Regulation
Wesley A. Magat
As defined in the classic treatise of Alfred Kahn (1970: 3), ‘‘regulation is the explicit replacement of competition with governmental orders as the principal institutional device for assuring good performance’’ from an industry.
Several aspects of this definition are import ant. First, systems of regulation are imposed by law through the political choice process because some segments of the population prefer the out comes that emerge from an administrative process to those resulting from the operation of unfettered markets. These groups may also prefer some aspects of the regulatory process itself, such as their sense of its fairness, to the market process of resource allocation.
Second, industries, and the businesses and consumers who comprise those industries, are regulated in order to improve upon the performance of the industries, at least as measured or perceived by some segments of the population. Welfare economics focuses on policies for maximizing social efficiency, defined as the sum of the benefits to consumers and companies from markets, whereas political economists tend to stress the distributional gains and losses resulting from regulation.
Third, regulation operates through agencies who act as the agents of the administrative and legislative branches of the government in carrying out laws. Regulatory agencies are con strained by their enabling statutes, by procedural restrictions such as the US Administrative Procedure Act (in the US context), and by the political forces which act upon the agencies. They carry out their missions through set ting rules, or regulations, and by adjudicating requests from affected parties such as an electric utility company.
One of the most famous results in economics is Adam Smith’s (1776) observation that eco nomic welfare can be maximized by organizing the distribution of goods and services through perfectly competitive markets. Much regulation can be justified as responses to so called ‘‘market failures,’’ that is, social inefficiencies arising from the operation of imperfectly competitive markets. From a political point of view, the logic is straightforward. If a market fails due to a market imperfection, then society can improve aggregate economic welfare by imposing regulations that force the market to operate as if it were perfectly competitive. Political forces can impose regulations on an economy even if those regulations only benefit the groups in political power at the expense of other groups, sometimes with an overall decrease in the aggregate level of economic welfare in the economy. In the latter case, the regulations stay in place until the political coalition behind them disintegrates or is beaten by another coalition, at which time the regulations are dismantled or the industry is deregulated (e.g., the American airlines industry was deregulated in 1978 after 40 years of regulation).
Based on the theory of market failure or the pursuit of political aims other than economic efficiency, several justifications for regulation can be identified (see Breyer, 1982).
Natural monopoly. If the number of companies in a market is small and if barriers to entry into the industry limit the competition from potential rivals, then the producers in the industry can raise their prices above the competitive levels without fear of a large loss of sales and profits. One of the entry barriers that limits the number of firms in an industry is due to increasing returns to scale. If the average cost of production falls dramatically at high volumes and industry demand is only strong enough to support one firm, or at most a few firms, at this high rate of production, then small companies are unable to enter and compete in the market because of their marked cost disadvantage. Local telephone companies, electric utilities, and natural gas distribution companies provide good examples of this kind of ‘‘natural monopoly’’ for which rate regulation limits the price charged to consumers of their products.
Spillover costs. When the costs of producing some product, such as paper, spill over to other producers (e.g., in the form of polluted water that must be cleaned before use) or to consumers (e.g., in the form of air pollution which causes respiratory problems), then markets fail to maximize economic welfare. Without facing sufficient incentives to bear the costs of the spillovers, companies tend to produce too much of the products or they devote too few resources to reducing the spillover effects. Hence the potential justification for government regulation, such as standards on the levels of hydrocarbon emissions from automobiles, emission taxes on hydrocarbons emitted by electric utilities, and allocations of radio broadcast frequencies to avoid the spillover costs (namely, the interference) that would be imposed upon existing stations from new stations broadcasting on the same frequencies.
Inadequate information. For markets to function smoothly, consumers and producers must possess accurate information about the availability of goods, their prices, and their quality. How ever, it is difficult to exclude others from the use of product information once it is produced or discovered, making information itself a good which is under supplied in markets and thus a candidate for government programs that encourage further supply. The US National Weather Service provides information directly, while EPA’s gas mileage labeling requirements ensure that this information is available to new car buyers (see Viscusi and Magat, 1987; Magat and Viscusi, 1992).
