Why Regulators Can't Regulate Effectively

JUNE 01, 1986 by E.C. PASOUR

Dr. Pasour is a professor of economics at North Carolina State University at Raleigh

Government regulators face insurmountable knowledge and incentive barriers.

There is widespread agreement that government price regulation is not achieving its objective—whether the product is milk or electricity. However, there is no consensus as to why the results of price regulation are so unsatisfactory. Ralph Nader and consumer groups typically place the blame on the regulators. Others, including some economists, attribute the poor results to lack of resources devoted to regulation. There is a great deal of evidence, however, that larger expenditures by regulatory agencies will not solve the problems of price regulation.

Problems confronting price regulators are similar to those facing central planners of all types. This paper discusses the problems innate in central direction and describes the implications for two types of price regulation.

Economic planners are doomed to disappointment because of incentive problems and information problems.[1] Incentive problems are inherent in the political process because of the separation of power and responsibility. That is, political actors do not bear the major responsibility for the outcomes of their decisions. The incentive problem arises whether decision-makers are elected or appointed.

For the elected official, the next election is a primary concern and actions taken are heavily influenced by re- election considerations. Indeed, political incumbents have manipulated Social Security payments, agricultural price supports, and other government programs in attempts to affect upcoming elections. Politicians generally favor policies where the benefits are immediate and the costs are delayed. This short-run bias in the political process has contributed to the growth of government deficits in the United States during the past fifteen years. Budget-balancing is politically unpopular because the costs to the public are immediate but the benefits occur in the long run when current legislators may be out of office.

Non-elected public officials also have incentives to use the regulatory process to their own advantage. There is no single goal of bureaucrats, but salary, public reputation, and patronage are all associated with size of budget.[2] Thus, it is no accident that government agencies once established tend to grow regardless of changes in economic conditions.

Information problems also prevent regulators from regulating effectively. These information problems are rooted in the separation of knowledge and power. That is, individuals With decision-making power in the political process do not have and cannot obtain the specialized information about demand and supply conditions known by producers, consumers, and resource owners. Thus, even if government employees were all selfless public servants totally dedicated to the public weal, regulators would be unable to regulate effectively because of information problems.

Opportunity Cost and Entrepreneurship

Consider the problem that arises when regulators attempt to set utility prices on the basis of costs. The decision- maker is influenced by opportunity cost, and the opportunity cost of any action is the value of the sacrificed alternative. The cost of a vacation trip by Jones, for example, is the value he places on the refrigerator, automobile, or other good(s) or service(s) that must be given up if the trip is taken. Opportunity cost is subjective because the sacrificed alternative is not actually experienced. Thus, attempts to set prices on the basis of costs are futile because regulators cannot determine the costs that influence entrepreneurial choice.

Consider the cost of generating electricity in a nuclear power plant. Entrepreneurial expectations are always crucial in cost calculations involving depreciation, interest, and other outlays. Expectations concerning obsolescence, likelihood of closedowns, and so on, however, are likely to vary widely—especially in the case of nuclear power. Thus, the cost and revenue calculations of production processes ultimately hinge on subjective opinions.

Why not set public utility prices competitively on the basis of demand and supply conditions? Focusing on supply and demand does not avoid the problem that the relevant data are subjective. It is not a matter of discovering the demand or the supply for any particular product. Demand and supply for any product depend upon assumptions made. The amount of product consumers will purchase at any given price, for example, depends upon a number of factors including income, length of adjustment period, and expected prices of closely related products. Similarly, product supply depends upon length of run, expected input costs, expected tax policies, and so on. Thus, differences in expectations about the multitude of factors affecting demand and supply imply a difference of opinion about future product price.

Cost and revenue calculations and entrepreneurial actions ultimately hinge on subjective opinion. Furthermore, in cases in which utility commissions attempt to regulate prices, it is likely to be a matter of differences of opinion. Since entrepreneurial cost and revenue calculations are based on unique knowledge and attitudes toward risk, the validity of over-riding such calculations by the regulator is “dubious in the extreme.”[3] Although these theoretical problems are not widely recognized, there is growing disenchantment with the results of conventional approaches to utility regulation and increasing interest in various deregulation alternatives.[4]

A different problem arises when government attempts to redistribute income by raising product price—purporting to set product price on the basis of costs, as in farm price-support programs. During the Carter Administration, for example, cost of production was specified as the primary guide to be used in setting farm price supports.

However, cost of production is not feasible as a basis for price setting because cost is not independent of price. If government sets the price of (say) wheat above the competitive free market level, profit-seeking wheat growers will bid up the price of wheat land and other specialized resources required to produce wheat. Thus, competition brings about a strong tendency for prices of specialized wheat resources to increase as long as costs, including returns to entrepreneurship, are less than the expected product price. Under these conditions the best estimate of cost of production is product price. Even if the price of wheat were raised to (say) $10 per bushel, prices of wheat land and other resources would continue to increase as long as wheat farming was unusually profitable.

