A New Economic Theory of Regulation: Rent Extraction Rather than Rent Creation

Once upon a time, people believed that the government regulated various indus tries in “the public interest.” The idea was that certain conditions, such as “natural monopoly” or the ability to externalize significant costs, caus ed markets to fail and governments to step in to correct that failure. Econmnic regulation predicated upon market failure can be dated conveniently to the Interstate Commerce Act of 1887, in which the Congress established the Inters tate Commerce Commission to regulate railroads in the interests of shippers, principally farmers and small businesses. The legal notion of “affectation with the public interest” dates back much further, of course; and the concept of “market failure” was not introduced in those terms until a good deal later. But it is a useful simplification to say that for roughly eighty years (1885-1965), the market failure story, couched in various terms, was widely accepted. Toward the end of that period, however, econmnists began to point out certain problems with the story. For example, some noted that there was no plausible claim of market failure in certain regulated industries, such as motor carriers and airlines, sugges ting that regulation must be explained by some other factor. And, in an industry in which the market failure story seemed facially plausible – local distribution of electricity – George Stigler and Claire Friedland cast doubt upon the assumption that regulation had any appreciable effect upon price. Indeed, by the early 1970s, alternative explanations for, or ways of understanding, economic regulation were emerging with some frequency.