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enefit from reducing its costs of production. And the natural monopoly does not significantly
suffer if its costs of production increase. Thus, the natural monopoly lacks incentives to control
costs.
2. The regulators may not be able to obtain accurate information. The regulators will have to
rely primarily on cost information provided by the regulated natural monopoly. The natural
monopoly will have a self-interest in overstating production costs (in order to receive price
increases). The regulators may not be highly motivated to search for accurate information.
Theories of Regulation
Government regulation of business often does not appear to be aimed at correcting market
failure. Government regulations extend into many areas unrelated to controlling monopoly
behavior, or adjusting for externalities, or other obvious sources of market failure. Government
regulations also tend to be very detailed and specific instead of general. This raises two
questions: Why does the government regulate business activity as extensively as it does? Why
does the government regulate business activity as intensively as it does?
Three theories of regulation have been developed:
1. Public interest theory. The public interest theory of regulation holds that regulation serves
the public interest (promotes the general welfare). This theory assumes that elected officials
(who ultimately control regulations) are motivated to always act in ways that serve the public
interest. Our study of Chapter 28 would make us question this assumption. We saw in Chapter
28 that elected officials will often be responsive to special-interest groups. Special-interest
groups may influence legislators to support government regulations that are harmful to the
public interest (e.g. trade restrictions). A great deal of government regulation does not seem to
be serving the public interest.
2. Capture theory. The capture theory of regulation holds that the regulatory agency will be
captured (controlled) by the industry being regulated. The regulators may have previously
worked in the industry that they are now regulating. They may return to work in that industry
after they leave the regulatory agency. The firms in the regulated industry have a special
interest in the policies of the regulatory agency, and are likely to remain well-informed about
the policies of the agency and to lobby the agency for policies beneficial to the industry. The
general public is unlikely to lobby the agency, or to be well-informed about the agency’s
policies.
If the regulated industry captures the regulatory agency, the agency is likely to impose
regulations that serve the best interests of the regulated industry. Regulations have often been
used to protect the regulated firms from competition.
Example 3: Between 1938 and 1978, the federal government regulated prices and routes in the
interstate airline industry. The regulatory agency divided markets and limited price competition,
much as a cartel would. The regulatory agency also controlled the entry of new competitors into
the interstate airline industry. During the forty year period of government regulation, no new
carriers were permitted to enter the interstate airline market.
3. Public choice theory. The public choice theory of regulation holds that regulation serves the
best interests of the government regulators. Regulators would naturally tend to create
regulations that would serve their own self-interest. Regulators would favor a regulatory
approach that led to more regulatory power and a growing budget for the regulatory agency.
Regulatory agencies often choose a “micromanagement” approach to regulation.
Micromanagement (managing the details as well as the big picture) would increase regulatory
power, would require a larger regulatory staff, and would require a larger regulatory budget
compared to a “macromanagement” (focusing on the big picture) approach. Regulatory
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