Regulation can be defined a state-imposed limitation on the discretion that may be exercised by individuals or organizations, which is supported by the threat of sanction (Alan Stone).

Regulation is unlikely to be comprehensive in scope, and so even in regulated industries market forces determine the allocation of many aspects of production, distribution, and consumption.

Economic Instruments of Regulation

• Price: Allows a regulatory agency to control the market power of a monopoly or dominant firm. Traditionally price was used in "rate-of-return" regulation to recover average cost and assure a normal return on invested capital. More recently "price-cap" regulation is used. Each type of price regulation induces a different sort of incentive.
• Quantity: Frequently used for common-pool resources whose use is regulated by the government. Examples: Prorationing of oil production by the states of Oklahoma and Texas. Private contractual solutions to the dissipation of Hotelling rents failed, and owners of mineral rights petitioned the states to limit overproduction. Prorationing may affect number of wells or amount pumped from any given well. Another example: Harvest quotas on marine fisheries, game wildlife.
• Entry/Exit: Examples include the FCC restrictions on AT&T entering the computer market, CAB restrictions on entry into airline routes, FERC licensing of pipelines, etc.

History of Economic Regulation

Munn v. Illinois (1877): "Property does become clothed with public purpose when used in a manner to make it of public consequence, and affect the community at large. When, therefore, one devotes his property to a use in which the public has an interest, he, in effect, grants to the public an interest in that use, and must submit to be controlled by the public for the common good." -This case provided the foundation for economic regulation of firms possessing (or with intent to have, or conspiring to have) market power.

Interstate Commerce Act (1887): Context: RR industry was experiencing bouts of price wars, and were practicing price discrimination. Those charged high prices because of inelastic demand (often times farmers on the great plains, served by one RR) called upon the gov't to regulate; RR firms also called upon the gov't to regulate to prevent "injurious price competition."

Nebbia v. New York (1934): Munn case could be construed as only allowing economic regulation of public utilities. Nebbia made clear that that was not the case: "…in the absence of other constitutional restrictions, a state is free to adopt whatever economic policy may reasonably be deemed to promote public welfare, and to enforce that policy by legislation adopted for that purpose." -As long as, in a state's judgment, economic regulation (of commerce under the state's jurisdiction) is in the public interest, there is no constitutional barrier to such regulation.

Trends: Periods of increased regulation tend to be counter-cyclical to the overall business cycle, though there are exceptions (such as the period from 1940-70 of increased regulation). Economic regulation reached its peak in 1977, in which industries subject to economic regulation made up 17 percent of GDP. By 1988 this had fallen to 6.6 percent. See table 10.2 of text. Over the last 20 years we have generally been in a cycle of deregulation. With a few exceptions (e.g., Cable TV) economic deregulation has been broadly seen as a success.

Since the textbook was published we have seen a new round of Cable TV re-deregulation, the increasingly deregulated electricity industry and local telephone industry.

Key Steps:

• Legislation: States which administrative agency has jurisdiction over the regulation of the industry. Establishes the regulatory powers of the administrative agency. May create an independent regulatory commission (ICC, FCC, SEC, FERC, etc). Outlines general policy objectives.
• Administrative implementation
• Deregulation (?)

Rule-Making Process: Case-by-case (when the number of cases is small) or substantive rule-making, in which through a series of public hearings a set of general rules are formulated that are applicable to a broad class of regulatory circumstances under the jurisdiction of the regulatory body. Regulatory bodies frequently make decisions by vote of commissioners, and may even have administrative law judges to hear challenges. These decisions can be taken to the U.S. Court of Appeals. Regulation tends to favor the status quo. Why?

Economic Theory of Regulation: Competing hypotheses:

• Hypothesis: Regulation resolves market failures: Regulation in the public interest. Resolves market power (economic regulation) or externalities (environmental regulation) or imperfect information (public, occupational safety, health regulation). Regulation enhances efficiency or equity. Problem: Does not take into account the political process.
• Hypothesis: Regulation is generated by a politically captured agency. Regulation may have originally been emplaced to enhance efficiency, but the agency was later captured and the regulation redirected to serve the interests of the group that captured the agency.
• Stigler/Peltzman's economic theory of regulation:
  1. Regulatory agencies redistribute wealth (or enact policies that have the impact of redistributing wealth).
  2. Regulators want to be reelected or stay in power, and so enact policies to maximize political support.
  3. Interest groups compete by offering political support in exchange for getting favorable legislation.

The economic theory of regulation trades off incentive for individuals to lobby vs. cost of organizing individuals into an effective group; thus small groups where each individual has a lot at stake will tend to be the most effective at capture-industry rather than citizens. Thus monopolistic industries are likely to be regulated because citizens have a lot to gain, and competitive industries are likely to be regulated because the firms have a lot to gain.

• Becker model: Focus mostly on interest group competition; politicians/regulators simply transmit the pressure of the interest group rivalry. Each group makes investment in pressure based on expected gains (likelihood of overcoming the other group and getting favorable regulatory treatment), as in the Stigler/Peltzman model. The outcome of regulatory policy is a function of the relative investment of the two or more opposed interest groups. A political equilibrium occurs when neither interest group has an incentive to change their investment in pressure. Much like a Cournot model, except that the units of rivalry are pressure rather than output of goods/services. Note: since all pressure groups are subject to free-riding, the issue of free-riding is not critical in the Becker model because it (in some sense) cancels out across the rival groups. Note also that the Becker political equilibrium is not Pareto optimal, since if the groups could coordinate they could get the same political outcome for a smaller proportionate levels of pressure investment.

Critique of the economic theory of regulation: Too simplistic? Are regulators more complex than posited here?

Has the recent empirical record supported the economic theory of regulation? Not really during the deregulation period. For the most part, consumers have been made better off, and firms worse off, by deregulation of trucking, airlines, and telecommunications. Counterexamples: Cable TV, RR. Related counterexample: Failure of Clinton's plan to change U.S. health care delivery, due to heavy pressure from the health care industry. Another related counterexample: Role of lobbying by forest products industry on U.S. Congresses' recent failure to reduce subsidized road-building in the national forests. Thus evidence is mixed….

Taxicab Regulation

-Entry during the great depression lowered profits of taxicab firms, who used pressure to regulate entry, as in the economic theory of regulation. The taxicab industry is subject to local or state regulation, and has largely escaped the deregulation movement. Taxicab regulation includes regulation of fares (set directly or set fare ceiling), entry (number of firms, often by requiring purchase of a "medallion"). EX: New York used to have 13,500 medallions in 1937, which has fallen to