Alex Tabarrok

Discipline Monopolies

 Small groups with large potential benefits will organize more readily than small groups with small and diffuse benefits.  E.g. sugar producers versus sugar consumers.  Politicians respond to incentives->theory of regulation.  Capture theory (Stigler): Even when regulation is begun on behalf of the public interest over time firms capture the regulatory process and bureaucracy  Evidence supporting the capture theory of regulation:  revolving door deals - high-level regulators and other officials leave government and find high-level jobs in the same industry that they had been responsible for regulating.

 Consider some industries that are or have been highly regulated:  Airlines  Trucking  Taxi Service  Farming  All of these industries (with pos. exception of airlines) are highly competitive!  Where is the market failure?

 Note that beneficiaries of regulation are not simply “big business”  E.g. (some) farmers, truckers, taxi service, barbers, lawyers, physicians (occ. licensing).  Note also that farmers, truckers, taxi service etc. are not small groups; hence more is involved than the sugar lobby story.  Olson story of small, organized groups versus large, disorganized groups cannot be the whole story.  How do politicians trade off numbers/votes and monetary support?  What happens when two organized groups have conflicting interests?

 Assumptions  Regulation is supplied by utility-maximizing politicians and regulators in response to the demand for regulation by interest groups.  Those who control regulatory policy do so to maximize political support.  Political support comes in the form of votes or campaign contributions.

 Consider two industries with Demand elastic and inelastic.  Notice that for the same increase in price (the same R) which upsets consumers the regulated industry gets more profit when Demand is inelastic.  Benefit-cost ratio for regulators is higher when demand is more inelastic – therefore more likely that inelastic demand industries are regulated. Profits Delastic Profits Dinelastic

 A politician can divert some of the profits from the regulation to favored consumer or other groups.  E.g. prior to Amtrak one of the conditions of railroad regulation was the passenger rail would be subsidized by the railroad firms.  Electricity regulation may lead to cross-subsidies to specific customers such as rural customers.  Even though the rural customers may not be organized the politician cares about votes and makes sure the consumers know who is helping them (politician substitutes for organization).

 A politician wants to diversify, to give wealth transfers to different groups for the same reason consumers spread their purchase over many goods – diminishing marginal returns. Marginal Utility Apples Marginal Political Support Wealth transfers from politicians

Regulated Price MC Demand MR Monopoly Price

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 Hat tip for some slides to Christopher Brown.

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

Profits of regulated firms R, Utility Rate 0  MCMC MFMF RCRC RMRM Profit function Regulators “captured” by consumers Stigler solution— Regulators “captured” by regulated industry  Implication: Industries most likely to be regulated are either relatively competitive (agriculture, taxis,etc) or relatively monopolistic (network industries ).

Profits of regulated firms Utility Rates per KWH 0 R*  M1M1 M2M2 RCRC RMRM Suppose profit hill falls (e.g. increased in fixed cost). In monopoly equilibrium, monopolist would take the entire hit. In regulated equilibrium note that profit falls by less because R increases. The regulator spreads the hit across consumers and producers to maximize political support. R2*

MC Demand MR The political pursuit of profit also called “rent seeking” leads to wasteful expenditures that eat into the profit. The rents are eroded. Profit

 The Civil Aeronautics Board (CAB) extensively regulated airlines in the U.S. from 1938 to No firm could enter or exit the market, change prices, or alter routes without permission from the CAB. The CAB kept prices well above market levels, sometimes even denying requests by firms to lower prices!  The rents, however, were eroded.  Competition in quality  Nice meals  Wide seats  Under-booking  Unions

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