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16.3: Regulation: Protecting People from the Market

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  • Learning Objectives

    1. Compare the public interest and public choice theories of regulation.
    2. Discuss the costs and benefits of consumer protection laws.
    3. Discuss the pros and cons of the trend toward deregulation over the last quarter century.

    Antitrust policies are primarily concerned with limiting the accumulation and use of market power. Government regulation is used to control the choices of private firms or individuals. Regulation may constrain the freedom of firms to enter or exit markets, to establish prices, to determine product design and safety, and to make other business decisions. It may also limit the choices made by individuals.

    In general terms, there are two types of regulatory agencies. One group attempts to protect consumers by limiting the possible abuse of market power by firms. The other attempts to influence business decisions that affect consumer and worker safety. Regulation is carried out by more than 50 federal agencies that interpret the applicable laws and apply them in the specific situations they find in real-world markets. Table 16.2 “Selected Federal Regulatory Agencies and Their Missions” lists some of the major federal regulatory agencies, many of which are duplicated at the state level.

    Table 16.2 Selected Federal Regulatory Agencies and Their Missions

    Financial Markets
    Federal Reserve Board Regulates banks and other financial institutions
    Federal Deposit Insurance Corporation Regulates and insures banks and other financial institutions
    Securities and Exchange Commission Regulates and requires full disclosure in the securities (stock) markets
    Commodity Futures Trading Commission Regulates trading in futures markets
    Product Markets
    Department of Justice, Antitrust Division Enforces antitrust laws
    Federal Communications Commission Regulates broadcasting and telephone industries
    Federal Trade Commission Focuses efforts on consumer protection, false advertising, and unfair trade practices
    Federal Maritime Commission Regulates international shipping
    Surface Transportation Board Regulates railroads, trucking, and noncontiguous domestic water transportation
    Federal Energy Regulatory Commission Regulates pipelines
    Health and Safety
    Occupational Health and Safety Administration Regulates health and safety in the workplace
    National Highway Traffic Safety Administration Regulates and sets standards for motor vehicles
    Federal Aviation Administration Regulates air and traffic aviation safety
    Food and Drug Administration Regulates food and drug producers; emphasis on purity, labeling, and product safety
    Consumer Product Safety Commission Regulates product design and labeling to reduce risk of consumer injury
    Energy and the Environment
    Environmental Protection Agency Sets standards for air, water, toxic waste, and noise pollution
    Department of Energy Sets national energy policy
    Nuclear Regulatory Commission Regulates nuclear power plants
    Corps of Engineers Sets policies on construction near rivers, harbors, and waterways
    Labor Markets
    Equal Employment Opportunity Commission Enforces antidiscrimination laws in the workplace
    National Labor Relations Board Enforces rules and regulations governing contract bargaining and labor relations between companies and unions

    Theories of Regulation

    Competing explanations for why there is so much regulation range from theories that suggest regulation protects the public interest to those that argue regulation protects the producers or serves the interests of the regulators. The distinction corresponds to our discussion in the last chapter of the public interest versus the public choice understanding of government policy in general.

    The Public Interest Theory of Regulation

    The public interest theory of regulation holds that regulators seek to find market solutions that are economically efficient. It argues that the market power of firms in imperfectly competitive markets must be controlled. In the case of natural monopolies (discussed in an earlier chapter), regulation is viewed as necessary to lower prices and increase output. In the case of oligopolistic industries, regulation is often advocated to prevent cutthroat competition.

    The public interest theory of regulation also holds that firms may have to be regulated in order to guarantee the availability of certain goods and services—such as electricity, medical facilities, and telephone service—that otherwise would not be profitable enough to induce unregulated firms to provide them in a given community. Firms providing such goods and services are often granted licenses and franchises that prevent competition. The regulatory authority allows the firm to set prices above average cost in the protected market in order to cover losses in the target community. In this way, the firms are allowed to earn, indeed are guaranteed, a reasonable rate of return overall.

    Proponents of the public interest theory also justify regulation of firms by pointing to externalities, such as pollution, that are not taken into consideration when unregulated firms make their decisions. As we have seen, in the absence of property rights that force the firms to consider all of the costs and benefits of their decisions, the market may fail to allocate resources efficiently.

    The Public Choice Theory of Regulation

    The public interest theory of regulation assumes that regulations serve the interests of consumers by restricting the harmful actions of business firms. That assumption, however, is now widely challenged by advocates of the public choice theory of regulation, which rests on the premise that all individuals, including public servants, are driven by self-interest. They prefer the capture theory of regulation, which holds that government regulations often end up serving the regulated firms rather than their customers.

    Competing firms always have an incentive to collude or operate as a cartel. The public is protected from such collusion by a pervasive incentive for firms to cheat. Capture theory asserts that firms seek licensing and other regulatory provisions to prevent other firms from entering the market. Firms seek price regulation to prevent price competition. In this view, the regulators take over the role of policing cartel pricing schemes; individual firms in a cartel would be incapable of doing so themselves.

    Because it is practically impossible for the regulatory authorities to have as much information as the firms they are regulating, and because these authorities often rely on information provided by those firms, the firms find ways to get the regulators to enforce regulations that protect profits. The regulators get “captured” by the very firms they are supposed to be regulating.

    In addition to its use of the capture theory, the public choice theory of regulation argues that employees of regulatory agencies are not an exception to the rule that people are driven by self-interest. They maximize their own satisfaction, not the public interest. This insight suggests that regulatory agencies seek to expand their bureaucratic structure in order to serve the interests of the bureaucrats. As the people in control of providing government protection from the rigors of the market, bureaucrats respond favorably to lobbyists and special interests.

    Public choice theory views the regulatory process as one in which various groups jockey to pursue their respective interests. Firms might exploit regulation to limit competition. Consumers might seek lower prices or changes in products. Regulators themselves might pursue their own interests in expanding their prestige or incomes. The abstract goal of economic efficiency is unlikely to serve the interest of any one group; public choice theory does not predict that efficiency will be a goal of the regulatory process. Regulation might improve on inefficient outcomes, but it might not.