Regulatory Capture

Regulatory capture is a form of government failure where those bodies regulating industries become sympathetic to the businesses they are supposed to be regulating. Regulatory capture can mean monopolies can continue to charge high prices

The opposite of regulatory capture is ‘public interest theory’ – the idea that government regulation can influence monopolies to behave in the public interest.

regulatory-capture

How does regulatory capture occur?

1. Regulators become friendly with the firms they are dealing with. Spending time with people makes you more sympathetic to their viewpoint. If the regulator is in close contact and communication, then they can end up being sympathetic to their point of view and end up giving generous terms of  regulation.

2. Asymmetric information. The regulator may rely on information coming from the firm – e.g. information about prices, costs, levels of investment. With biased information, the regulator may be generous to firms – e.g. allowing price increases to fund ‘necessary investment.’

3. Inefficiencies of public sector. It is argued that those working for a regulator do not have the same incentives to work hard and act like surrogate competition. Public regulators cannot keep any reduced profit. Owners of business by contrast have a greater vested interest in promoting higher profits. This means it can be an unbalanced competition.

4. Possibility of corruption. Firms giving ‘bribes’ to regulators.

5. Under-resourced. In the UK OFGEM (regulator of whole gas and electricity industry) has 878 staff. This compares to 28,579  staff in British Gas, 10,000 National Grid and 15,000 at EDF Energy (Regulators bound by limitations)

6. Firms can push for regulation of their industry. According to Adam A. Posner the “The railroads supported the enactment of the first Interstate Commerce Act, which was designed to prevent railroads from practicing price discrimination, because discrimination was undermining the railroads’ cartel.”

American Telephone and Telegraph pressed for state regulation of telephone service because it wanted to end competition among telephone companies (Theories of regulation, 1974 link).

It is a similar situation with trucking and airlines. Companies felt that if there is government regulation, ostensibly to limit prices, it also has a role of limiting competition. For many companies, they prefer government regulation to free market forces.

Evaluation

  • Will regulators really be inefficient? Why do we assume people who work for public regulators will be more inefficient and less focused than counter-parts in the private sector? Even if public sector workers are paid less than th eprivate sector – this is not in itself a reason to give in. People in public sectors still seek to improve their human capital and gain a good reputation from doing a good job.
  • It depends how the regulation is set up. If regulators are set up to both cut prices and encourage competition – then firms may not promote more regulation. In the UK, after privatisation of telephones, electricity and gas, regulators did achieve some success in opening market to competition and ultimately creating markets which have a degree of competition.
  • Lack of alternative? With a natural monopoly, such as tap water or railways, there is little choice but to have a government regulator. It is not possible to have effective competition in an undustry with a natural monopoly. Regulators can enable the industry to benefit from economies of scale, but also avoid the worst excesses of monopoly power.

Natural monopoly at 10,000 units

  • Many vested interests can try to influence the regulator. Capture theory suggests firms put pressure on the regulator. But, this is only part of the story. Utilities like electricity and gas are often national news items – the regulator can also face pressure from public opinion, politicians and consumer groups.

Potential Examples of regulatory capture

  • HMRC – giving generous tax deals to large companies that it is investigating.
  • OFGEM – UK regulator for gas and electricity markets. In early 2016, with falling gas wholesale prices, the big energy companies were able to increase their profit margins, equalt to £120 per customer. But,  shown to be charging 9 per cent more than it cost them to provide gas and electricity to households. This translated into £120 profit per customer, according to regulator Ofgem. But according to ‘This is Money‘ the information was quietly removed. Since then it has been impossible for households to know whether providers are making a fair return.
  • Oil and Gas Drilling in US. Minerals Management Service (MMS) responsibile for offshore oil drilling in US made it easy to drill in offshore areas.
  • Interstate Commerce Commission (ICC) A regulator for the railroads which did little to promote competition and lower prices.
  • Financial regulators in build up to credit crisis – became too cozy with large banks allowing slippage in mortgage lending strategies. (Financial instability hypothesis)

Further reading

“The economic theory of regulation” George Stigler (1971)

“Theories of regulation” Adam A. Posner (1974)

Related pages

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