Public Choice and Regulation

Lecture 11

Recap: when do markets lead to efficient outcomes?

Markets lead to efficient outcomes when transaction costs are zero.

Recap: when do markets lead to efficient outcomes?

Markets lead to efficient outcomes when transaction costs are zero.

When transaction costs are not zero, externalities and information asymmetries can exist given a specific assignment of property rightsand they can lead to inefficiencies.

If markets may not deliver efficient outcomes, what is the alternative?

One possibility is to rely on government.

Government uses coercion to orchestrate collective action where decentralized coordination fails.

Relying on government presumes two things.

1. That government can achieve the efficient level of production.

Or at least come closer to efficiency than markets can.
This is an information problem: does government have the knowledge needed?

Relying on government presumes two things.

1. That government can achieve the efficient level of production.

Or at least come closer to efficiency than markets can.
This is an information problem: does government have the knowledge needed?

2. That government aims to achieve that efficient level.

This is an incentive problem: do political agents actually pursue efficiency?

Avoid the “nirvana fallacy.”

Nirvana Fallacy: when you attack an obtainable (but imperfect) option by comparing it to an unobtainable (but perfect) alternative.

A failure in logical reasoninglike the ad hominem fallacy, but applied to policies rather than people: you reject a real option because it falls short of an imaginary ideal.

The nirvana fallacy in practice: vaccine policy.

In April 2021, regulators paused a COVID-19 vaccine over blood-clot concerns. Compare the numbers:

The actual tradeoff

6
individuals experienced blood clots

7 million
had received the vaccine

566,000
COVID-19 deaths (at the time)

~0.2%
chance of dying if infected

Comparing the vaccine (imperfect) to a world without any blood clots (unobtainable) commits the nirvana fallacy. The correct comparison is vaccine vs. no vaccine.

The simple “market failure ︎→︎ government intervention” prescription assumes away public choice concerns.

It treats government as a benign social planner that both knows the efficient outcome and reliably pursues it.

Public choice analysis challenges both assumptions.

Public choice analysis rejects the presumption that public policy can necessarily correct so-called market failures.

Markets and governments are both recognized to be imperfect.

Public choice analysis rejects the presumption that public policy can necessarily correct so-called market failures.

Markets and governments are both recognized to be imperfect.

While sources of market failure (externalities, information asymmetries) dominate policy discussions, public choice economists insist on also acknowledgingand accounting forsources of government failure.

Public choice applies economic analysis to political agents.

Government is not a benign “social planner.”

It is composed of individuals who make choices and take actions.

Political agents are rational and self-interested.

They respond to incentives.
They need information to act consistently with those incentives.

What does public choice analysis predict about political outcomes?

Public choice analysis predicts…

1. Voters will be rationally ignorant, participation will be low.

2. Politicians will favor special interests over the public interest.

3. Bureaucracies will be inefficiently large.

4. Political agents who favor general interests will be selected against.

Prediction 1: Voters will be rationally ignorant.

But firstwhy do people vote at all?

Two theories of voting

Instrumental voting theory

Voting is aimed at influencing election outcomes.
Voters cast ballots to have preferred policies enacted.
When asked, most people claim to be instrumental voters.

Expressive voting theory

Voting is aimed at sending a signal to others.
E.g., demonstrating that you are a responsible, civic-minded person.

Instrumental voting is irrational.

The costs of voting are non-negligible. But the probability of being the decisive voter is essentially zero.

The average voter has a 1 in 60,000,000 probability of being decisive in a presidential election.
Even in a highly contested “battleground” state, the probability rises only to about 1 in 10,000,000.

If you are not decisive, your vote does not change the outcomeso your expected instrumental benefit is essentially zero.

Expressive voting is consistent with observed behavior.

Voters express values and identity, not just policy preferences.

Demonstrating patriotism, civic virtue, or group membership.
“If you didn’t vote then you have no right to complain!”

Expressive voters need not vote their true policy preferences.

Someone may prefer peace to war on instrumental grounds…
…but recognize their vote will not be decisive and place positive value on expressing patriotism.
Result: expressed political preferences may diverge from sincere preferences.

Whether instrumental or expressive, voters are likely to be rationally ignorant.

There are a large number of complex policy issues.

Becoming informed is costly in time and effort.

If the probability of a vote being decisive is essentially zero, the marginal benefit of becoming better informed is also essentially zero.
Being ignorant does not decrease the expressive value of a vote.

Rational ignorance is the predictable equilibrium outcome, not a failure of character.

Prediction 2: Politicians favor special interests over the public interest.

Politicians as vote-maximizers

Politicians aim to win and retain officethey are vote maximizers.

Special interest groups pay for policies that concentrate benefits on them and spread costs widely.

By funding a politician’s campaign, a special interest group increases his or her ability to gain votes.
Individual voters bear very small costs from any single policynot worth organizing to resist.

Rationally ignorant voters do not hold politicians accountable for favoring special interests.

The information cost of tracking policy favors is high, the individual benefit is negligible.

Prediction 3: Bureaucracies will be inefficiently large.

What do bureaucrats maximize?

Firms maximize profits.

Politicians maximize votes.

Bureaucrats maximize the size and budget of their agency or department.

