The Skeptical Regulator*
Modest Observations on Regulatory Policy
Release 2.2 n March 2004

It is in vain to say, that enlightened statesmen will be able to adjust these clashing interests, and render them all subservient to the public good. Enlightened statesmen will not always be at the helm . . .

The inference to which we are brought, is, that the causes of faction cannot be removed; and that relief is only to be sought in the means of controlling its effects.

- James Madison, The Federalist No. 10

Madison recognized that a governing structure based upon majority rule imposes costs on portions of the citizenry. As such, the founders sought to establish a constitutional framework that would mitigate the impact of "factions" acting in their own self-interest.

However, a normative "public interest" view of governance prevailed for nearly two centuries after the founding of the nation. Despite the fact that enormous amounts of wealth were being funneled through political institutions, economists and political scientists largely assumed that collective action was an unqualified good, focusing their efforts instead on activities in the private sector. In the regulatory arena, this "public interest" view meant that, where perceived market failures were taking place, regulatory oversight was both necessary and beneficial.

But this "public interest" view of regulation fell short of explaining how things really happened. As an explanation for how regulation worked in practice, scholars began to explore the broad contours of what came to be known as public choice theory. James Buchanan and Gordon Tullock's seminal book, The Calculus of Consent , rejected the notion of a reified, independent public interest. Buchanan and Tullock recognized that self-interest drives the collective decisionmaking process, regardless of whether the motives of each individual are altruistic or not. Collective action is thus "methodologically individualistic," and the same economic principles used to describe the actions of individuals in the private market can also apply to describe those decisions made by collective action.

In essence, The Calculus of Consent formalized the Madisonian principles of constitutional governance. Grounded in common sense, public choice has become both a powerful explanatory device and a caution for skeptical regulators.

Regulating in the Public Interest

Market failure was the central tenet of the traditional regulatory philosophy. [1] The "public interest" theory of regulation was embodied by the Interstate Commerce Act of 1887. The Act vested an administrative agency with the authority to control both the price and supply of service in the railroad industry. Tariff filings and certificates of public convenience and necessity were tools used by the agency to erect entry and exit barriers. The fewer firms there were to oversee, the better. The ICC, for instance, failed to act on a number of applications for entry into the interstate trucking market prior to the Motor Carrier Act of 1980. This view of regulation dominated throughout the progressive era and beyond. It was the basis for regulation of the airline, trucking, energy, and telecommunications industries, among others.

As Judge Posner points out, the public interest theory of regulation was based on two faulty assumptions: (1) that markets are fragile and will operate very inefficiently if they are left alone; and (2) that government regulation is virtually costless. [2] However, despite its shortcomings, the public interest theory of regulation continued to persist. Public choice theory not only helped to explain why, but also served as a catalyst for a paradigm shift toward a new theory of regulation.

Towards Deregulation

By the 1970s, economists were pointing out that government failure could occur just as readily, if not more so, than market failure. The concept of rent-seeking emerged as one branch of public choice theory following a 1967 article written by Gordon Tullock. Under this theory, the profit motive from the private marketplace is applied to the realm of collective action. [3] If a party senses that there is a non-trivial chance to gain a reward through politics, it will use its resources in an effort to obtain that reward. Where a number of parties compete for a finite reward, the resources spent by the losing parties will be wasted. In the end, these costs will be realized by less politically powerful groups, namely consumers. The practice of expending resources for capturing a transfer ordered by government is called rent-seeking.

Once obtained, jockeying for regulatory favor does not simply cease. George Stigler introduced the related concept of industry capture in an article entitled The Theory of Economic Regulation, [4] where he concluded that "regulation is acquired by the industry and is designed and operated primarily for its benefit." Under Stigler's view, regulatorily-prescribed barriers to entry, price-fixing, and direct subsidizations are all generalized forms of rent-seeking. Judge Posner once examined the prevalence of internal subsidies in regulated industries and concluded that neither the public interest nor the regulatory capture models could fully explain them. [5] Through "taxation by regulation," he concluded, the regulatory function is to move money between competing interest groups.

Without a doubt, it is impossible for agencies to operate in a political vacuum. History is replete with examples of regulators showing a tendency to listen more to those who want protection. In telecommunications, the ability of customers to freely choose their own premises equipment took decades. The Hush-a-Phone decision in 1955 held that the FCC could not interfere with a customer's modification of a phone, but customer premises equipment was not fully unbundled until the break-up of the Bell System in 1984. Nor was the FCC fully complicit in allowing MCI to enter into competition with AT&T in the long-distance market. Further, once MCI was allowed to enter, the FCC prevented AT&T from fully competing with them. Consumers lost here as regulators kept prices artificially high to calibrate market shares within the long distance industry. Another classic example of rent-seeking is when the ICC extended its regulatory oversight to the trucking industry to protect the rail industry against a direct source of competition. Finally, the broadcast industry and its regulation is nothing but an orgy of rent-seeking and economic irrationality.

Over time, the view that looking for a governmental fix can cause more problems than it solves has gained widespread acceptance. The ICC and CAB no longer exist. Deregulation continues to occur in the telecommunications and energy sectors. This does not mean that public choice is irrelevant. In industries transitioning towards full competition, public choice considerations may be even more acute.

