A Graphical Exposition of the Economic Theory of Regulation

I. INTRODUCTION Historically, many if not most economic theories have advanced in three fairly distinct stages, progressing from descriptive to graphical to mathematical formulations, generally in that sequence. The economic theory of regulation, however, has been an exception to this normal order of progression. The fundamental corpus of this theory was laid out initially in the descriptive discussions provided by Stigler (1971), Posner (1974), and others. From these early presentations, however, the theory was subsequently formalized mathematically by Peltzman (1976) and Becker (1983) without passing through the graphical stage of its development. (1) Regardless of the chronological order of the progression of this theory, however, we believe that a fully developed graphical exposition is likely to be of considerable value even now. At least two considerations support this view. Specifically, by making this theory more accessible to a wider audience and by better illustrating the basic underlying mechanics behind it, the likelihood of significant future advancement, we believe, is enhanced. Indeed, currently there remain a number of observed regulatory phenomena that have yet to be satisfactorily explained by the existing theory (e.g., the deregulation movement and the specific pattern of observed cross-subsidies). (2) An improved understanding of the fundamental components of the theory should facilitate its further advancement and lead to an expanded ability to explain a broader range of regulatory practices. We illustrate this point through a variety of applications to provide an improved understanding of, inter alia, the markets likely to be chosen for regulation, the propensity of regulatory benefits to be spread across interest groups, the symbiotic nature of regulation and cross-subsidization, and the economics of deregulation. We also are able to depict graphically the relationship between the economic theory of regulation and the traditional normative model of regulation, which assumes that regulators maximize social welfare. The article is organized as follows. In section II, we briefly describe the regulator's general optimization problem--viz., what precisely is being maximized and what constraints apply to that maximization problem. The latter topic--the constraints--will be of primary interest here. Section III presents the formal graphical analysis of these constraints by deriving what we label the regulator's "benefits budget constraint." As its name suggests, the benefits budget constraint defines the locus of maximum benefits the regulator is able to deliver to the affected interest groups. Importantly, that constraint is determined by the prior, unregulated market equilibrium price and output and by general market parameters, such as demand elasticity, costs, and so on. Section IV describes the resulting regulatory equilibrium. Section V, then, applies the graphical tools developed in sections II-IV to explain a number of commonly observed regulatory phenomena. Here, both the ability to provide new insights and the pedagogical value of the graphical approach are illustrated. Finally, section VI concludes. II. THE REGULATOR'S GENERAL OPTIMIZATION PROBLEM The economic theory of regulation postulates that regulators will attempt to maximize some objective function (most generally, the regulator's utility) by implementing regulatory policies that benefit (and, by necessity, harm) particular interest groups. (3) The benefits provided to these groups are then used to "purchase" from them the objects that are directly valued by the regulator--that is, the direct arguments contained in the regulator's objective function. The distribution of these benefits and harms across the affected groups (which is determined by the regulator's choice of a particular regulatory policy) is selected to maximize the value of the regulator's objective function. The ability of any specific interest group to curry regulatory favor, then, will depend on the capacity of that group to deliver the objects of value to the regulator in exchange for the benefits provided by the regulatory process. …