With command over more resourcespeople and moneycome raises and promotions.
A firm is “successful” when it is profitable, a politician when re-elected, a bureaucrat when more visible and powerful.
There is no bottom-line profit signal to discipline bureaucratic growth.

Prediction 4: Principled political agents are selected against.

Adverse selection in the political market

Public choice assumes politicians are self-interestednot necessarily selfish.

Many politicians may genuinely care about good policy.

But the incentive structure selects against principled agents.

A candidate who does not pander to special interests is less likely to be elected.
A bureaucrat who does not maximize budget and agency size is less likely to be promoted.

The result is an adverse selection problem.

Principled political agents are either selected out of the system…
…or they must compromise their principlesat least in partto survive within it.

Public choice helps us understand the regulatory environment businesses face.

Regulation: government intervention into markets, including taxes, subsidies, and legislative and administrative controls over economic activity.

Two competing theories explain where regulation comes from and what it does.

Public Interest Theory vs. Capture Theory

Public Interest Theory

Markets are fragile and likely to work inefficiently if left unfettered.

Externalities, information problems, and market power all generate welfare losses.

Government intervention can offset those social welfare losses.

Agricultural subsidies and price controls on utilities.
Minimum wage laws and union protections.
Occupational licensing.

Howevermany regulations appear prima facie to not be in the public interest.

Their benefits are unclear, while their direct and indirect costs are substantial.

Example: occupational licensing

Occupational licensing requires practitioners to obtain government permission to work in a field.

In 1950, roughly 5% of U.S. workers required a license. Today, roughly 25% do.
Licensed occupations include interior designers, florists, hair braiders, and tour guidesalongside doctors and lawyers.

The public interest justification: protect consumers from low-quality or dangerous practitioners.

The public choice critique: licensing restricts entry, raises prices, and concentrates benefits on incumbents.

Who lobbies for licensing requirements? Existing practitionerswho benefit from reduced competition.
License to Work: A National Study of Burdens from Occupational Licensing (Institute for Justice) documents these costs extensively.

Capture Theory offers an alternative explanation of regulation.

Both regulators and the regulated firms or individuals are rational and self-interested.

Capture Theory

Regulatory capture occurs when groups have an interest in the outcome of policy decisions and allocate resources to achieve desirable outcomes.

Regulators can gainvotes, campaign finance, control over resourcesby providing those outcomes.

Groups form special interests and engage in rent-seeking.

This creates a demand for regulation from private interests…

…which is satisfied by the supply provided by legislators and regulatory agencies.

Firms can obtain monopoly rents through regulation.

Traditional means: alertness to profit opportunities, collusion.

Political means: influencing legislators and regulatory agencies.

When the political route has higher net benefits, firms will organize and rent-seek.
Incumbents lobby for regulations that raise barriers to entry, reducing competition.

George Stigler formalized this insight (Nobel Memorial Prize in Economics, 1982).

“The Theory of Economic Regulation” (1971).
Regulation is typically acquired by the industry and designed and operated primarily for the industry’s benefit.

Capture theory, George Stigler (1911–1991), Nobel Laureate 1982

“As a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit.” George J. Stigler, “The Theory of Economic Regulation,” Bell Journal of Economics and Management Science, 1971

The insight: Rather than asking “has the market failed?” and concluding “therefore regulate,” Stigler asked: who actually demands regulation, and what do they get from it? The answer is almost always concentrated interests, not dispersed consumers. Understanding this is essential for navigatingand potentially shapingthe regulatory environment your business faces.

Public Interest Theory vs. Capture Theory

Public Interest Theory

Regulation corrects market failures.
Government acts as a benign social planner.
Interventions reflect the general welfare.

Capture Theory (Stigler)

Regulation reflects demand from special interests.
Legislators supply regulation in exchange for political support.
Interventions often harm consumers and entry-level competitors.

Both theories can be true in different contexts.

The question is always: who benefits? Who bears the cost?

Implications for business decision-making

Understand the regulatory environment as a product of political incentives.

Regulations are not necessarily in the public interest, they may exist because someone lobbied for them.

Regulations can be a tool for competitive advantage.

Incumbents use occupational licensing and other barriers to limit entry.
Understanding this lets you anticipate your competitors’ political strategies.

Managers who understand public choice are better equipped to navigateand potentially shaperegulation.

Public choice: the four predictions revisited

1. Rational ignorance of voters

1/60,000,000 probability of being decisive ↠ zero marginal benefit to becoming informed.

2. Politicians as vote-maximizers favor special interests

Campaign finance + rationally ignorant voters = incentive to serve concentrated interests.

3. Bureaucrats maximize agency size

No profit signal, advancement tied to resource command.

4. Adverse selection against principled agents

The system selects for those willing to pander, principled agents must compromise or exit.

The choice is never between a perfect market and a perfect government.

Both markets and governments can fail. The relevant question is always comparative:

Which institutionin this specific context, with these specific information and incentive constraintsis likely to produce a better outcome?

Public choice analysis insists that we apply the same skeptical scrutiny to government that we apply to markets.

Discussion: can you explain these regulatory patterns?

Why do incumbent taxi firms lobby against ride-sharing regulations?

Why do established doctors support strict occupational licensing for new medical professionals?

Why do agricultural subsidies persist even when economists across the political spectrum criticize them?

Why might a newly created regulatory agency eventually come to represent the interests of the industry it regulates?