The Capture Theory Regulation

The Capture Theory Regulation

Who benefits from and who is burdened by regula­tion? Regulated firms may benefit from the process by direct subsidies of money, entry control, price fixing, or control over substitutes or complements. Regulation is almost never an unmixed blessing. Regulated industries (railways, electrical utilities, etc.) or occupations (barbers, funeral directors, local contractors, etc.) must submit to certain rules, regulations, "standards" of conduct, or other interferences. These are costly and reduce the net return to the regulated firm, but as long as the net benefit is positive and lobbying costs are not prohibitive, those who stand to gain from the regulatory process will demand it.

Why will politician-regulators supply regulation? Stated another way, how do businesses go about demanding regulation in a system where outright bribes are illegal? Politically effective coalitions (e.g., nurses, carpenters, "the Moral Majority," etc.) do so with votes and other resources such as monetary sup­port or "campaign contributions." A more basic question is, how do regula­tions get passed that hurt many people (consumers) a little but benefit a few people (industry) a lot? Certain characteristics of a democratic political pro­cess make this possible. Stigler noted that (1) political decisions must be made simultaneously, unlike market decisions, and that (2) a democratic process (through representatives) must involve all parties simultaneously—those very interested in a decision, those somewhat interested, and those uninterested ("Theory of Economic Regulation," pp. 10-11). In these circumstances, the larger damage to majorities (the "deadweight loss" analyzed above) may not find expression against the smaller gains of minorities. Information acquisition is a good with costs and benefits. An individual has no incentive to acquire costly information on issues of no concern to him or her, but the individual votes on these issues anyway, ordinarily through a full-time representative af­filiated with a political party. As Stigler argues:

The representative and his party are rewarded for their discovery and fulfillment of the political desires of their constituency by success in election and the perquisites of office. If the representative could confidently await reelection whenever he voted against an economic policy that injured the society, he would assuredly do so. Un­fortunately virtue does not always command so high a price. If the representative denies ten large industries their special subsidies of money or governmental power, they will dedicate themselves to the election of a more complaisant successor: the stakes are that important. This does not mean that the representative and his party must find a coalition of voter interests more durable than the anti-industry side of every industry policy proposal. A representative cannot win or keep office with the support of the sum of those who are opposed to: oil import quotas, farm subsidies, airport subsidies, hospital subsidies, unnecessary navy shipyards, an inequitable public housing program, and rural electrification subsidies ("Theory of Economic Regulation," p. 11).

Politics and the voting process are thus a gross filter of individual preferences. Regulations of all kinds are simply the result of interactions of self-interested demanders, i.e., effective coalitions of individuals who stand to gain from reg­ulation and political suppliers who must endure periodic reelection constraints. Does this mean that the "public interest" comes in last in this process? In the modern approach to regulation, the term "public interest" itself takes on a different meaning. The public interest is not some abstract legalism; rather, it is merely a summation of individuals' interests on some issue. If transactions costs among consumers were zero, they would most certainly buy out monop­olies such as that depicted in Figure 4. In other words, for a sum PcPmAF, consumers could buy out the monopolist and gain triangle AFG, the dead­weight loss. But in an imperfect world where coalition costs are positive and where the state is permitted to coerce (in a democratic setting), monopolies created by regulation can reduce the welfare of consumers.

It is important to recognize that regulation does not always support the spe­cial interests of industrial market groups. Consumer or environmental groups may also form effective coalitions to impact upon the political process. Pref­erences of nonmarket groups may be registered, and different groups may cap­ture the process at different points in time. Identification of the specific con­figurations of costs and benefits facing demanders and politician-suppliers of regulations is an ongoing task engaging contemporary economists in this field. One of the central problems is to develop a sound single theory of political decision making within bureaucracies. The important point is that the outlines have been developed of a positive economic theory of the regulatory process assuming self-interested, endogenous politicians.

