides an analytical framework for understanding economic-political interactions and how technological change affects those interactions, as well as how special interest lobbying, rent-seeking, and regulatory capture can influence the direction and pace of technological change.
The Innovator’s Dilemma: Network industries like electricity and communications have common technological and economic characteristics, including network effects and economies of scale and scope. This prism uses Clayton Christensen’s work on “the innovator’s dilemma” to understand the technological aspects of unexpected competition from disruptive innovation. Why do technology startups overtake established incumbents? How do software, digitization, and the internet affect existing regulated networks? Another important element of this prism is a focus on the role of network architecture, and how network architecture can influence innovation and new technology adoption (including, for example, distributed energy resource interconnection).