Demand *and supply* matter.

In a recent newsletter, I explained the two basic theories of regulation, specifically regulation of prices, in economics. In particular, I am interested in the positive aspects of the theory. When do they predict regulation? What do they predict the effects of regulation will be in terms of prices/profits/quantities?

The first theory was the “public interest” theory, which predicts regulation will step in to correct monopoly pricing. The second theory was the “industry capture” theory, which predicts producers in an industry will use regulation to their own advantage at the expense of consumers, effectively stealing from them.

I see two problems with both theories. First, regulation is costless to implement; regulator simply chooses a price and implements it. (It’s not free in the sense that there are winners and losers from higher or lower prices) Because regulation is costless, the theories ignore that someone needs to supply the regulation and that different enforcement mechanisms may differ in their cost. Second, regulation is imposed on one side of the market against their will. This neglects any use of regulation as a way for people to exchange and benefit each other.

Lots of economists have developed theories of regulation that partially fix these problems. Today, I want to focus on two: a well-known theory from Sam Peltzman (1976) and a unknown theory from Li Way Lee (1980). (Luckily Josh was a student of Lee’s, so he pointed me to the paper.)

Peltzman’s More General Theory of Regulation

Peltman, building on earlier work from George Stigler, sets forth the task of building an explicit model of the demand and supply of regulation. He takes seriously that regulation must be provided by someone. Since it must be supplied at some cost, it will only be supplied in exchange for something that the regulator values.

For simplicity, the regulator wants political support and sets the regulated price to maximize his support. But there is a trade-off (this is price theory). Raising the price loses support from consumers. Lowering the price loses support from producers. The regulator needs to weigh those against each other.

He adds to this the basic assumption of diminishing returns. For example, each increase in the price gains additional support from the producers, but less than the last price increase.

The support-maximizing regulator sets the price so that the marginal gain from producers from increasing their monopoly rents is offset by the loss of support from consumers from their loss of consumer surplus.

Unlike the public interest theory, Peltzman’s theory predicts price will be above the competitive price. Unlike the capture theory, Peltzman’s theory predicts price will be below the monopoly price. A regulator that has to pay the political costs would not go to either extreme.

The theory that industries with few producers, even if not necessarily a monopoly, will receive regulation. Because of the costs of organizing and the concentration of benefits, a small monopoly rent to the producers will likely gain large political support from the producers, in terms of donations or other campaign support.

What makes Peltzman’s theory unique is that it also predicts that industries with a lot of competitors will be regulated as well. The reason is that a small increase in price will benefit lots of firms whose employees/owners will then vote in favor of the politician.

Combined, Peltzman’s theory predicts that competitive industries or natural monopolies will be more likely to be regulated. Both come from thinking through the role of diminishing returns in the political market.

Peltzman argues his theory “may help explain such phenomena as the concurrence of regulation of ostensible "natural monopolies" like railroads, utilities, and telephones with that of seemingly competitive industries like trucking, airlines, taxicabs, barbers, and agriculture.”

There are lots of interesting tidbits in the Peltzman piece, but every price-theorist should be familiar with the idea that 1) regulation must be supplied and 2) there are diminishing returns in the political market.

Li Way Lee (1980)

Lee takes a slightly different tack. He starts by considering a market that is a private cartel. What he adds to the normal analysis is that it is not costless to enforce a cartel. Real resources need to be spent agreeing on an implicit/explicit cartel agreement, monitoring each other, etc.

Lee states from the point that state regulation must be agreed upon. It is a mutually beneficial exchange between consumers and producers.

For producers to agree, they must expect higher profits under regulation. But consumers also need to agree, meaning they get a higher surplus as well. The only way both sides can gain from the political trade of equilibrium is if there are efficiency gains on the table, absent regulation.

There are two ways that regulation can increase the size of the pie. First, we can simply assume that the state has a lower cost of enforcing the cartel agreement. Since state regulation would save resources, there are gains relative to market cartelization that can be distributed to the consumers.

Because the market is a private cartel by assumption, there is another efficiency gain that could occur. Since there is a deadweight loss from the cartel, if regulation leads to a lower price and higher quantity, some of the gained surplus can be distributed back to the cartel to compensate for the lower price.

Both scenarios (lower enforcement costs or more complicated transfers) are the really same thing. In Lee’s formulation, it doesn’t matter whether it is a lower cost agreement or whether it’s more complicated transfer scheme than the private cartel can enforce. The government expands the feasible set of trades.

Unfortunately, Lee doesn’t spend a lot of time on why the government has lower enforcement costs than the private cartel. He argues “the state has certain advantages over private industry in the enforcement of private contracts, of which a cartel is a special case.” Effectively, he assumes there are more gains on the table if people use the lower-cost technology: government regulation.

One possible problem with Lee’s model is that it is a chicken model. The government is assumed to have a lower-cost technology. Therefore, it is more efficient for the government to enforce the cartel.

While we should always be on the lookout for chicken models (and I’ll write more on this someday), it should not concern us too much here. For our purposes, Lee is not making a normative claim that governments should regulate. It is a positive model of regulation; he is giving conditions where you should predict regulation. He predicts regulation will occur when there are efficiency gains to doing so. That follows from the human propensity to truck, barter, and exchange.

Comparing the Four Theories

I certainly don’t believe that the only value of a theory is in the prediction that it generates. However, that is one valuable service of a theory. All four of these theories of regulation have “testable implications.”

If regulation is imposed on a non-competitive market, all four theories make predictions about what will happen to prices and profits. The capture theory predicts higher prices and higher profits. The public interest theory predicts lower prices and lower profits. Peltzman’s theory predicts lower profits and lower prices. Lee’s theory predicts higher profits and lower prices.

In the case of markets that would be competitive without regulation, only the capture theory and Peltzman’s theory predict that regulation will still occur. Both predict that prices and profits will be higher with regulation than without regulation.

Anecdotally, I can think of examples that seem to fit all four theories. Ultimately though, it is an empirical question which of these theories best explains more cases of regulation.