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Regulation: The Evidence

Economic historians and students of regulation have found substantial evidence that the railroads supported the establishment of the Interstate Commerce Commission, that utility companies supported the establishment of state utility regulation, and that various occupational groups have usually been the main proponents of occupational licensure. Further, there have been a number of studies showing that occupational groups earn more in states in which they are regulated than in states in which they are not. Finally, those groups that are regulated often oppose most vigorously efforts to repeal regulation.

However, there are some regulations that have not been supported by those who are regulated. Regulations that affect many different industries--such as regulation intended to promote worker safety, equality of employment, and pollution cleanup--have not generally been sought by groups that are regulated. Nonetheless, there is considerable evidence that much regulation fits the private-interest hypothesis more closely than the public-interest hypothesis.

The private-interest theory of regulation suggests that much regulation will create economic inefficiency. A considerable amount of regulation involves industries that have a substantial amount of competition (such as agriculture, transportation, and oil and gas production), and both the theoretical and empirical evidence suggest that this regulation will lead to higher prices and lower quantities, which is economically inefficient. The adverse effects of regulation can be partially offset by competition in service if competition is not allowed in price. Thus, airlines, which could compete only to a limited extent on price during the years in which they were tightly regulated, could and did compete on the quality and quantity of service. They advertised the quality of meals, the frequency of flights, the courtesy of stewardesses, and the availability of movies.

Paradoxically, regulation of competitive industries may in the long run offer no financial benefit to those regulated, but repealing it may cause considerable harm to the industry. For example, taxi service is regulated in New York City, and the number of cabs is limited. To operate a cab, one must have a permit to operate, called a medallion. Someone entering the industry must buy a medallion from someone who already owns one. The value of this medallion reflects capitalized value of the greater-than-competitive returns that regulation brings. A new entrant thus finds only a competitive return in the industry once the cost of the medallion is taken into account. (In recent years, medallions have cost more than $50,000.) If regulation ceased, those taxi owners now in the market would suffer a capital loss because their medallions would cease to have value. The only taxi owners who seem to have truly benefited from regulation were those in business at the time regulation began. They were able to capture the full benefit of the regulation, leaving none for those who entered the business later.

Though theory says that regulation of monopoly can increase economic efficiency, empirical studies have not yet shown that this regulation actually increases efficiency in practice. Ideal regulation from an economic efficiency standpoint makes a monopoly set price equal to marginal cost. However, marginal cost figures make sense only if the firm is minimizing its costs, and once the government starts trying to lower price to marginal cost, the firm has an incentive to increase costs. As a result, government almost never tries to set price equal to marginal cost.

The alternative that is usually used is for regulators to allow a monopoly only a competitive return on its investment. This type of regulation gives the firm two incentives, neither of which is socially desirable: to increase costs (through higher salaries and perquisites, for example) and to invest more than they need to. Regulation almost always contains provisions protecting the regulated monopolist from any competition. Theoretically, one can show that under certain conditions the public is served when monopoly is protected, but whether the conditions needed to make this argument hold exist in the case of any regulated monopolies is uncertain.

A strong case for nonprice regulation (such as environmental, safety, and health) can also be made on theoretical grounds, but again there is doubt about the extent that actual regulation lives up to its theoretical potential. Part of the problem is lack of good data with which to test hypotheses about the effects of this regulation. Economists have been unwilling to accept regulation as desirable simply because its publicly stated goals are desirable. They have tended to argue that the regulation will have desirable effects only if the proper incentives are created.

An example of a case in which incentives may not be ideal is the program of approving new drugs that the Food and Drug Administration runs. To be approved for use in the United States, a new drug must undergo a series of time-consuming and expensive tests to show that it is safe. This procedure means that unsafe drugs are unlikely to be allowed onto the market. An example was the drug Thalidomide, which was released in Europe but never approved for use in the United States. Thalidomide caused serious deformities in infants when taken by mothers during early stages of pregnancy. But this procedure also means that safe drugs that could save lives will be delayed (and hence lives will be lost), and drug companies have little incentive to develop drugs for rare diseases because the cost of testing diminishes the probability of ever making a profit. This structure of approval is almost inevitable. Deaths and problems that an unsafe drug causes are highly visible and widely publicized. They will cause unfavorable publicity and embarrassment to the agency, including perhaps congressional inquiries. Deaths caused by the unavailability of drugs are far less noticeable and do not attract the same intensity of publicity.

The subject of regulation is a changing and developing field, and all conclusions it has reached are subject to change. The basic theory sketched here only scratches the surface of this subject. Regulation is subject to a variety of influences besides the interests of those who are regulated, and these interests can modify regulation in a variety of ways. Further, when a regulatory agency is securely established, it can have considerable leeway in opposing the interests of those who are regulated.

The most important point that emerges from economic study of regulation is that the publicly-stated rationale for government action may differ from its true purpose, and that intended results may differ from actual results. Arguments that ignore these distinctions may have wide appeal to the general public, but they will not be taken seriously in scholarly discussion.

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Copyright Robert Schenk