2  Reasons for regulating

This section reviews the seminal theories of regulation to understand the incentives faced by regulators, the costs and benefits of regulation, the concept of “fiscal illusion” and theories of why regulations are made.

2.1  Major theories of regulation

Theories of regulation try to explain why regulation is adopted. The traditional public interest theory “regarded market failure as the motivating reason for the entry of regulation” with regulation correcting the inefficiency (Peltzman, 1989).

2.1.1  Public interest

Public interest theory suggests that government regulation is a response to public demands for government to rectify situations of market failure through imperfect competition, market disequilibria, missing markets (caused by hidden or asymmetric information, high transaction costs, externalities, public goods) or market outcomes that are undesirable for social reasons (den Hertog, 1999).

This of course assumes that (1) the market outcome represents a “failure” of some sort, and the market is not capable of fixing the problem itself, (2) that the government is capable of fixing that failure so that the optimal efficient outcome will be achieved (given constraints from institutions, technology and information) and (3) that the benefits of doing so will outweigh the additional costs created by the intervention (after taking into account administrative costs and any new allocative inefficiencies).

In summary, public interest theory can be said to assume that the regulatory regime will both aim for and achieve economic efficiency. Relaxing these assumptions leads to the concept of regulatory failure (see below), a concept that is not always considered in regulatory decisions. Public interest theory also fails to predict how the public interest is translated through political institutions into a decision, who will be regulated and who will receive the benefits or bear the costs, or the form of the regulation (den Hertog, 1999).

2.1.2  Economic theory and regulatory capture

This altruistic view of regulation was not seen as universally convincing and in the 1960s alternatives began to emerge. These included capture theory where regulations comes to serve the interests of those regulated, the economic theory or Chicago theory of regulation where it serves as a response to “interest group” demands, and public choice theory which focuses on rent seeking behaviour (Posner, 1974).

Regulatory capture occurs where, due to industry control of information, the effects of repeated interactions and career opportunities, the regulator comes to serve the interests of the regulated (Posner, 1974). This can be through direct subsidies, entry restrictions or tariffs, controls on substitutes, or price fixing (Stigler, 1971). Issues include why the industry cannot prevent the creation of the regulator in the first place, why regulation imposes burdens on industry in favour of others, or why costly regulation is accepted (although this could be to shield against more effective regulation) (den Hertog, 1999).

An extension of this approach, the economic theory of regulation or the Chicago theory of government, suggests that a regulatory regime may itself be “acquired by the industry and is designed and operated primarily for its benefit” (Stigler, 1971: p3). Regulation is sought through the supply of votes and resources to politicians with the cost reflecting factors such as the cost of the proposed regulation and the geographic concentration of benefits or costs.

Regulatory capture could occur, for example, where an agency was established to conduct occupational regulation for quality reasons and became captured by that same profession to achieve benefits for incumbents through entry restriction.[1] This is one example of regulation as a means of taxation of one group on behalf of others. Such regulation which can go as far as explicit reduction of some property rights in favour of rights held by others, sometimes referred to as government takings (Guerin, 2002b). This can also be described as “taxation by regulation” and used to explain regulated services provided below cost though “internal subsidies” from other profitable services (Posner, 1971:22). It can be argued that this is a deliberate choice by the state to ensure provision of the service without direct fiscal impact, effectively substituting a specific narrowly-based tax for funding from general taxation revenue with reduced scrutiny and less pressure to balance against competing uses of the funding. Such approaches can also reflect “a coalition of regulated firms and those of their customers who receive services below cost as a consequence of regulation” (Posner, 1971:47).

It can be argued that there is an optimum size for effectiveness of such a political coalition to seek gains through regulation, as beyond that size the interest of each member of the coalition becomes too small, and the losses to each opponent become too high (through information and organisation costs), and large coalitions are difficult to organise given the range of issues arising in elections (Peltzman, 1989). These costs can be argued to limit both the size of a coalition and its gains (Peltzman, 1976).

This could lead to a dichotomy where consumers lobby for regulation of monopolistic industries while firms lobby for regulation of competitive industries. Also the number of individuals or firms involved may influence the choice between private cartelisation and seeking regulation through political channels; ie, “it may be cheaper for large-number industries to obtain public regulation than to cartelize privately” (Posner, 1974, p346).

Such a view is consistent with a rent seeking interpretation of political behaviour, with rent seekers wasting resources to obtain regulatory rents, and politicians and bureaucrats capturing a share of the efficiency losses of regulation. It also supports a marginal approach to political allocation of regulatory benefits where more than one group receives those benefits (Peltzman, 1989). The economic theory of regulation still, however, does not address the political mechanism by which regulation is achieved, or how this mechanism itself influences the outcome (den Hertog, 1999).

2.1.3  Pressure groups and public choice

The theory of competition among pressure groups, with their success depending on factors such as their efficiency in producing pressure, the size of the groups involved, and the efficiency of the proposed tax or subsidy was outlined by Becker (1983). Rising deadweight costs of regulation constrain inefficient regulation as the marginal gains to the beneficiaries shrink relative to the losses to others. More efficient replacement regulation, or regulation which addressed costly market failure, could therefore gain support and regulators would tend to focus on potential regulation where the net benefit was greatest. Reductions in the benefits from an existing regulatory regime, due to growing deadweight costs or external factors such as rising costs or growing competition, can therefore prompt deregulation (Peltzman, 1989).

Public choice theory applies a utility maximising approach to political choices and invokes the concept of “politics as exchange”. The rules of such exchange are set through constitutional design, based on consent. Groups then face an incentive to undertake rent-seeking activity within those rules if they can gain at the expense of others, primarily through lobbying for policies that achieve concentrated benefits for themselves in exchange for costs diffused across others (van den Hauwe, 1999). Interest groups themselves can be concentrated geographically, by industry or even by a single issue.

This discussion illustrates that there are many ways in which groups can influence regulation and that regulation has redistributive effects, but does not explain why particular regulations emerge and why in some cases regulation shapes interest groups while in other cases the reverse occurs. Conversely there are also multiple arguments as to why deregulation occurs, including (1) shifts in influence of interest groups, (2) a group deciding it can perform better without regulation, (3) declining profits in the regulated sector, and (4) increasing deadweight costs of regulation (den Hertog, 1999). The predictive value of these theories is therefore limited.