The Theory of Regulation
The issue: What factors can explain why certain markets/industries are subject to economic regulation and others are not? Moreover, economic regulation produces winners and losers--what determines who wins and who loses? Here we present the essential features of three alternative theories of regulation, including
|The public interest theory
|The capture theory
|The economic theory
According to the
public interest theory (or what Viscusi, Vernon, and Harrington refer to as "Normative
Analysis as a Positive Theory" or NPT),
regulation is the manifestation of political pressure brought to bear by
the public, which demands that a market
|Monopoly power enjoyed by railroad companies gave rise to discriminatory freight charges--to the detriment of farmers and industries located in remote areas. Interstate Commerce Commission (ICC) was created to correct for this market failure.
|Incompletely specified property rights create the possibility of externalities or spillovers (such as air pollution). Hence the Clean Air Act and regulation of firms by the Environmental Protection Agency (EPA).
|Increasing returns to scale (or natural monopoly) creates a situation wherein regulation can be welfare-enhancing (more about natural monopoly later).
The public interest theory does not have much support among economists these days. For example
|Winston writes that "[t]he weakness of this theory is its assumption that perfectly informed social welfare maximizers are either managing the regulation or running the regulated firms" [Winston 1993, p. 1266].
|Viscusi, Vernon, and Harrington state that "NPT puts forth the hypothesis that regulation occurs when it should occur because the potential for a net social welfare gain generates a public demand for regulation". They note, however, that "[m]any industries have been regulated that are neither natural monopolies nor plagued by externalities; for example, price and entry regulation in trucking, taxicab, and securities industries".
The capture theory [see George Stigler, "The Theory of Economic Regulation," Bell Journal of Economics, 2, 1971:3-21] is summarized by the following points:
|Government has "legal" coercive power and thus has monopoly control of the "supply" of regulation.
|Government regulation can protect incumbent firms from rivalrous price wars and prevent entry into lucrative markets.
|Since the regulated firm oftentimes has a more comfortable and profitable existence than the non-regulated firm, private companies "compete" for a scarce supply of regulation.
|Though a regulatory agency such as the ICC or the FCC may have been created with the (vague) intention of correcting market failures, as time goes by the agency is subject to "capture" by the firms they regulate. That is, the regulatory agency invariably tends to issue regulations that work to the advantage of regulated firms.
|Regulated firms expend considerable resources to lobby the regulators. It is not uncommon for an official of a regulatory agency to wind up in a high-paying job with a firm that previously fell under their regulatory purview. The regulators may not want to antagonize the firms they regulate because they want to "keep their options open."
|Capture theory predicts that regulated firms will earn higher rates on return (on average) than non-regulated firms.
D Knocks on the capture theory
|Does not supply a theoretical explanation of the process by which the regulators get captured.
|Does not square with the widespread practice of cross-subsidization in regulated industries.
|Cannot be reconciled with the long list of regulations adopted by regulatory agencies but opposed by regulated firms.
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