Other Modern Approaches to Regulation

The economic and political ap­proaches to regulation outlined above suggest that any effective coalition might obtain regulation through the political process. This view assumes, for example, that regulation may be obtained by some industry irrespective of whether the firms' long-run costs are declining over large blocks of output. The presence or absence of natural monopoly conditions, in other words, is not the foundation of an explanation for government regulations. Altering con­straints faced by suppliers and demanders of regulation is the only way to get a diminution of the activity. But what if natural monopoly conditions (de­clining marginal costs, great capital fixity) are present? Does that mean that agency regulation of the type discussed in early sections of this chapter is in­evitable?

The so-called Chicago theory of regulation has dealt with this question. In a view derivative of Sir Edwin Chadwick's nineteenth-century assessment of similar problems, Harold Demsetz in 1968 questioned the ne­cessity of regulating (in traditional fashion) industries having scale economies in production ("Why Regulate Utilities?"). Demsetz proposed that formal regulation of utilities would be rendered unnecessary where governments could allow "rivalrous competitors" to bid for the exclusive right to supply the good or service over some indefinite "contract" period. In such a system, as Demsetz shows, the existence of natural monopoly does not imply monopoly price and output, given (1) an elastic supply of potential bidders and (2) pro­hibitive collusion costs on the part of potential suppliers.

Under certain restrictive conditions a "competitive" price and output could be achieved under Demsetz's plan. Critics of this idea have strongly questioned the plan as a substitute for tradi­tional forms of regulation, and they cite problems of market uncertainty, in­formation and policing costs, investment criteria, and so on as making the plan practically unworkable. Government ownership of certain basic property rights would also attach to the scheme. All of this might be somewhat irrele­vant, however, since it is probable that Demsetz never intended his conception to serve as a "Chicago theory of regulation." There is not much empirical sup­port for the existence of natural monopoly in utilities and other regulated in­dustries, and the "Chicago position" on the matter—if there is a unified posi­tion—is that deregulation and the return of competition to most regulated activities would improve consumer welfare.

A final contemporary view of the regulatory process offers a possible ave­nue through which regulation may be supported. Victor Goldberg's view ("Regulation and Administered Contracts") is that regulation is very much akin to private or public long-term contracts to serve and be served. Further, he argues that the vast complications associated with long-term contracts may provide a rationale for regulation. Goldberg's analysis is principally concerned with natural monopolies, though his considerations are important for the reg­ulation of other industries as well.

There is a similarity between the regulatory process and long-term relational contracts giving producers a right to serve and consumers a right to be served. Owing to uncertainty and other problems, both parties to the contract limit fu­ture options in order to achieve optimality over time (all other theories con­sidered in this chapter are static and carry no intertemporal implications). Con­tracts, or regulation, in Goldberg's view, provide procedural mechanisms for adjudicating future contingencies. Increasing the producers' right to serve makes the contract more attractive to producers while simultaneously making the contract less attractive to consumers. The opposite is true of the consum­ers' interest in the right to be served. In Goldberg's words:

[C]onsumers want to maintain freedom to terminate the agreement so that they can take advantage of lower prices and/or superior technologies as they appear. The only variable under the agent's control is the level of production of the right to serve.

The optimal protection will be that at which the expected marginal benefits to the consumers of increased durability and decreased producer risk (lower prices) are just offset by the expected marginal costs of decreased flexibility ("Regulation and Administered Contracts," p. 433).

Thus Goldberg's justification for regulation is that long-term contracts are difficult to define and enforce because it is costly to delimit, ex ante, their many provisions. The regulatory body is an ongoing monitoring agent that con­tinually defines the relation between consumers and producers over time in much the same way that common-law courts continually interpret rights and obligations of citizens vis-a-vis other citizens and the state. (Goldberg is not optimistic about the efficiency of private contracting under public laws of con­tract.) Goldberg has not proved a case for regulation. No market failure is cited. But he has demonstrated an intriguing possibility. With risk-averse con­sumers and capital fixity, some regulation may be appropriate when viewed over a period of time. These views are, of course, in strong contrast to those developed earlier.