Alex Tabarrok

The Economic Theory of Regulation

The Public Interest Theory
Discipline Monopolies

Internalize Externalities
Public Goods (i.e. Air Pollution, Highway Safety)

Regulation shows up where the public demands, and public demand

is driven by the opportunity for net welfare gains

Social welfare can be enhanced or maximized by a well-informed

social planner
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

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.
Capture Theory

 Government has a monopoly on the "supply" of regulation

 Regulation protects incumbent firms from price competition and
prevents entry into profitable markets
 Private companies compete for regulation
 Intention to correct market failures does not prevent natural evolution
to serve customer – those who are actually paying for regulation
 Firms pay a lot to their regulators i.e. lobbying

 KEY: Capture theory predicts regulated firms will have higher rates
of return than unregulated firms
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?
Problems with Capture Theory

Doesn’t explain cross-subsidization in regulated

industries
 A politician can divert some of the profits from the
regulation to favored consumers, at the expense of
regulated firms. More on this later
Doesn’t explain the large number of regulations that
firms explicitly do not want, and spent a lot of capital
trying to prevent or obstruct
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 P ric e

Demand elastic and inelastic.

 Notice that for the same increase in
price (the same R) which upsets
consumers the regulated industry Profits
R e g u la te d Dinelastic
gets more profit when Demand is P ric e

inelastic. M C
 Benefit-cost ratio for regulators is
Profits
higher when demand is more Delastic

inelastic – therefore more likely that D e la s tic

D in e la s tic
inelastic demand industries are
regulated. Q u a n tity
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.
Marginal
Marginal
Utility
Political
Support

Apples Wealth transfers from

politicians
Spreading the Wealth

Monopoly Price
Regulated Price

MC

Demand

MR
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.
 Iso-Political Support Curves
M3 M2

M1
Profits of regulated firms

 
2 Note: M3 is
preferred to M2,
which is
1  preferred to M1

0 R1 R2 Utility Rates
Hat tip for some slides to per KWH
Christopher Brown.
Equilibrium Regulatory Choice
M3
M2

Profits of regulated firms M1


 max Profit function

1

0
RC R* RM Utility Rates
per KWH
 Regulator Does not want “Extreme” Outcomes

 Implication: Industries Regulators

MC “captured” by
most likely to be consumers Stigler solution—
Regulators “captured” by
regulated are either regulated industry

Profits of regulated firms

relatively competitive 
(agriculture, taxis,etc)  max MF
or relatively
monopolistic (network
industries ). Profit function

0
RC RM R, Utility Rate
Equilibrium Regulatory Choice

M2 Suppose profit hill falls

(e.g. increased in fixed
M1 cost).
Profits of regulated firms

In monopoly equilibrium,
monopolist would take the
entire hit.
 In regulated equilibrium
1 note that profit falls by less
because R increases.
2 The regulator spreads the
hit across consumers and
producers to maximize
political support.

0
RC R* R2* RM Utility Rates
per KWH
Rent Seeking and Deregulation

The political pursuit of profit

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

MC

Demand

MR
 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

M2

Profits of regulated firms M1


Profit function

1

0
RC R* RM Utility Rates
per KWH
Bootleggers and Baptists
or politics makes strange bedfellows