How Insurance Works

Principles of Microecon 80 – Government Failures – Regulatory Capture

In this video we will look at a form of government
failure called “regulatory capture”. So, what is regulatory capture? In brief,
regulatory capture occurs when regulators end up serving the industries they are supposed
to be regulating rather than serving the public as a whole.
How does regulatory capture come about? There are three primary means: first, campaign contributions.
It isn’t unusual for important interest groups to give substantial campaign contributions
to influence elections. gathers information about campaign contributions,
and the results are often interesting. First, most of the biggest donors support Democrats.
Most of the biggest donors also happen to be labor unions. So, is it any wonder that
the Democratic Party tends to support more pro-union policies, while the Republicans
tend to oppose such policies? Some organizations – like the National Association of Realtors
– divide their money almost evenly between the parties. An odd practice if one is trying
to influence the outcome of an election, but a spectacular strategy if one believes that
whoever gets elected will be in a position to benefit you.
Second, lobbying. In addition to direct campaign contributions, various organizations will
pay professional lobbyists to try to influence legislation to their benefit. Studies show
that money spent on lobbying provides phenomenal returns. That is: lobbying is popular because
it works. Third, shared personnel. It isn’t unusual
for regulators to have originated in the industry that they are hired to regulate. To some degree,
this feels reasonable. After all, who knows the business of banking better than a banker?
So, why not hire a banker to regulate banks? Surely, they have the expertise. The problem,
of course, is that regulatory agencies tend to be something of a revolving door – people
will move from industry into regulation and then back into industry. This raises the question:
who are they serving when they are in the regulatory bureaucracy? Are they serving the
public, or are they serving their former and future employers?
What, then, are the consequences of regulatory capture? In order to answer this question
we first need to think about those cases in which regulation would exist. It really only
makes sense to regulate an industry in matters where the interest of the industry runs against
the best interest of the public. For example, when monopolies restrict production to prop
up their prices and profits, or when polluters ignore the consequences of the pollution they
create. If regulatory capture occurs, however, we can first be confident that those regulations
that would benefit the public at the expense of the regulated will not get passed.
However, things are a bit worse than that. With the power of regulation at your disposal,
all kinds of self-serving options are available – from securing government contracts, as
in the case of defense contractors, to requiring people to buy your product, as in the case
of health insurance under Obamacare, to special tax treatment, as in the case for mortgage
interest, health expenses and gifts to charitable organizations, to stifling competition as
in the case of pharmaceuticals which benefit from patent extensions and broadcasters and
publishers which benefit from long copyright protections. Naturally, some people also benefit
from these – the mortgage interest tax deduction benefits millions of homeowners. However,
there are two negative consequences to this kind of policy.
First, most of these policies are simply redistributions. When mortgage interest is tax deductible,
but the government is continuing to spend, then that money has to come from someone.
So, people without mortgages have to pay more so that people with them can pay less. Second,
these policies redirect resources – often in inefficient ways. Allowing people to deduct
mortgage interest on their taxes encourages people to take on larger mortgages than they
otherwise would. This directs resources into banking and homebuilding that could have provided
more value elsewhere in the economy. But, the fact that other choices are taxed in a
way that mortgages are not redirects the behavior of the public.
So, what can be done about regulatory capture? I suggest two possibilities. First, the influence
of the regulated on regulation can be limited. Placing limits on campaign contributions,
lobbying, and the revolving door between industry and regulatory agencies are all ways that
this influence could be mitigated. However, there are legitimate concerns here. After
all, it is true that the regulated industries do have useful information when we are writing
regulations. Since providing information itself provides a path for influence to happen, the
only way to cutoff influence is also to cut off information. Even setting aside concerns
about free speech, this practical consequence alone suggests the choice is between regulating
largely in the dark and regulating under the influence of the regulated. This leads us
then to the second possibility: regulation itself can be limited. If regulatory agencies
have little power, then there is little to be gained from trying to influence them. True,
that means that we have decided not to do much about any of the problems that regulation
would be designed to try to solve, but at the same time it would also mean that we would
eliminate a tool that regulated industries have to benefit themselves at the expense
of the public. Obviously, there are tradeoffs involved, and the correct answer is not simple.
However, an awareness of the tradeoffs at least allows us to make a somewhat informed
decision. To sum up: regulatory capture occurs when
regulated industries have significant influence over the content of regulations. They secure
this influence through campaign contributions, lobbying, and personnel. As a consequence,
regulated industries can end up in a position to use the power of the regulator to benefit
themselves. To limit this problem, we can limit the influence of industry on the regulators
or we can limit the influence of the regulator themselves.

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