Regulatory economics is the economics of regulation, in the sense of the application of law by government or an independent agency for various purposes, such as centrally-planning an economy, remedying market failure, enriching well-connected firms, or benefiting politicians (see Regulatory capture). It is not considered to include voluntary regulation that may be accomplished in the private sphere.
Regulatory capture is the process by which a regulatory agency, created to act in the public interest, instead advances the commercial or special concerns of interest groups that dominate the industry that the agency is charged with regulating. The probability of regulatory capture is economically biased, in that vested interests in an industry have the greatest financial stake in regulatory activity and are more likely to be motivated to influence the regulatory body than dispersed individual consumers, each of whom has little particular incentive to try to influence regulators. Thus the likelihood of regulatory capture is a risk to which an agency is exposed by its very nature.
Public services can encounter conflict between commercial procedures (e.g. maximizing profit), and the interests of the people using these services (see market failure), as well as the interests of those not directly involved in transactions (externalities). Most governments therefore have some form of control or regulation to manage these possible conflicts. This regulation ensures that a safe and appropriate service is delivered, while not discouraging the effective functioning and development of businesses.
For example, the sale and consumption of alcohol and prescription drugs are controlled by regulation in most countries, as are the food business, provision of personal or residential care, public transport, construction, film and TV, etc. Monopolies are often regulated, especially those that are difficult to abolish (natural monopoly). The financial sector is also highly regulated.
Regulation can have several elements:
- Public statutes, standards or statements of expectations.
- A process of registration or licensing to approve and to permit the operation of a service, usually by a named organisation or person.
- A process of inspection or other form of ensuring standard compliance, including reporting and management of non-compliance with these standards: where there is continued non-compliance, then:
- A process of de-licensing whereby that organisation or person is judged to be operating unsafely, and is ordered to stop operating or suffer the penalty of acting unlawfully.
This differs from regulation in any voluntary sphere of activity, but can be compared with it in some respects. For example, when a broker purchases a seat on the New York Stock Exchange, there are explicit rules of conduct the broker must conform to as contractual and agreed-upon conditions that govern participation. The coercive regulations of the U.S. Securities and Exchange Commission, for example, are imposed without regard for any individual's consent or dissent as to that particular trade. However, in a democracy, there is still collective agreement on the constraint—the body politic as a whole agrees, through its representatives, and imposes the agreement on the subset of entities participating in the regulated activity.
Other examples of voluntary compliance in structured settings include the activities of Major League Baseball, FIFA (the international governing body for professional soccer), and the Royal Yachting Association (the UK's recognized national association for sailing). Regulation in this sense approaches the ideal of an accepted standard of ethics for a given activity, to promote the best interests of the people participating as well as the acceptable continuation of the activity itself within specified limits.
In America, throughout the 18th and 19th centuries, the government engaged in substantial regulation of the economy. In the 18th century, the production and distribution of goods were regulated by British government ministries over the American Colonies (see mercantilism). Subsidies were granted to agriculture and tariffs were imposed, sparking the American Revolution. The United States government maintained a high tariff throughout the 19th century and into the 20th century until the Reciprocal Trade Agreement was passed in 1934 under the Franklin D. Roosevelt administration. However, regulation and deregulation came in waves, with the deregulation of big business in the Gilded Age leading to President Theodore Roosevelt's trust busting from 1901 to 1909, and deregulation and Laissez-Faire economics once again in the roaring 1920s leading to the Great Depression and intense governmental regulation and Keynesian economics under Franklin Roosevelt's New Deal plan. President Ronald Reagan deregulated business in the 1980s with his Reaganomics plan.
In 1946, the U.S. Congress enacted the Administrative Procedure Act (APA), which formalized means of assuring the regularity of government administrative activity, and its conformance with authorizing legislation. The APA established uniform procedures for a federal agency's promulgation of regulations, and adjudication of claims. The APA also sets forth the process for judicial review of agency action.
Theories of regulation
The development and techniques of regulations have long been the subject of academic research, particularly in the utilities sector. Two basic schools of thought have emerged on regulatory policy, namely, positive theories of regulation and normative theories of regulation.
Positive theories of regulation examine why regulation occurs. These theories of regulation include theories of market power, interest group theories that describe stakeholders' interests in regulation, and theories of government opportunism that describe why restrictions on government discretion may be necessary for the sector to provide efficient services for customers. In general, the conclusions of these theories are that regulation occurs because:
- the government is interested in overcoming information asymmetries with the operator and in aligning the operator's interest with the government's interest,
- customers desire protection from market power when competition is non-existent or ineffective,
- operators desire protection from rivals, or
- operators desire protection from government opportunism.
Normative economic theories of regulation generally conclude that regulators should
- encourage competition where feasible,
- minimize the costs of information asymmetries by obtaining information and providing operators with incentives to improve their performance,
- provide for price structures that improve economic efficiency, and
- establish regulatory processes that provide for regulation under the law and independence, transparency, predictability, legitimacy, and credibility for the regulatory system.
