Theories of regulation and the deregulation movement

We started this paper with what seemed a paradox: no sooner had the various “special interest” theories of regulation achieved a degree of acceptance than regulatory reforms were instituted in many industries consistent with the public interest. On the face of it, this appeared to give reason to doubt the validity of the special-interest theories. The analysis presented in this paper suggests an alternative explanation: I have argued that if the Peltzman theory is extended in a subtle but important direction, the extended theory can easily explain both the regulatory policies of the past fifty years and the changes which have occurred in the last five. The change I have made in the Peltzman theory is as follows. Peltzman's model assumes that in the absence of regulation, markets would work efficiently, i.e., that there are constant returns to scale and no externalities. The Peltzman regulator then uses regulation to redistribute income, reducing economic efficiency in the process. Suppose, however, that a Peltzman regulator in fact faced market failure, such as scale economies, so that marginal cost pricing would not necessarily recover total costs without subsidies. That is the assumption on which my model is based. This model of support-maximizing regulatory behavior has important implications, implications which explain both regulatory policies and reforms which previous models have been unable to do. That is because, faced with market failure, a rational, support-maximizing regulator could easily end up enhancing economic efficiency, rather than harming it. So, unlike the case of the Peltzman model and other “capture-theory” models, the present model of support-maximizing behavior shows that a rational regulator could easily behave in the public interest, at least some of the time, using policies which bear a striking similarity to second-best Ramsey taxation (indeed, my model is equivalent to a many-person Ramsey tax with a political-support function serving as a social-welfare function). Thus, the model developed here can explain the apparent motivation of the political system to regulate railroads, airlines, and telecommunications when economies of scale made policies of cross-subsidization or Ramsey taxation efficient, and to withdraw regulation when demand growth (and perhaps technological change) exhausted those scale economies for most traffic. These policies would appear to be consistent with public-interest considerations. But the model can equally well explain the special-interest motivations which caused most to doubt the validity of the public-interest theory in the first place. Further strengthening the argument of those believing that regulation is motivated by a combination of public-interest and special-interest concerns, it has been argued here that even a regulator behaving under the assumptions of Peltzman's original model (with no market failure) will have an incentive to reduce regulation if the efficiency cost of regulation increases (because of shifts in costs, demand, or technology). There is yet another way in which the public-interest will be represented in a special-interest model (either Peltzman's original one or my extension of it): that is, if the refinements suggested by Levine are empirically correct. Since the Peltzman (and other Chicago) models depend on the assumption of imperfect information to the general public as to what they are losing, Levine argues that for small redistributions of income, the public interest will be dominated by private interests. But if it is discovered that the public is losing substantial amounts of wealth through the regulatory process, then there will be an incentive for the system to correct itself, and the public interest will assert itself in the process once again. Levine has presented considerable evidence supporting his model in the context of airline regulation, but more empirical work is needed to determine its general validity. In addition to the three industries considered in detail, several other industries have experienced a degree of deregulation in recent years, including banking, natural gas extraction, petroleum, stock brokerage, trucking, cable television, and broadcasting. Space does not permit analysis of these industries, except for a few words about two of them, trucking and banking. As previously mentioned, truckers were regulated largely because of pressure from the railroads to reduce their competition. Truckers themselves (both workers and investors), however, soon started earning excess rents in a way quite consistent with the capture theory (Moore, 1978). It is worth noting, however, that when railroads were deregulated, so were truckers. Someone subscribing to the pure-capture theory of regulation would have difficulty explaining truck deregulation (it is true that fuel prices rose rapidly in the 1970s, but the ICC granted rate pass-throughs very quickly, and there is little evidence that the truckers themselves wanted deregulation). On the other hand, regulatory policy based to some degree on public-interest considerations might very well have an incentive to regulate trucking which stems from a need to regulate railroads (Braeutigam, 1979). Bank regulation is motivated by different factors, including the need for macroeconomic stability and the alleged need to protect depositors against risk. But entry controls in banking, combined with strict ceilings on interest rates payable (many of which have just been removed) would seem to involve the same kind of producer payoffs attempted in airlines and trucking (see, for example, Phillips, 1975). Analogous to the cases discussed above, also, it can be argued that economic realities caused structural shifts which forced the hand of bank deregulation. If, as happened for many years, the nominal, market-clearing interest rate for short-term deposits shifted mildly within a range of one to five per cent, then controlling maximum rates on bank-savings accounts (and setting checking-account rates at zero) should have been easy. But what if such short-term rates fluctuated between five and fifteen per cent, often with violent swings? Would not the cost of imposing stable and binding ceilings rise? If so, the same interplay between efficiency and special-interest considerations outlined for transportation and telecommunications would seem to have occurred in the banking industry. But this point needs more research. The analysis presented in this paper could be criticized on at least two counts. First, I have relied more on common sense to arrive at the conclusions I make than on full comparative-static analysis, considering the relevant determinants of second-order and cross-partial derivatives of equations being maximized. I have done this because the relevant matrices of second- and cross-partial derivatives are not diagonal, and the signs of those derivatives are ambiguous. And Peltzman has shown that even when the relevant matrices are diagonal, the results are still ambiguous. But this is not inconsistent with my argument. I am not arguing that deregulation is an inevitable result of higher efficiency costs of regulation in the context of the Peltzman model, but rather that it is a possible and perhaps probable result. This brings us to a second possible criticism of this analysis: perhaps it is impossible to reject the model presented here, combining special- and public-interest considerations, under any circumstances. If so, then it can explain anything after the fact, including the deregulation movement, but it has little predictive power (this is in fact a criticism of the Chicago models by Joskow and Noll, 1981). In response to this, I have already argued, again intuitively rather than with analytical rigor, that the future course of government policies toward the railroad industry can at least be crudely predicted, using this model. Furthermore, I would like to put forth the hypothesis that for a wide variety of political-support functions and regulatory situations, it is likely in the context of the present model that an increase in the efficiency cost of regulation will, all other things equal, induce a regulatory reform which tries to increase economic efficiency. But I suggest this hypothesis not so much as a clear conclusion (for I certainly have not proved it) but as a suggestion for further research. Indeed, the line of reasoning presented in this paper probably raises more questions than it answers. If it could be agreed that the regulatory process maximizes something (be it a social-welfare function or a political-support function) which is itself a function of the economic costs incurred and benefits received by various economic groups, then this could provide a common framework for two schools of thought — public-interest and special-interest — to analyze regulatory behavior. Whether this path of analysis is to be fruitful, however, only further research will tell. Copyright Martinus Nijhoff Publishers 1984