8.12: Limitations of Market Regulation

Although regulation offers the possibility of addressing market failure and inefficiencies that would not resolve by themselves in an unregulated free market economy, regulation is not easy or cost free.

Regulation requires expertise and incurs expenses. Regulation incurs a social transaction cost for market exchanges that is borne by citizens and the affected parties. In some instances, the cost of the regulation may be higher than the net efficiency gains it creates. Just as there are diminishing returns for producers and consumers, there are diminishing returns to increased regulation, and at some point the regulation becomes too costly.

Regulators are agents who become part of market transactions representing the government and people the government serves. Just as market participants deal with imperfect information, so do regulators. As such, regulators can make errors.

In our discussions about economics of organization in Chapter 5, we noted that economics has approached the problem of motivating workers using the perspective that the workers’ primary goal is their own welfare, not the welfare of the business that hires them. Unfortunately, the same may be said about regulators. Regulators may be enticed to design regulatory actions that result in personal gain rather than what is best for society as a whole in readjusting the market. For example, a regulator may go soft on an industry in hope of getting a lucrative job after leaving public service. In essence, this is another case of moral hazard. One solution might be to create another layer of regulation to regulate the regulators, but this adds to the expense and is likely self-defeating.

When regulation assumes a major role in a market, powerful sellers or buyers are not likely to treat the regulatory authority as an outside force over which they have no control. Often, these powerful parties will try to influence the regulation via lobbying. Aside from diminishing the intent of outside regulation, these lobbying efforts constitute a type of social waste that economists call influence costs, which are economically inefficient because these efforts represent the use of resources that could otherwise be redirected for production of goods and services.

One theory about regulation, called the capture theory of regulation postulates that government regulation is actually executed so as to improve the conditions for the parties being regulated and not necessarily to promote the public’s interest in reducing market failure and market inefficiency (the capture theory of regulation was introduced by Stigler (1971)). For example, in recent years there has been a struggle between traditional telephone service providers and cable television service providers. Each side wants to enter the market of the other group yet expects to maintain near monopoly power in its traditional market, and both sides pressure regulators to support their positions. In some cases, it has been claimed that the actual language of regulatory laws was proposed by representatives for the very firms that would be subject to the regulation.