Consider the telecommunications industry today. As Posner pointed out, the social and political ends the regulator sought to ensure in the monopolized world could be met through the internal pricing mechanism: internal subsidies flowed from urban to rural areas and from business to residential customers. The aggregate cost these subsidies imposed on consumers could be comfortably hidden, in large part, because consumers did not have the choices they enjoy today.

Once local markets were opened to competition, political considerations run in many more directions. Maintaining affordable rates is in tension with the inducement of competition in residential markets. Allowing rates to rise, on the other hand, is in tension with the universal service provisions of the 1996 Act. Reforming universal service is resisted by the local exchange companies who rely on the current access charge regime. And so on.

In the end, competition will continue to expose the costs that once were acceptable or concealed. Consumers are "less ignorant" when they have a growing number of choices, and asymmetrical regulation will be punished in the marketplace. The pace of technological change further increases the likelihood and severity of error costs. This is precisely the phenomenon that lies at the heart of the battle being waged at the FCC over VoIP.

Additionally, regulators face internal institutional pressures and the specter of putting themselves out of business. In a recent empirical study, Jaison Abel compared the maintenance of price caps in states with competitive entry. Where price caps exist, there is nearly 60 percent less net fringe entry compared to local markets subject to other forms of regulation. Abel concluded that "[p]rice cap regulation has provided strategic advantages to incumbent firms facing entry by limiting competition within their markets." [6]

What would regulators gain by doing this, when the goal of deregulation is to facilitate as much competition as possible? Abel's answer is survival. His study found that commissions in states that have adopted price cap regulations have, on average, 71 more staff members than commissions that have not. Abel then concluded that "slowing the development of competition in this traditionally regulated industry has provided a direct benefit to state regulators both by increasing the political support they receive and by providing a way to maintain their relevancy in an age of deregulation and increased competition."

Being a Skeptical Regulator

Public choice theory is the single most powerful explanation for regulatory behavior. Firms act in their self-interest. Regulators act in their self-interest. There is a market for regulatory favor. Entities will invest in that market commensurate with expected rewards.

Public choice theory is thus skeptical, or as James Buchanan puts it, "politics without romance." The incentives for parties to rent-seek; that is, seek regulatory favor instead of submitting to market discipline, will be ever present. Further, these rent-seeking incentives may well impede a market from coming into being: why submit to the vagaries and disciplines of the market when regulatory favor may be safer and cheaper?

Administrative regulation is particularly prone to rent-seeking behavior. Where in the broader market relatively stable notions of contract and property govern relations between parties; in the regulated world, property and contract rights are up for grabs, at least as it relates to the regulatees. Therefore, regulated industries see a disproportionate share of public choice-inspired behavior.

Rent-seeking is also charged to be in the eye of the beholder. One company's unjust, below cost unbundling imposition is another's necessary access to "essential facilities." One generator's costs for grid upgrades are another's unjust socialization of transmission costs.

Since public choice incentives do not go away, the regulatory art demands that the regulator shrink the space in which the rent-seeking incentives operate. Strict adherence to the imperatives for regulation must be observed. Likewise, a world where all property, contract and mutual obligations are within the "public interest" discretion of the regulatory agency is a world where rent-seeking will be rampant. To shrink the space for rent-seeking, the unfettered discretion of the regulator must shrink as well. If parties know their legal rights and obligations, and know they are relatively certain, they will spend less to change that status quo.

Thus, the skeptical regulator must pay attention to the public choice hazards of regulation. Those hazards can be alleviated by moving toward a world of concrete rules, by giving substance to broad legal standards such as the "public interest" or "just and reasonable." No doubt, the transition to competition in the regulated industries requires involves close oversight and perilous transitions. But it also requires an awareness of the perils of regulatory favoritism, rent-seeking and arbitrage.

- The Skeptical Regulator

Next up for The Skeptical Regulator: Creative Destruction and Regulation

Footnotes

* The Progress & Freedom Foundation debuted The Skeptical Regulator in July 2003. The periodic essays are authored by president Raymond Gifford and other fellows at the Foundation. Send comments to regulator@pff.org

1. For a thorough discussion, see Joseph D. Kearney & Thomas W. Merrill, The Great Transformation of Regulated Industries Law , 98 Colum. L. Rev. 1323 (Oct. 1998).

2. Charles F. Phillips, The Regulation of Public Utilities at 182 (PUR 1993).

3. See, e.g. , James M. Buchanan, Public Choice, Politics Without Romance , Policy Quarterly (Spring 2003), available at http://www.cis.org.au/Policy/spr03/polspr03-2.htm.

4. George J. Stigler, The Theory of Economic Regulation , 2 Bell J. Econ. 3 (1971).

5. Richard A. Posner, Taxation by Regulation , 2 Bell J. Econ. 22 (1971).

6. Jaison R. Abel, Entry Into Regulated Monopoly Markets: The Development of a Competitive Fringe in the Local Telephone Industry , 45 J. L. & Econ. 289 (Oct. 2002).