Alternatively, many heterodox economists working outside the neoclassical tradition, such as in institutionalist economics, economic sociology and economic geography, as well as many legal scholars (especially of the legal realism and critical legal studies approaches) stress that market regulation is important for safeguarding against monopoly formation, the overall stability of markets, environmental harm, and to ensure a variety of social protections. These draw on a diverse range of sociologists of markets, including Max Weber, Karl Polanyi, Neil Fligstein, and Karl Marx as well as the learnt history of government institutions involved in regulatory processes.
Principal-agent theory addresses issues of information asymmetry, which in the context of utility regulation, generally means that the operator knows more about its abilities and effort and about the utility market than does the regulator. In this literature, the government is the principal and the operator is the agent, whether the operator is government owned or privately owned. Principal-agent theory is applied in incentive regulation and multipart tariffs.
Regulation as red tape
The World Bank's Doing Business database collects data from 178 countries on the costs of regulation in certain areas, such as starting a business, employing workers, getting credit, and paying taxes. For example, it takes an average of 19 working days to start a business in the OECD, compared to 60 in Sub-Saharan Africa; the cost as a percentage of GNP (not including bribes) is 8% in the OECD, and 225% in Africa.
The Doing Business project has informed or inspired 120 reforms around the world. It is the World Bank's top-selling publication and accounts for half of all the media coverage of the World Bank Group.
The Worldwide Governance Indicators project at the World Bank recognizes that regulations have a significant impact in the quality of governance of a country. The Regulatory Quality of a country, defined as "the ability of the government to formulate and implement sound policies and regulations that permit and promote private sector development" is one of the six dimensions of governance that the Worldwide Governance Indicators measure for more than 200 countries.
During the late 1970s and 1980s, some forms of regulation were seen as imposing unnecessary 'red tape' and other restrictions on businesses. In particular, government support of cartel activity was seen as diminishing economic efficiency. Regulatory agencies were often seen as having been captured by the regulated industries, as a means of diminishing competition between industry participants, and so not serving the public interest. As a result, there has been a movement towards deregulation in a number of industries. These include transportation, communications, and some financial services.
One example is the international monetary system: it is now much easier to transfer capital between countries. As a result, the globalisation of markets has increased.
An accompaniment of deregulation has been 'privatisation' of industries that previously had been under government control. The hope was that market forces would make these industries more efficient. This program was widely pursued in Britain throughout the later years of the last century. Critics argue that although this has increased choice in services, their standards have declined and wages and employment have been reduced.
Some, particularly libertarians, feel there has been little progress in deregulation during recent decades, and controls on small businesses, for example, are greater than ever. They feel deregulation is an aspirational, rather than a real, intention.
Others support re-regulation on the basis that deregulation has gone too far and given too much power to corporations and special interests at the expense of the power of the people's elected representatives.
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The regulation of markets is to safeguard society and has been the mainstay of industrialized capitalist economic governance through the twentieth century. Karl Polanyi refers to this process as the 'embedding' of markets in society. Further, contemporary economic sociologists such as Neil Fligstein (in his 2001 Architecture of Markets) argue that markets depend on state regulation for their stability, resulting in a long term co-evolution of the state and markets in capitalist societies in the last two hundred years.
There are various schools of economics that push for restrictions and limitations on governmental role in economic markets. Economists who advocate these policies do not necessarily share principles, such as Nobel prize-winning economists Milton Friedman (monetarist school), George Stigler (Chicago School of Economics / Neo-Classical Economics), and Friedrich Hayek (Austrian School of Economics), as well as Richard Posner (Chicago School / Pragmatism), all of whom have sought substantially to limit economic regulation. Generally, these schools attest that government needs to limit its involvement in economic sectors and focus instead on protecting negative individual rights (life, liberty, and property). These schools would assure economic rights equally, rather than diminish individual autonomy and responsibility for the sake of remedying any sort of putative "market failure." They tend to regard the notion of market failure as a misguided contrivance wrongly used to justify coercive government actions.
These economists believe that government intervention creates more problems than it is supposed to solve—as well-meaning as some of these interventions may be—chiefly because government officers are incapable of accurate economic calculation, lacking any reliable ability (or true incentive) to gather, integrate, or honestly evaluate the vast amounts of information that guide the "invisible hand" of a free market.
The Austrian School economists, beginning with Ludwig von Mises, see regulations as problematic not only because they disrupt market processes, but also because they tend only to bring about more regulations. According to Austrian theory, every regulation has some consequences besides those originally intended when the regulation was implemented. If the unintended consequence are undesirable to those with the power to regulate, there exist two alternative possibilities: do away with the existing regulation, or keep the existing regulation and institute a new one as well to treat the unintended consequence of the old one. In practice, regulators very seldom even consider that the problems they detect may actually be the consequence of prior regulation, so the second option is preferred far more often than the first. The new regulation, however, has unintended consequences of its own that bring about this cycle anew. If unchecked, the result over time is regulation so extensive as to amount to a state-run economy.