Paternalism. Regulation is sometimes justified on the basis that consumers sometimes make decisions which are not in their own best interests. This argument can easily become a slippery slope, quickly overriding freedom of choice in many economic decisions, but for certain classes of decisions government paternalism is at least arguable. State regulation of alcohol sales to minors and inebriated adults is one commonly accepted example of a paternalistic regulation. There is strong evidence that even well educated adults have difficulty in accurately assessing health and safety risks, and in making self protection decisions concerning these low probability risks. Both of these risks provide a potential justification for banning the direct sale to consumers of certain chemical and pharmaceutical products.
Moral hazard. Markets cannot function well without contracts written over private exchanges, and efficient contracts cannot be written unless the actions of parties involved in the contract are observable. Otherwise, the problem of moral hazard arises. Employers may under invest in the safety levels of their work environments if these safety levels are not observable by employees; consumers may use products carelessly if the products are covered by warranties and other forms of insurance; and doctors and their patients may agree to excessive levels of medical care if a third party insurer pays with out the ability to observe levels of care. In all of these cases government regulation has been suggested as a way of correcting the market failure.
Redistribution. Regulation is a political response by groups of citizens to override the outcomes of the market process. Given the ability of every level of government to create winners and losers from regulatory action, it is not surprising that much government regulation is motivated at least in part by efforts to redistribute resources, whether it be set aside provisions for women and minority firms in government contracts and spectrum sales, grandfathering or relaxed pollution standards for existing versus new sources of pollution, or regulatory barriers to entry into long distance telephone markets. (For further discussion, see Schmalensee and Willig, 1989: ch. 22; Magat, Krupnick, and Harrington, 1986; Cohen and Stigler, 1971.)
While the examples in this entry are based on American regulatory institutions, the general principles behind the political causes and eco nomic justifications for regulation are shared by all market based economies.
See also corporate social performance; efficient markets; environment and environmental ethics; global warming; hazardous waste; Securities and Exchange Commission
Bibliography
Baumol, W. J. (1977). On the proper cost test for natural monopoly in a multiproduct industry. American Economic Review, 67, 809 22.
Breyer, S. (1982). Regulation and its Reform. Cambridge, MA: Harvard University Press.
Cohen, M. and Stigler, G. (1971). Can Regulatory Agencies Protect Customers? Washington, DC: American Enterprise Institute for Policy Research.
Derthick, M. and Quuirk, P. J. (1985). The Politics of Deregulation. Washington, DC: Brookings Institution.
Kahn, A. E. (1970). The Economics of Regulations: Principles and Institutions. New York: John Wiley.
Magat, W. A., Krupnick, A. J., and Harrington, W. (1986). Rules in the Making. Washington, DC: Resources for the Future.
Magat, W. A. and Viscusi, W. K. (1992). Informational Approaches to Regulation. Cambridge, MA: MIT Press.
Noll, R. G. and Owen, B. M. (1983). The Political Economy of Deregulation. Washington, DC: American Enterprise Institute.
Schmalensee, R. and Willig, R. D. (eds.) (1989). Hand book of Industrial Organization. Amsterdam: North-Holland.
Smith, A. (1776). An Inquiry into the Nature and Causes of the Wealth of Nations. London: W. Strahan, T. Cadell.
Spulber, D. F. (1989). Regulation and Markets. Cambridge, MA: MIT Press.
Viscusi, W. K. and Magat, W. A. (1987). Learning About Risk: Consumer and Worker Responses to Hazard Information. Cambridge, MA: Harvard University Press.
Viscusi, W. K., Vernon, J. M., and Harrington, J., Jr. (1992). Economics of Regulations and Antitrust. Lexington, MA: D. C. Heath.