New Political Economy Of Regulation

The New Political Economy Of Regulation

Deregulation of some industries became stylish among both Democratic and Republican politicians in the 1970s, a fact that represents a distinct and dra­matic shift in emphasis from the philosophy of "New Deal liberalism" in the United States. Historically, regulation of some industries, especially those re­garded as "utilities," or natural monopolies, has been considered in the "public interest." After the establishment in 1887 of the first large federal reg­ulatory agency (the Interstate Commerce Commission), economists spent great quantities of paper and ink trying to devise better pricing tools to be implemented in the regulatory process. A vast literature developed on such subjects as marginal-cost pricing, price discrimination, and peak-load pricing, all ostensibly to be of some use in implementing public policy in the regulated areas of the economy. The whole regulatory process was seen as stemming directly from market failure and from the consequent necessity of government actions in the interests of the public. While imperfections in the regulatory pro­cess were acknowledged, most economists lined up behind the view that reg­ulation was required due to the presence of "natural monopoly" and, further, that the process could be perfected by successive approximations in control. Unfolding intellectual events of the 1960s changed all of this within the eco­nomics profession and, ultimately, among politicians and the public as well. We have already discussed one of these developments—the emergence of the public-choice paradigm with its emphasis upon politicians as endogenous ac­tors in economic processes. It simply remained to apply these principles to the regulatory process through a theory of rent or profit creation by politicians and regulators ("the government"). The stage was set by two important papers ap­pearing in 1962. George Stigler and Claire Friedland broke the ice with an es­say questioning the effects of regulation on such variables as rate levels, the degree of price discrimination, and the rate of return ("What Can Regulators Regulate? The Case of Electricity"). Their surprising conclusion, based on statistics before and after electrical-utility regulation, was that regulation was almost totally ineffective at controlling the quantities it was designed to con­trol. They noted:

The theory of price regulation must, in fact, be based upon the tacit assumption that in its absence a monopoly has exorbitant power. If it were true that pure monopoly profits in the absence of regulation would be 10 or 20 percent above the competitive rate of return, so prices would be on the order of 40 to 80 percent above long run marginal cost, there might indeed be some possibility of effective regulation. The electrical utilities do not provide such a possibility ("What Can Regulators Regu­late?" p. 12).

A second contribution was no less influential in questioning long-held be­liefs about regulation. Harvey Averch and Leland L. Johnson developed a the­ory about the firm's actions when facing a regulated rate of return constraint ("Behavior of the Firm under Regulatory Constraint," 1962). They concluded that, under certain conditions, regulated firms would overinvest in fixed cap­ital, at least from society's point of view. Although optimal (i.e., profit maxi­mizing) from the regulated firm's position, too much capital (relative to labor inputs) could force up the costs of utility services to society. The empirical relevance of this Averch-Johnson effect is still being debated by economists and econometricians, but their allegations, along with those of Stigler and Friedland and other writers, helped agitate a general rethinking of the whole regulatory process. This reassessment was, moreover, strongly influenced by the economics of politics and rent seeking.