The capture theory of regulation

Box 4. The capture theory of regulation

Standard models of regulation often assume that regulators pursue a set of social objectives. In these models there is no difference between what regulators ought to do and how they actually behave. Even early on, however, this view of the regulator as a benevolent maximiser of social welfare was regarded as flawed, see Kahn (1971), Stigler (1971), Buchanan (1972), Posner (1971, 1974), and Peltzman (1976). The “capture” or “interest group” theory of regulation empha- sises the objectives of regulators as rent-seeking, analyses the behaviour of the regulators in terms of maximising political support, and emphasises the role of interest groups (including regulated firms) in the formation of regulatory policy. 1 The risk of regulatory capture is higher when information asymmetries exist

(Laffont and Tirole, 1993), 2 but regulatory capture is possible even under complete information as long as the organisational or transactions costs associ- ated with preventing the regulatory outcome are large. 3

Political economy considerations are also useful in interpreting regulatory reform. The larger the costs of regulation, the weaker the political sustainability of a given regulatory arrangement. 4 The overstepping of these bounds in many industries in the 1960s and 1970s probably encouraged the OECD-wide regulatory reform movement (as regards the experience of the United States, see Keeler, 1984 and Peltzman, 1989). Costs of regulation for regulated interests became excessive because i) procedures were increasingly cumbersome, partly due to the need to mediate between a growing number of conflicting parties; ii) pressures were exerted by regulated firms competing on activities that could not be regu- lated (e.g. service competition in air travel); and iii) entry into unregulated activi- ties substituted for regulated ones (e.g. call-back or closed user groups telephone services, road vs. rail freight). Such pressures undermined the ability of regulated interests to extract rents from unorganised groups (Noll, 1999).

1. In a more formal sense regulators (or politicians) can be seen as maximising their chances of being re-appointed (or re-elected), weighing differently the support of the various groups affected by regulation to reflect their relative importance or power. Interest groups, on the other hand, will influence government up to the point where the marginal benefit from regulatory favouritism is equal to the marginal cost of influence- seeking activities.

2. This is because interest groups have more power to influence the regulatory process in the presence of asymmetric information. For example, the regulator has more discretion, e.g. from the public, parliament or ministers, when asymmetries of information are stron- gest and regulation less efficient. Also firms have greater possibilities to distort information in the presence of asymmetries, and thus it becomes easier to “capture” the regulator.

3. For example, the power of an interest group to influence regulatory decisions will depend upon its stake and the costs of influence-seeking activities. The logic of collec- tive action implies that for a given issue, the smaller the group, the higher the per capita stake and the higher the stake, the greater are the incentives to affect the regulatory process (Olson, 1965).

4. While politicians usually give regulators some leeway to redistribute income through the regulatory process (with a concurrent cost in efficiency), this is sustainable only if the efficiency costs of regulation are low or the welfare weights applied by the regulator to different groups differ by a small amount (Keeler, 1984). The costs of regulation include the burden of regulatory compliance and the effects on the responsiveness of regulated firms to changes in technology, costs and demand (Noll, 1999).

OECD Economic Studies No. 32, 2001/I