Regulation

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Regulation

Regulation involves attempts by the government to monitor and correct any disorders in the workings of free markets. Formally, economic regulation refers to all types of taxes and subsidies as well as to governmental controls over prices, market entry, and other aspects of economic activity. Some regulation might directly impose monetary costs (e.g., taxes or fines on noncompliers), while other types of regulation might impose costs indirectly by mandating standards that might be costly to adhere to. Examples of regulation include limits on emissions from vehicles, fire-retardant materials used in children’s bedding, airline safety standards, smoking bans, food safety, and consumer protection laws.

While the extent of government intervention in economic activity remains a matter of heated debate, few individuals would argue for a complete absence of regulation. Two widely accepted issues deserving of regulation might be related to a country’s monetary system (smooth working of the banking system and the money supply) and national defense. These attempts might be focused on both buyers and sellers, or might be directed at one of the parties. Banking laws are examples of laws that affect both buyers and sellers, while regulations by the Occupational Safety and Health Administration (OSHA) can be viewed as aimed directly at sellers. The disorders or imperfections that regulation seeks to rectify might be related to prices (too high prices), quantity or service (not all customers being served), reliability (failure to adhere to schedules), and fairness, among other issues. In practice, common instances of regulation include promotion of competition, safeguarding the interests of buyers or sellers (or both), protecting the environment, and defending national interests. For instance, the Clayton Act and the Sherman Act are two primary laws in the United States that deal with provision of fair market competition.

HISTORICAL PERSPECTIVE

Historically speaking, regulations have changed over time with new technologies, new concerns, and new revelations (e.g., harmful environmental effects of certain known substances). Sometimes, however, certain unexpected events bring about a flurry of regulations (or deregulations) in a rather short period of time. Examples of such events include the Great Depression, the 1973 oil embargo, and certain natural calamities. The Great Depression prompted governments to better regulate their economies so they could prevent wide and sudden variations in the unemployment and inflation rates. In the United States, the Federal Reserve System, which governs the money supply and oversees the banking system, was a direct offshoot of the Great Depression. The oil embargo led to various regulations regarding oil conservation including provisions for minimum fuel efficiency on automobiles. Further, natural disasters such as hurricanes and earthquakes can lead to tougher building codes in vulnerable areas.

Governments generally set up regulatory agencies to impose and monitor regulations. These agencies usually have semi-autonomous status to keep them relatively free of political pressures, although in a number of instances the regulated agencies end up enforcing the regulations passed by the executive branch. These agencies might be national (Federal Communications Commission), or they may be sub-national (Illinois Commerce Commission). In some instances, cross-national organizations such as the World Bank and United Nations impose codes of conduct across nations. However, such regulations generally are difficult to enforce and are usually less effective.

THEORETICAL UNDERPINNINGS

The theoretical underpinnings of regulation may be understood in the context of the three widely cited theories of regulation: (1) public interest theory; (2) capture theory; and (3) economic theory of regulation. According to the public interest theory, regulation is supplied or enacted by governments to correct inefficient and/or unfair market practices or outcomes. However, this theory implicitly assumes that regulators have the capacity and the willpower to determine what is fair and efficient. Since the late twentieth century, the public interest theory has been somewhat revised to recognize that regulatory agencies themselves might be inefficient. It is also unclear from this theory how public interest matters take the form of legislation. The capture theory of regulation can be seen as drawing from both economics and political science. According to this theory, regulatory agencies over time tend to be dominated or influenced by the industries they regulate. In other words, the integrity of the regulatory agencies tends to be compromised by their clientele. This theory, however, ignores special interest groups other than the regulated industries (e.g., consumers). The economic theory of regulation is primarily due to the work of the scholar George Stigler. This theory suggests that the economic laws of demand and supply can be employed to understand regulation. Alternately stated, the optimal amount of regulation would balance the demand and supply of government intervention. The demanders of regulation may be viewed as special interest groups (consumers) or parties being harmed by the current state of affairs (businesses unable to compete in protected markets). The suppliers of regulation are the regulatory agencies. This theory also recognizes that in the real world enactment of rules and regulations is not based purely on economic considerations. Rather, they are enacted in a political-economic context. The use of the laws of demand and supply enables efficiency in the provision of regulation. However, the economic theory of regulation has not been refined to the point where it enables us to predict specific industries in which regulation will be found.

IMPLEMENTATION AND BENEFITS

In imposing various types of regulation, regulators should be mindful of equity or fairness aspects on the one hand and efficiency or wastage considerations on the other hand. Generally, there is a tradeoff between the two criteria. For instance, some regulatory intervention that is relatively equitable (e.g., minimum wage laws providing a “fair” wage to unskilled or less-skilled workers) is usually not efficient (i.e., minimum wage laws do not allow the markets to work efficiently and impose undue hardships on some businesses). Thus, regulators have to weigh relative pros and cons of intervention and impose the socially optimal level of regulation. The socially optimal level would generally be less than total regulation (e.g., there should be a socially desirable level of pollution; getting rid of all pollution would impose undue costs on the society in terms of sacrifices to be made, such as no electricity generated via nuclear or thermal power plants and no polluting vehicles).

The main benefit of regulation is that it corrects shortcomings in the workings of markets. Some benefits of regulation, however, might be diffused over time, while the costs might be upfront. In such cases, it becomes difficult for regulators to convince the affected parties of the desirability of regulation. An example of this may be environmental regulation. Regulations mandating the cleanup of toxic waste dumps impose costs up front but their benefits in terms of improvement in the environment and related health benefits would only be realized over time.

The costs of regulation include the costs of compliance and the costs of monitoring. Sometimes the monitoring costs can turn out to be very high with the result that in certain instances products might either not be regulated or not be regulated effectively. Other times there are unexpected consequences of regulation when markets are connected or are interdependent. For instance, tougher regulation ensuring the purity of the milk supply would affect the milk industry directly, but also related industries that make use of dairy products (restaurants, cheese, coffee, and ice cream, for example).

Price regulation might impose direct price controls on products (price cap regulation), or it might control prices indirectly (via rate of return regulation where regulated firms are free to set prices, provided they do not earn above a specified rate of return on capital). Price cap regulation can affect the regulated firm’s investments in research and development, while it has been shown that the rate of return regulation leads to overcapitalization (i.e., regulated firms would use more capital than they would in the absence of such regulation). Thus, one type of regulation does not seem suitable for all cases.

Sometimes regulation is uncertain and not all types of intervention are predictable. Such uncertainty might plague both suppliers of regulation (i.e., government) and the parties affected by regulation. Governments might not know a priori whether they would have to regulate a new technology (new supersonic airplane) because of some future undesirable side effects (new airplane too noisy for residential areas). The public is uncertain whether and when current or future products might face additional regulations. A case in point is the impending threat of restrictions on cell phone usage while driving.

In practice, even after regulators have determined that certain products or industries need to be regulated, there is generally a time delay (called a regulatory lag) between the realization of the need for intervention, the enactment of relevant laws and their implementation. This reduces the effectiveness of regulatory intervention as it affords the affected parties time to find ways to circumvent the regulations. In certain cases, the regulatory lag might be long enough to make rules unnecessary when they are finally put into place.

In conclusion, regulation seems essential in many instances. One could differ in one’s perceptions about the scope of regulation, but its desirability in many instances seems real. Over time government intervention needs to be dynamic to be efficient and effective. Certain industries might not need regulations over time, while new regulatory instruments might have to be developed in other instances, such as in the regulation of the Internet.

SEE ALSO Antitrust; Antitrust Regulation; Deregulation; Privatization