Rethinking Regulatory Capture | AIER

Reprinted from Independent Institute

Regulatory capture theory, popularized in article Nobel laureate George Stigler concludes that regulators are becoming “captured” by the firms they regulate. Regulators act in the best interest of the firms they regulate, not in the public interest.

Regulatory capture occurs in part because regulated firms are focused on regulatory outcomes. On the contrary, the general public has diluted interest. Regulated firms have a strong incentive to influence regulators. Majority members general public have virtually no incentive to do so.

Suppose, for example, that a firm’s regulatory protection would cost each of that firm’s million customers $5, which would then be transferred to the firm. Individuals have little incentive to counter this $5 cost they incur, while the firm will receive $5 million from regulation. The firm will lobby diligently for regulatory protection, while most consumers are likely to be unaware that regulation even exists.

A good real-life example is the mandatory inclusion of ethanol in motor fuels. Consumers have little objection to this, although we know that consumers would prefer an ethanol-free motor fuel. (Otherwise, there would be no reason to enact it.) Meanwhile, corn farmers and processors benefit enormously from this mandate in exchange for the small cost imposed on many consumers.

Regulated firms have other advantages as well. The big one is that the information the regulator uses to regulate the firm comes directly from the firm, so the firm can control this flow of information to its advantage. Another benefit is that regulators and regulated entities are more likely to know each other personally and want to stay on good terms with their friends.

The title of this post is also the title article I posted recently in Private Enterprise Journal, which complements this theory of regulatory capture. In order to create a regulator (and a regulator), it is first necessary that its creator provides certain advantages.

The creator has the advantage that the regulated firm becomes dependent on a constant stream of regulatory benefits. If regulation is deregulated, the regulated firm will suffer losses, perhaps severe enough to bankrupt the firm. Thus, regulated firms must continue to pay legislators and regulators to maintain a favorable regulatory environment.

Decades ago, airlines were regulated to limit competition between them. When airlines were deregulated in 1978, the loss of this regulatory benefit bankrupted many of them. What happened to Eastern Airlines? Braniff? Pan-American? weighted average cost? They have become victims of deregulation.

To avoid the same result as airlines, regulated firms are encouraged to support politicians and legislators who have the power to continue or repeal existing rules. As Stigler explained, regulation benefits regulated firms. However, it also makes these firms dependent on continued regulation.

Thus, politicians are able to receive payments from these regulated firms. Firms can hope to maintain a supportive regulatory environment by providing campaign contributions and other political support.

The end result is that regulated firms are “captured” by legislators and regulators. In exchange for regulatory protection, these firms become dependent on constant regulation. They must continue to pay—literally or figuratively—in order to maintain their regulatory protections.

Disney provides example what happens when firms do not support those who are entitled to continue their regulatory protections. In 1967, the Florida state government effectively allowed the company to set up its own government to run Walt Disney World. In 2022, the company opposed legislation backed by the Florida Legislature and Governor DeSantis. In response, the legislature abolished their privilege of self-government.

Firms that benefit from regulatory protection must continue to support legislatures that can remove that protection or they will lose it. Stigler concluded that regulators are being taken over by the firms they regulate. However, it is the regulated firms that ultimately end up in the hands of legislators and regulators who have the right to terminate their regulatory protection.

Randall G. Holcomb

Randall G. Holcomb

Randall G. Holcomb is the DeVoe Moore Professor of Economics at Florida State University. He received his Ph.D. in economics from Virginia Tech and taught at Texas A&M University and Auburn University before coming to Florida in 1988. Holcomb is also a Senior Fellow at the James Madison Institute and a Senior Fellow at the Independent Institute in Oakland, California.

Dr. Holcomb is the author of twenty books and over 200 articles published in academic and professional journals. His books include Political capitalism: how economic and political power is created and maintained (2018) and Coordination, cooperation and control: the evolution of economic and political power (2020).

Get notified of new articles from Randall G. Holcombe and AIER.