The Economic Theory of Regulation

Alex Tabarrok

The Public Interest TheoryDiscipline Monopolies

Logic of Collective Action and Regulation

Small groups with large potential benefits will organize more readily than small groups with small and diffuse benefits. E.g. sugar producers versus sugar consumers.

Politicians respond to incentives->theory of regulation. Capture theory (Stigler): Even when regulation is begun on

behalf of the public interest over time firms capture the regulatory process and bureaucracy

Evidence supporting the capture theory of regulation: revolving door deals - high-level regulators and other officials leave

government and find high-level jobs in the same industry that they had been responsible for regulating.

Comparing Public Interest and Private Interest Theories of Regulation

Consider some industries that are or have been highly regulated: Airlines Trucking Taxi Service Farming

All of these industries (with pos. exception of airlines) are highly competitive!

Where is the market failure?

Expanding the Theory

Note that beneficiaries of regulation are not simply “big business” E.g. (some) farmers, truckers, taxi service, barbers, lawyers,

physicians (occ. licensing). Note also that farmers, truckers, taxi service etc. are not small

groups; hence more is involved than the sugar lobby story. Olson story of small, organized groups versus large, disorganized

groups cannot be the whole story. How do politicians trade off numbers/votes and monetary

support? What happens when two organized groups have conflicting

interests?

Peltzman Model of Regulation

Assumptions Regulation is supplied by utility-maximizing politicians

and regulators in response to the demand for regulation by interest groups.

Those who control regulatory policy do so to maximize political support.

Political support comes in the form of votes or campaign contributions.

The Model

Consider a regulator such as an electricity regulator that sets a rate, R (more generally the regulator has influence over a pRice.)

Consumers want low R but the regulated firm wants high profits, .

The politicians/regulators face a trade-off. If they allow higher profits, they gain political support from firms they regulate but lose support from consumers and vice-versa.

Gain to Regulators from Regulation

Consider two industries with Demand elastic and inelastic.

Notice that for the same increase in price (the same R) which upsets consumers the regulated industry gets more profit when Demand is inelastic.

Benefit-cost ratio for regulators is higher when demand is more inelastic – therefore more likely that inelastic demand industries are regulated.

MC

De las tic

D ine las tic

R egu la tedPrice

Price

Quan tity

Profits Delastic

Profits Dinelastic

Cross-subsidization

A politician can divert some of the profits from the regulation to favored consumer or other groups. E.g. prior to Amtrak one of the conditions of railroad

regulation was the passenger rail would be subsidized by the railroad firms.

Electricity regulation may lead to cross-subsidies to specific customers such as rural customers.

Even though the rural customers may not be organized the politician cares about votes and makes sure the consumers know who is helping them (politician substitutes for organization).

Diversification and Diminishing Returns

A politician wants to diversify, to give wealth transfers to different groups for the same reason consumers spread their purchase over many goods – diminishing marginal returns.

MarginalUtility

Apples

MarginalPoliticalSupport

Wealth transfers from politicians

Regulated Price

Spreading the Wealth

MC

Demand

MR

Monopoly Price

Iso-political support curves

The trade-off between R and profits is illustrated by the iso-political support function.

The iso-political support function illustrates all combinations of R and that yield equal political support.

Pro

fits

of

reg

ula

ted

firm

s

Utility Rates per KWH

0

1

2

R1

M1

M3 M2

Note: M3 is preferred to M2, which is preferred to M1

R2

Hat tip for some slides to Christopher Brown.

Iso-Political Support Curves

Pro

fits

of

reg

ula

ted

firm

s

Utility Rates per KWH

0

1max

R*

M1

M3

M2

RC RM

Profit function

Equilibrium Regulatory Choice

Pro

fits

of

reg

ula

ted

firm

s

R, Utility Rate0

max

MC

MF

RC RM

Profit function

Regulators “captured” by consumers Stigler solution—

Regulators “captured” by regulated industry

Regulator Does not want “Extreme” Outcomes

Implication: Industries most likely to be regulated are either relatively competitive (agriculture, taxis,etc) or relatively monopolistic (network industries ).

Pro

fits

of

reg

ula

ted

firm

s

Utility Rates per KWH

0

1

R*

M1

M2

RC RM

Equilibrium Regulatory Choice

Suppose profit hill falls (e.g. increased in fixed cost).In monopoly equilibrium, monopolist would take the entire hit.In regulated equilibrium note that profit falls by less because R increases.The regulator spreads the hit across consumers and producers to maximize political support.

2

R2*

Rent Seeking and Deregulation

MC

Demand

MR

The political pursuit of profit also called “rent seeking” leads to wasteful expenditures that eat into the profit. The rents are eroded.

Profit

Rent dissipation in airlines

The Civil Aeronautics Board (CAB) extensively regulated airlines in the U.S. from 1938 to 1978. No firm could enter or exit the market, change prices, or alter routes without permission from the CAB. The CAB kept prices well above market levels, sometimes even denying requests by firms to lower prices!

The rents, however, were eroded. Competition in quality

Nice meals Wide seats Under-booking

Unions

Rent Seeking and Deregulation

Pro

fits

of

reg

ula

ted

firm

s

Utility Rates per KWH

0

1

R*

M1

M2

RC RM

Profit function

Bootleggers and Baptistsor politics makes strange bedfellows