Stigler-Peltzman model Petr Gapko

Course structure BLOCK 1 – REGULATION AS AN IMPLICATION OF MARKET IMPERFECTIONS BLOCK 2 – APPLIED REGULATORY POLICY (CZ, EU & USA) BLOCK 3 – REGULATION AS AN IMPLICATION OF THE POLITICAL PRESSURE OF INTEREST GROUPS BLOCK 4 – PRACTICAL APPLICATION (MICROSOFT CASE)

Course structure BLOCK 3 – REGULATION AS AN IMPLICATION OF THE POLITICAL PRESSURE OF INTEREST GROUPS Stigler model, Becker model

Recap of regulation theories The issue: What factors can explain why certain markets/industries are subject to economic regulation and others are not? Moreover, economic regulation produces winners and losers- -what determines who wins and who loses? Here we present the essential features of three alternative theories of regulation, including The public interest theory The capture theory The economic theory source:

Normative Theory as a Positive Theory According to the NTPT, regulation is the manifestation of political pressure brought to bear by the public, which demands that a market failure be corrected.market failure

NTPT - Examples Monopoly power enjoyed by railroad companies gave rise to discriminatory freight charges--to the detriment of farmers and industries located in remote areas. Interstate Commerce Commission (ICC) was created to correct for this market failure. Incompletely specified property rights create the possibility of externalities or spillovers (such as air pollution). Hence the Clean Air Act and regulation of firms by the Environmental Protection Agency (EPA).externalities

Criticism of NTPT Viscusi, Vernon, and Harrington state that NTPT puts forth the hypothesis that regulation occurs when it should occur because the potential for a net social welfare gain generates a public demand for regulation". They note, however, that "[m]any industries have been regulated that are neither natural monopolies nor plagued by externalities; for example, price and entry regulation in trucking, taxicab, and securities industries"

The capture theory Government has "legal" coercive power and thus has monopoly control of the "supply" of regulation. Government regulation can protect incumbent firms from rivalrous price wars and prevent entry into lucrative markets. Since the regulated firm oftentimes has a more comfortable and profitable existence than the non-regulated firm, private companies "compete" for a scarce supply of regulation.

The capture theory Though a regulatory agency may have been created with the (vague) intention of correcting market failures, as time goes by the agency is subject to "capture" by the firms they regulate. That is, the regulatory agency invariably tends to issue regulations that work to the advantage of regulated firms.

The capture theory Regulated firms expend considerable resources to lobby the regulators. It is not uncommon for an official of a regulatory agency to wind up in a high- paying job with a firm that previously fell under their regulatory purview. The regulators may not want to antagonize the firms they regulate because they want to "keep their options open." Capture theory predicts that regulated firms will earn higher rates on return (on average) than non-regulated firms.

Does not supply a theoretical explanation of the process by which the regulators get captured. Does not square with the widespread practice of cross-subsidization in regulated industries. Cannot be reconciled with the long list of regulations adopted by regulatory agencies but opposed by regulated firms. Criticism of the Capture theory

Economic Theory of Regulation Regulation: a way how interest groups reach public benefit Assumptions when do interest groups do well The public wealth is not what’s going on

Economic Theory of Regulation Original papers: Stigler, G. J.: The Theory of Economic Regulation, in: Stigler, G. J.: Chicago Studies in Political Economy, pp , The University of Chicago Press, Chicago and London 1988 Peltzman, S.: Toward a More General Theory of Regulation, in: Stigler, G. J.: Chicago Studies in Political Economy, pp , The University of Chicago Press, Chicago and London 1988

The Stigler - Peltzman model Also known as the Economic Theory of Regulation (ET), here is Professor Peltzman's attempt to extend and improve upon Stigler’s "capture theory" of regulation.Stigler’s "capture theory" Presentation based on:

Suppositions of the ET Various groups (e.g., consumers and regulated firms) compete against each other in the political arena to increase their income and wealth, or to achieve other objectives (such as environmental cleanliness). That is, groups vie to shape regulatory initiatives in a way that will serve their own (sometimes narrowly-defined) interests. Agents are rational in choosing actions that are utility-maximizing.

The basic hypothesis of the ET Regulation is one means by which state power can be exercised to the benefit of specific groups. Regulation is supplied by utility- maximizing politicians and regulators in response to the demand for regulation by interest groups.

Key assumption Those who control regulatory policy do so to maximize political support. Political support comes in the form of votes or campaign contributions.

Optimal regulatory policy Let the political support function (M) be described by: M = M(R,  ) Where R is rates established for the regulated service (e.g., electricity) by the regulatory authority (e.g., the New York Public Service Commission) and  is the allowed level of profit earned by the regulated firm (e.g., New York Edison). Notice that M is inversely related to R, ceteris paribus, and directly related to , ceteris paribus. That is: and

In other words, regulators or politicians prefer to set low rates, other things being equal, since this strategy will garner political support from the customers of regulated firms. On the other hand, allowing the regulated firm to earn high profits (which would mean higher rates, by the way) puts the regulated in good stead with business and social elites that own/control regulated firms.

Conflicting agendas Thus we have two interest groups with conflicting agendas. Consumers want low rates; whereas regulated firms want high profits. The politicians/regulators face a trade-off. If they allow higher profits, they gain political support from firms they regulate but lose support from consumers. The reverse is also true. This tradeoff is illustrated by the iso-political support function.iso-political support function The iso-political support function illustrates all combinations of R’s and  ’s that yield equal political support.iso-political support function

Profits of regulated firms Utility Rates per KWH 0 R1R1   M1M1 M3M3 M2M2 Note: M 3 is preferred to M 2, which is preferred to M 1 R2R2

Profits of regulated firms Utility Rates per KWH 0R*   M1M1 M3M3 M2M2 RCRC RMRM Profit function

Profits of regulated firms Utility Rates per KWH 0   MCMC MFMF RCRC RMRM Profit function Regulators “captured” by consumers Stigler solution— Regulators “captured” by regulated industry

We never see these extreme cases in practice. Rates established always fall between R C and R M. In states with powerful consumer advocacy groups (e.g., Wisconsin, Massachusetts), rates generally are closer to R C than in states with weak consumer advocacy (e.g., Mississippi)

Compromise: significant decrease of opposition with a small price movement P* -> P mon. : opposition of consumers P* -> P konk. : opposition of the monopoly Cena p Izokvanty pol. podpory M(∏,p) ∏(p) ∏ P monopol P konkur. P* Highly probable that the regulator won’t choose monopolistic or competitive price

Explain whether and how the regulation will be Heavily competitive environment & monopolistic price: pressure of consumers to change the regulation Heavily monopolistic environment & competitive price: pressure of the monopoly to change the regulation It’s not about a public wealth! Economic criterions used

Next lecture: G. Becker: A Theory of Competition Among Pressure Groups for Political Influence