Why Regulate Prices?

Is regulation about market failures or government failures?

Price theory focuses a lot on prices. (Big, if true 🤯).

In our benchmark competitive model in economics, prices adjust to coordinate the desires of buyers and sellers of goods.

But prices don’t always adjust as in the model. Sometimes, that is by choice of the buyers and sellers in the market. Sometimes, that is because of a government price control, where the government commands what the price can and cannot be. This newsletter focus on government price regulation.

The basic economics courses have a disjointed approach to regulation. The main example studied (price controls in a competitive market) shows how regulation decrease welfare, but the only theory of regulation ever presented (natural monopoly regulation) shows how regulation increases welfare.

The purpose of this week’s newsletter is to more clearly separate these basic theories: their basic predictions and weaknesses. With the groundwork laid, my next post will deal with more advanced theories of regulation and what they teach us.

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Industry Capture vs. Public Interest

When we introduce price controls in Econ 101, we often suppose that the regulation comes ex nihilo on a competitive market. Regulation just falls from the sky, I guess.

The price control results in a deadweight loss, relative to a competitive market without the price regulation. We know the story.

Unfortunately, there is little emphasis on why the regulation actually exists. There is no real “theory of regulation” for these price controls in 101. If there is an implicit theory, it is what’s called regulatory capture or industry capture.

The idea is that some suppliers capture the regulatory apparatus and use it to their advantage. In essence, the suppliers get the government to come in and impose the monopoly outcome for them. The monopoly outcome is good for suppliers. Often, we assume it’s the suppliers (the industry) that have an easier time capturing regulators since they are smaller in number and more organized, but either side can capture the government in principle. The regulation exists because of a government failure.

Besides industry capture, if students see another example of regulation, it is later in the course under the topic of monopoly. Here we start with a monopoly of some sort and then consider the imposition of a price regulation that lowers the price, presumably toward the competitive price.

This model at least flirts with a theory of regulation and why it exists; there is inefficiency due to monopoly and the regulation improves upon this. This regulation is in the consumers’ or “the public’s” interest. The regulation exists because of a market failure.

Both of these theories (capture vs. public interest) make testable predictions about the causal effect of regulation on prices and profits. The capture theory predicts that regulation drives up prices and profits. The producers use the regulatory apparatus to extract more for themselves. Similarly, the public interest theory predicts that regulation drives down prices and profits. The “public”, i.e. the consumers, use the regulatory apparatus to extract more for themselves. (At least that’s my interpretation, which is much more believable than assuming the executive branch is a benevolent planner.)

From a normative perspective, economists generally favor public interest regulation and are against capture regulation. By definition, public interest regulation increases overall welfare, while the capture theory envisions politics as an area to take stuff from other people and destroy wealth along the way.

P.S. Despite the long hair, this is definitely not me.

It’s more than just a normative difference that some people think regulation is good and some think regulation is bad. All welfare comparisons are relative to some baseline, so we need to keep that straight.

The public interest starts with a monopoly market, most often a natural monopoly, and then shows that regulation improves welfare. The capture theory starts with a competitive market and then shows that regulation decreases welfare. It isn’t really a normative disagreement about whether regulations are “good” but it is grounded in a positive disagreement about the competitiveness we expect to see in the markets studied and a positive disagreement about what governments do.

Although these are the two main—somewhat competing—theories of regulation that I teach in principles of microeconomics, they suffer from two flaws that they share in common.

First, both involve their own form of Harold Demsetz’s “nirvana fallacy.” The capture theory assumes the market in question would be perfect if not for the price control. The public interest theory assumes the government is perfect in setting price equal to marginal cost.

These nirvana fallacies are why it is better to view these theories as benchmark models than as the best available theories. They highlight some of the competing forces at play in the political sphere. Yes, it is true people use the political sphere for wealth extraction, as the capture theory stresses. Yes, it is also true that people use the political sphere for wealth creation, as the public interest theory stresses.

The second flaw in common is that both theories must have winners-and-losers; government helps one side at the expense of the other. There is no agreed-upon regulation. It’s simply assumed that one side happens to win the tug of war. If the market is a monopoly, then the consumers will win (for some unspecified reason) and they will be able to use the regulation to their benefit. If the market is competitive, then some producers will win (again for some unspecified reason) and they will be able to use the regulation to their benefit.

This focus on politics-as-extraction downplays the human propensity to truck, barter, and exchange. It views politics and policy as zero-sum (in the sense that one wins only at the expense of the other). I think this is a major misconception of what politics is within democracies, and definitely what it can be.

Luckily, price theory can help us discover the beneficial outcome of selfish behavior.

In my next newsletter (subscribe so you don’t miss it!), I will lay out two alternative theories of regulation that take more seriously the idea of politics-as-exchange. One is well understood and due to Sam Peltzman. The other is sadly ignored and due to Li Way Lee.

Neither of these theories is perfect either, but an applied price theorist should keep them (and the two benchmark models in this post) at hand to understand the world around us.