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If increasing returns to scale cause monopoly to form, antitrust policy may not be appropriate. With increasing returns, one large firm can produce at lower costs than several smaller firms. Monopolies that form for this reason are called natural monopolies. Breaking them up into smaller firms makes no economic sense because it increases costs, and perhaps price. When economies of scale are the source of monopoly, some economists have argued that regulation may be appropriate policy.

Government regulation can take many forms, but all involve putting limits on what a business (or consumer) can do. Certain activities, prices, or products become illegal and others become mandatory. Economic theory suggests that the ideal form of regulation for a monopoly would be to force it to set its price equal to its marginal cost. Forced to price as if it were a price taker, the monopoly should find it profitable to increase output to the economically efficient level. Life, however, is more complicated than theory.

The publicly-stated goal of regulation is to improve the well-being of the public. If economists were convinced that publicly-stated goals were achieved, they would find the topic of regulation rather boring. But their private-interest view of government gives a rather different view of how regulation works than the view with which most people are familiar. In the private-interest view, regulation only comes into being when it is in the private interests of the legislators to bring it into existence.

Because legislators are elected in a democracy, it is in their interests to do those things that contribute to their re-election. To be re-elected, legislators need votes, and to obtain votes, they need campaign funds and volunteer workers. (Some legislators come from districts that are relatively safe, and these legislators may have more leeway in voting their prejudices, ideology, or whims than others who are in less-safe districts.) Groups that seek regulation must be able to supply either votes or money or both. Because there is a cost to getting regulation, a group will not seek it unless the issue is of considerable importance to the group. Due to the free-rider problem, groups that are very large and in which each individual has only a small stake in the central issue are difficult to organize. Also, if an issue is of only small importance to an individual, it is unlikely that he will vote on the basis of a candidate's stance on that one issue because there are so many different issues on which most candidates take a stance.

One group that can often be organized is a group that is or will be regulated. The effects that regulation has on them will be very visible to this group, and the group is usually relatively small relative to other groups that are affected by the regulation. As a result, some economists have proposed that regulation often comes about because it is sought by the very groups that are regulated. The most prominent proponent of this view was George Stigler.

This idea may seem to contradict common sense. Regulation involves a reduction in choice and thus should make those regulated worse off. However, recall the model of the prisoner's dilemma. In a case of this sort, decision-makers will be willing to have their choices restricted, provided that all others have their choices restricted in the same way. Thus, if regulation can increase prices by restricting competition, either through a minimum price or control of entry and substitutes, there are potential gains for sellers. There are risks and costs involved in obtaining regulation, however. First, there are costs of organizing and lobbying. If a group is large, there may be free-rider problems (though the potential for unfavorable treatment if the regulation is passed may help offset this). Then, once regulation is in place, it may not work precisely the way that those who sought it thought it would. Outsiders will be involved in the industry, and there is the possibility that they may be unfriendly. Also, regulation involves red tape, which may be a cost to those who are regulated.

The interest group will be successful in establishing regulation if it can promise the legislators substantially more votes or money (usually campaign funds to obtain more votes, but not always) than the opponents of the regulation can. The reason it will be able to control the regulatory agency, or "capture" it, involves the behavior of a different part of government, the bureaucrats.

The economic hypothesis assumes that the bureaucrats—non-elected government officials—are motivated on the basis of narrow self-interest. (Did you expect any other assumption?) They serve in an organized group—their agency or department—and in many ways their behavior will be shaped by the constraints the agency faces, just as the behavior of those in a corporate business is shaped by the constraints the business faces. The regulatory agency must purchase resources, including services of lawyers, accountants, and economists. It must produce an output, which is the regulation. Finally, it must obtain funds for its continued existence. The funds it obtains depend ultimately on its product, regulations. If the regulations are made sloppily, they may be challenged in the courts and overturned. If this happens too frequently, the agency may attract unfavorable attention and this may result in funds being cut. Or, if its regulations unfavorably affect organized special-interest groups, these groups will through lobbying efforts try to cut the funds that the agency is given or try to change the personnel who run the agency.

The bureaucrats who make up the regulatory agency have a variety of goals, just as those who make up a corporation have a variety of goals. In both cases, some of those goals can be realized only if the agency survives. Bureaucrats who threaten the survival of their organization will face dismissal if that can be done, or face strong pressures to change behavior. Unlike the customers of a business firm, who can "leave" and take their business elsewhere if the product does not satisfy them, "customers" of a regulatory agency cannot leave. But they can voice their complaints and in general try to make life miserable for those responsible.

Thus, we see that many economists have been skeptical that regulation achieves its promised effects. But is this skepticism about regulation consistent with facts that are available? Can cases be found in which those regulated sought regulation? What evidence is there that those who are regulated want to be regulated? Only if the answers to these questions suggest that the economic approach has some validity is it worthwhile to discuss what it implies for economic efficiency.

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