In past blogs, I’ve written about lots of different market failures. If you want to learn more about public goods, the tragedy of the commons, information asymmetry, natural monopolies, or externalities, check out the relevant links.
Today I wanted to talk about another problem that occurs in markets, but one that is not technically a market failure (some people use the term “government failure”): regulatory capture.
What is “regulatory capture?”
In classical microeconomic theory, firms are profit-maximizing entities. In competitive markets where prices are determined by market forces, it follows that for a firm to increase their profits they need to lower their costs.* This system is designed to drive innovation, pushing firms to improve their processes and products in order to get a competitive advantage in the marketplace. That’s the goal of the competitive market: firms that innovate more successfully get a competitive advantage and enjoy higher profits.
However, perfect competition is a theoretical ideal. In the real world, there is all sorts of noise that muddies the water. These are the market failures that we’ve spent so much time going over, and the end result is that markets often need some kind of intervention from the public sector in order to operate more efficiently. Regulatory capture occurs when the presence of regulations gives firms an incentive to use political capital to improve their standing in a market instead of relying on a competitive advantage.
One example would be a company lobbying policymakers for more strict licensing requirements in order to keep new competitors out of the market. If regulators adopt those rules primarily because of pressure from existing firms rather than because the rules benefit the public, this would be an example of regulatory capture. They haven’t invested in improving their service, but by pushing for more stringent regulations they can artificially inflate their presence in the market.
Another example would be when public officials rely on expertise from industry representatives to help form regulations. This can happen anywhere, but it is especially prevalent in highly technical industries such as information technology and energy.
The challenge with these industries is that policymakers don’t have the expertise required to make sensible regulations. The industries are just too complicated. So, they must rely on advice from members of the industry who have a vested interest in making sure the regulations suit their needs rather than overall social wellbeing.
What can policymakers do about regulatory capture?
The short answer is deregulation. Of course, there are many markets where the threat of regulatory capture is not as important as solving a market failure, so the decision whether to regulate or not is entirely dependent on the specific circumstances of a particular market. Policymakers could try and implement a regulatory budget to try and balance these competing interests.
In cases where regulators must rely on firms for specialized information, the ideal would be to have more subject matter experts working in the public sector. While governments may never have the same level of expertise as the industries they regulate, building independent expertise and seeking input from a broad range of stakeholders can make regulatory capture less likely and help ensure that regulations are designed to benefit the public rather than a handful of firms.
* Firms could also charge more for a higher-quality product, but it generally is easier to think of goods in markets as being homogenous and that producers can generate more or less surplus based on what kind of competitive advantage they have during production.