A similar phenomenon occurs when product price is increased by governmental restrictions on entry through the use of land allotments, taxi medallions, and so on. In each case of restricted entry, expected benefits of increased price are incorporated into higher costs so that expected profits of new entrants are similar to those of other investments of comparable risks.

Moreover, the gains to producers arising from government largesse are transitional, accruing to the affected firms when a program is implemented (or benefit level increased). Later producers are not helped because the benefits of higher prices are offset by higher costs. Thus, government programs of this type result in a “transitional gains trap.”[5] Once a government program is instituted and the expected benefits incorporated into higher input prices, all producers incur windfall losses if the program is terminated.

The preceding scenario is important in explaining the financial plight today of many farmers who purchased land in the late 1970s when agricultural product prices were high. Owners of farm assets generally received transitional gains during this period because of the government’s inflationary monetary and fiscal policies. In the heady economic environment of the late 1970s, farmers and other investors recklessly bid up prices of land and other farm assets because of expected favorable product prices and continued increases in prices of farm real estate. As the rate of inflation plummeted during the early 1980s, prices of farm land, buildings and other specialized agricultural resources also decreased dramatically. Once inflationary expectations are incorporated into higher resource prices, government policies that reduce inflation expectations impose windfall losses on owners of specialized resources, just as do reductions in price supports.

Farm programs affect farm asset owners and farm operators differently. Owners of farm assets receive short- run gains either if farm programs are implemented or if benefit levels are increased. However, farmers in their roles as farm operators or farm laborers receive little or no long-run benefits from farm programs. The benefits to farm operators are offset by increased costs. Farm programs also have little effect on returns to farm labor because farm labor readily moves in and out of agriculture. Since competition for labor and entrepreneurial skills tends to equate returns throughout the labor market, the return to labor in the rest of the economy (not farm programs) is the main determinant of farm incomes in the long run.[6]

Conclusions and Implications

Two reasons have been discussed as to why regulators cannot regulate prices effectively. First, neither the costs nor benefits of regulatory actions are borne mainly by the regulators. Second, even if there were no incentive problem, information prevents public utility commissions and other regulatory agencies from setting price on the basis of cost. Thus, even if regulators have the proper incentives, they cannot obtain the required information to regulate in the “public interest.” The highly specialized information of consumers and producers will be most fully utilized in decentralized competitive markets.

Regulators cannot regulate effectively either when they attempt to set price at the competitive level, or when they attempt to redistribute income by raising prices. In the latter case, benefits are incorporated into input prices raising costs to all producers. Thus, gains from government programs to assist producers are transitional and short lived. Moreover, when a price is arbitrarily increased, there is no economic basis for determining what the price should be. That is, if a policy benefits some people at the expense of others, there is no objective procedure to weigh the gains and losses in determining whether the policy is beneficial to the public at large. Thus, public policy recommendations ultimately involve value judgments.

The conclusion is that public policy cannot be prescribed on the basis of economic rules. Economic efficiency rules are beneficial to individual decision-makers but these rules, as Hayek emphasizes, are not the answer to public policy problems.[7] The data necessary to use economic efficiency rules for policy purposes cannot be obtained by government planners—whatever the policy at stake.

The analysis of public policy issues appears in a different light when incentive and information problems are taken into account and the subjectivity of costs and benefits is recognized. The focus of attention shifts from economic efficiency rules to the institutional framework that provides the greatest opportunity for individuals to cooperate in pursuing their own ends through decentralized coordination of their activities. Much work remains to be done in increasing understanding of the operation of the competitive market process where entrepreneurial activity is fueled by subjectivist expectations. However, no further work is required to show why price regulation invariably fails to achieve its purpose.

1.   Many of the points of this paper are discussed in more detail in the author’s paper “Information, Incentives, and Regulation” in Electric Power: Deregulation and the Public Interest, John C. Moorhouse, ed. {San Francisco, CA_: Pacific Institute for Public Policy Research, forthcoming).

2.   See William A. Niskanen, Jr. Bureaucracy and Representative Government (Chicago: AIrline, 1971).

3.   G.F. Thirlby, “Economists’ Cost Rules and Equilibrium Theory,” Ch. 11 in L.S.E. Essays on Cost, J.M. Buchanan and G.F. Thirlby, eds. (London: Weidenfeld and Nicolson, 1973). p. 281.

4.   A number of regulatory reform proposals are discussed in Electric Power: Deregulation and the Public lnterest, John C. Moorhouse. ed. (San Francis. co, CA.: Pacific Institute for Public Policy Research. forthcoming).

5.   Gordon Tullock, “The Transitional Gains Trap.” Bell Journal of Economics 6 (1975): 671678.

6.   D. Gale Johnson. “The Performance of past Policies: A Critique,” Ch. 2 in Alternative Agricultural and Food Policies and the 1985 Bill, Gordon C. Rausser and K.R. Farrell, eds. {Berkeley, CA.: Giannini Foundation, 1985).

7.   F.A. Hayek, “The Use of Knowledge in Society,” pp. 7%91 in Individualism and Economic Order {Chicago: University of Chicago Press, 1948).


July 1986

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