The public interest theory of regulation centers potential market failure---examples include problems emerging from excessive monopoly power, asymmetric information, strategic behavior, and externalities. The idea that imperfect information adversely affects market solutions is used most to rationalize laws regulating consumer protection and labor markets.
The public interest theory of regulation is the idea that people need protection from business abuses or other market failures. This theory assumes that regulation serves the public's interest by restricting harmful business activities.
Using antitrust policy to lessen monopoly power by breaking up huge firms may inefficiently raise costs. If the minimum efficient scale of production (MES) is high relative to market demand, then at most only a few firms can achieve the lowest possible production costs. Government provides highways, but most other natural monopolies (industries with such extensive economies of scale that only one firm can operate efficiently) are privately owned---e.g., electric generation, railroads, cable TV, and the distribution of natural gas.
Requiring competition among small firms inefficiently denies the public the lower costs and prices available through economies of scale. But how can policymakers prevent natural monopolies from limiting output and raising prices?
The dilemma a natural monopoly poses is diagrammed in Figure 6, which shows how economies of scale may allow only one firm to operate efficiently. If two firms each produced Qm, average total costs for each firm would be ACm (point c). Since 2Qm= Q0, limited demand drops the prices (P0 at point a) these two firms could charge below ACm. Having two or more firms is unsustainable, because each would lose money until only one survived. If consumers bought from an unregulated monopoly, however, output would be limited to Qm and sold at price Pm, possibly exceeding the price associated with some competition. Price exceeds marginal cost in this monopoly solution, so there is economic inefficiency.
The public interest is served best if only one firm exploits these economies of scale and then prices appropriately. A regulated uniform price restricted to a "fair price" Pr (point d) would yield normal profits, and consumers would pay less than the unregulated price Pm. However, socially optimal pricing and output requires that P= MC. Could a regulator reasonably require that the last unit Q0 be sold at price P0 so that efficiency is realized? If a price of P0 is charged for each unit of output, the firm's revenue equals area Oabc, which is inadequate to cover total costs equaling area Ofec. No firm would be willing to stay in business if regulations forced such constant losses. Fortunately, a form of price discrimination provides a way out of this quandary.
Block pricing techniques can efficiently generate sufficient revenues to cover all costs, including a normal rate of return for a regulated monopolist.
In a block pricing system the more you use of the regulated monopolist's product, the lower the price for extra units.
For example, block pricing is used for electricity rates. You pay a hookup fee and then a minimum monthly charge. As you use more electricity, your total bill rises but the rate per extra kilowatt hour declines. Figure 7 replicates the cost and demand data in Figure 6 but shows that with block pricing, revenues (the entire crosshatched area) can cover costs (area Ofec). Because the price of the last unit equals its production cost (point b) in this example, marginal social benefit equals marginal social cost and this market operates efficiently. Notice that block pricing uses price discrimination to yield efficiency. Block pricing is commonly used for public utilities (natural gas, electric, and telephone services), for railroads and other forms of regulated transportation, and for pipelines.
Rate Making in Practice
In practice, utility regulation is a complex process that absorbs the efforts of thousands of people. Rate making (setting utility prices) requires the agency to select a base period for calculations (usually the preceding year). All the firm's operating costs, including depreciation and taxes, are then summed. A reasonable accounting profit, derived by multiplying the rate base by the percentage rate of profit allowed, is added to operating costs.
The rate base is the value of capital to which the profit rate applies. The regulator ideally adjusts rate structures so that total revenue covers all operating costs, including a normal profit.
Desires for minimal rates must be weighed against allowing normal rates of return. This trade-off invariably provokes disagreements about (a) appropriate values for items allowed in the rate base, (b) "fair" rates of return, and (c) how to structure rates. A utility has few incentives for efficiency if all "costs" are allowed. Executive limousines, corporate retreats in lush resort areas, and generous employee benefits would all become "costs." On the other hand, rates must adequately protect the financial health of the utility for it to attract capital for expansion or to respond to new environmental regulations. Finally, the regulatory commission must continually monitor the quality of service.
Utility commissions normally target rates of return in the 8 to 12 percent range. Changes in fuel costs, demand, or efficiency can cause sustained deviations from the target return, prompting the regulatory commission to adjust the rates. When people are not especially concerned about their utility bills, regulated monopolies may operate inefficiently and still squeeze favorable rate structures from regulators. When higher costs arouse the public, however, utility companies may be unable to charge rates high enough to cover costs.
Externalities and Direct Regulation
Benefits or costs to a party not directly involved in an activity are externalities. Some forms of auto safety equipment convey externalities. Others do not. Seat belts and air bags, for example, protect only a car's occupants and could be sold just like wheel covers, stereos, and so on. Drivers and their passengers are the primary beneficiaries of this equipment. It directly protects the individual buying it, and externalities are negligible.
Shock-absorbing bumpers, on the other hand, generate externalities. The buyer gains, but other drivers do as well. Damages are reduced when a car with a shock-absorbing bumper collides with other cars. External benefits are bestowed on passengers of cars with regular bumpers, but payments for such external benefits are impossible to collect. Thus, private purchases of shock-absorbing bumpers will be less than socially optimal, so carmakers are now required to provide such bumpers. This is an example of a positive externality in which regulation governs the form of a good. Compulsory education and inoculations against communicable diseases also entail positive externalities.
Negative externalities spread costs beyond the transaction in question. If a firm discharges waste into a stream, people who use the stream for recreation pay part of the costs, even if they never buy the product. No firm will adequately control its waste voluntarily if cleaning up imposes costs not borne by its competitors. Competitors will undercut price premiums that cover the higher costs of nonpolluting firms. Government intervention may be necessary to compensate for these third-party costs. Direct regulation generally limits some forms of pollution and forbids other, more dangerous pollutants. We leave a detailed discussion of environmental policies to a later chapter.
In summary, rationales for government intervention in business activities emerge from several sources. Some regulations are responses to economies of scale in production or the nature of the product itself. Some regulation arises from an industry's ability to promote its self-interest; some also serves the bureaucrats charged with administering the law, who gain power and larger budgets by expanding the scope and complexity of regulation. Finally, externalities are the primary rationale for environmental protection. Each of these explanations seems to fit specific cases, but the overseeing of business is only part of the regulatory landscape. Your activities are also shaped by governmental regulation.
The public interest rationale for regulation went unchallenged for years. When regulation has not operated in the public interest, a standard interpretation is that these imperfections are simply consequences of imperfect people doing their jobs as regulators in imperfect ways. Only recently has this explanation for regulatory peccadilloes been questioned.