Transcript The Economic Theory of Regulation

Alex Tabarrok
Discipline Monopolies

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.

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?

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?

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.



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, 𝜋.
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.



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.
Price
Regulated
Price
Profits
Dinelastic
MC
Profits
Delastic
Delastic
Dinelastic
Quantity

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).

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
Utility
Marginal
Political
Support
Apples
Wealth transfers from
politicians
Monopoly Price
Regulated Price
MC
Demand
MR
 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 𝜋 that yield equal political
support.
M3
M2
M1
2

1
0
Hat tip for some slides to
Christopher Brown.

Note: M3 is
preferred to M2,
which is
preferred to M1

R1
R2
Utility Rates
per KWH
M3
M2
M1

 max
Profit function

1
0
RC
R*
RM
Utility Rates
per KWH

Implication:
Industries most likely
to be regulated are
either relatively
competitive
(agriculture,
taxis,etc) or relatively
monopolistic
(network industries ).
MC
Regulators
“captured” by
consumers
Stigler solution—
Regulators “captured” by
regulated industry

 max
MF
Profit function
0
RC
RM
R, Utility Rate
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.
M2
M1

1
2
0
RC
R* R2*
RM
Utility Rates
per KWH
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
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
M2
M1

Profit function

1
0
RC
R*
RM
Utility Rates
per KWH