Laissez-faire advocates do not oppose monopolies unless they maintain their existence through coercion to prevent competition (see coercive monopoly), and often assert that monopolies have historically developed only because of government intervention rather than a lack thereof. Specifically, every regulation has some associated cost of compliance. If these costs increase the total cost of operation enough to block new entry into a market but allow existing firms to continue to generate a profit, the regulation effectively cartellizes or monopolizes the industry. When existing firms are able to lobby for regulation, this effectively becomes an opportunity to do away with competitors.
Some economists argue that minimum wage laws cause unnecessary unemployment, for the same reason that a minimum price on anything will decrease the quantity of it that people purchase. If a minimum wage law is passed that makes it illegal to pay less than M per hour, employers will continue to keep on payroll only those workers whose hourly work brings in more than M in revenues. Consequently, those workers who are least productive, and are therefore likely to be paid the least without a minimum wage, are also the ones most likely to become unemployed after a minimum wage is implemented.
Another argument against regulation is that laws against insider trading reduce market efficiency and transparency. If a firm is "cooking the books," insiders, without restraint on insider trading, will take short positions and lower the share price to a level that aggregates both insider and outsider knowledge. If insiders are restrained from using their knowledge to make transactions, the share price will not reflect their insider information. If outsider investors (those whom such laws are supposed to protect) buy shares, their purchase price won't reflect the insider knowledge and will be high by comparison to the price after the insider information becomes public. Outsiders wind up taking an avoidable loss. If insiders were allowed to trade freely, the price would never get as high to begin with, and outsiders would lose less money.
Another position held by most economists is that government-enforced price-ceilings cause shortages. If the public is willing to buy Q units of some good at price P, and the sellers of that good are willing to sell Q units at P, then in the absence of regulation, the market for that good will clear. That is, everyone who wants to buy or sell at price P will be able to do so. If a regulation imposes a price ceiling below P, sellers will be willing to sell some lesser quantity, Q - a, and buyers will be willing to buy some greater quantity, Q + b, at the new price. In addition to a shortage of a + b units, there is also the matter of deciding who should get the units offered, since at the regulation price, demand will exceed supply. Such situations typically generate ways to avoid the effects of the market imbalance and clear the market, such as 'black markets'.
A recent comprehensive study of evidence on government regulation has supported the Iron Law of Regulation which claims “There is no form of market failure, however egregious, which is not eventually made worse by the political interventions intended to fix it.”
- Administrative law
- Averch-Johnson effect
- Constitutional economics
- Rule according to higher law
- Price-cap regulation
- natural monopoly
- Public choice theory
- Regulated market
- Regulation school
- Worldwide Governance Indicators
- Gary Adams, Sharon Hayes, Stuart Weierter and John Boyd, "Regulatory Capture: Managing the Risk" ICE Australia, International Conferences and Events (PDF) (October 24, 2007). Retrieved April 14, 2011
- Body of Knowledge on Infrastructure regulation Theories of Regulation.
- "A Decade of Measuring the Quality of Governance" (PDF).
- Armstrong, J. Scott; Green, Kesten C. (2013). "Effects of corporate social responsibility and irresponsibility policies" (PDF). Journal of Business Research.
- Cebula, R., & Clark, J. (2014). Economic Freedom, Regulatory Quality, Taxation, and Living Standards, MPRA Paper 58108, University Library of Munich, Germany.
- Journal of Regulatory Economics (1989 - ) 
- World Bank "Doing Business project"
- Worldwide Governance Indicators Worldwide ratings of country performances on Regulatory Quality and other governance dimensions from 1996 to present.
- Simeon Djankov, Rafael La Porta, Florencio Lopez-de-Silanes and Andrei Shleifer (2002), "The Regulation of Entry", Quarterly Journal of Economics 117, Feb. 2002
- Move Over, Adam Smith: The Visible Hand of Uncle Sam Report concludes that the U.S. government surreptitiously intervenes in the American stock market
- Pharmaceutical Price Controls in OECD Countries Implications for U.S. Consumers, Pricing, Research and Development, and Innovation by U.S. Department of Commerce
- The Competitive Enterprise Institute has a project on Economic Regulation
- The Progress and Freedom Foundation houses the Institute for Regulatory Law and Economics (IRLE) in Washington, D.C.
- Lawrence A. Cunningham, A Prescription to Retire the Rhetoric of 'Principles-Based Systems' in Corporate Law, Securities Regulation and Accounting(2007)
- Body of Knowledge on Infrastructure Regulation