Bootleggers and Baptists Go Digital.

• Author: Stagnaro, Carlo
• Position: Regulation of emerging digital services - Report

Technical change in general and digitalization in particular enhance competition by reducing the cost of transactions (Munger 2015). However, potentially valuable transactions may be prevented by already-existing or newly introduced regulations. Why are such regulations that clearly have a welfare-decreasing effect not promptly removed?

Economists have developed models to understand why regulation exists. They have found that policy makers do not always pursue the general interest (however defined) but rather their own personal interest--as much as anybody else in society. In doing so, they interact with pressure groups that may have an interest (monetary or otherwise) in the proposed regulations.

A useful framework to understand how the regulatory process works comes from the bootleggers-and-Baptists (B&B) theory. The theory was originally proposed and later refined by Bruce Yandle (Yandle 1983, 1999, 2010; Smith and Yandle 2014). As Yandle explains, it gets its name "from a common phenomenon in the United States in regions that restrict the sale of alcoholic beverages on Sunday. Baptists lobby for the associated regulations; they prefer a world where less alcohol is consumed. Bootleggers, the illegal sellers of alcoholic beverages, support the laws as well. Sunday closing laws shut down legitimate sellers, giving an open field in which bootleggers can sell their wares" (2010, 3). Boodeggers and Baptists need not explicitly cooperate with each other, although that may happen: what matters is that their joint interest and their interaction can drive down the political cost of regulations.

This paper tries to answer the following question: Can B&B help to understand the regulation of emerging digital services? The paper builds both on the existing economic literature and on the author's experience in the Italian Ministry of Economic Development during the Renzi (2014-16) and Gentiloni (2017-18) governments. The next two sections review the relevant literature. Then I put B&B in the context of digital services and present a few case studies from my experience in Italy.

Theories of Economic Regulation

Why does regulation exist? The demand for regulation is affected by changes in the economic environment, which can be either exogenous or endogenous. Yandle (1983) identifies at least four factors that may affect the demand for regulation: (1) technological change; (2) demographic change; (3) significant changes in factor costs; and (4) new information. Whenever any of these changes happens, a case can be made for or against regulation.

Economists have developed several explanations concerning what happens next--that is, how regulatory decisions are made--and which specific regulations are likely to emerge from societal or economic changes. Adam Smith and Bruce Yandle (2014) track five potential theories to explain the emergence of regulation and how collective decisions are made.

To begin with, an argument can be made that regulation is introduced to correct so-called market failures--that is, all the circumstances whereby markets do not spontaneously deliver an efficient resource allocation. This assumption lies at the core of the so-called theory of the public interest. A famous example is Arthur Pigou's (1920) treatise on externalities, which introduced the notion of Pigouvian taxes to align the private and social cost of goods. The theory fell short of explaining how things work in the real world, not least because it assumed complete information (Coase 1960).

More sophisticated explanations emerged over time, starting from the acknowledgment that policy makers may have their own legitimate goals, which they take into account as they perform their jobs (Tullock, Seldon, and Brady 2002). The socalled regulatory-capture theory recognizes that policy makers do not possess all the relevant information. In order to make a meaningful decision, they entertain a relationship with vested interests.

George Stigler (1971) and Sam Peltzman (1976), among others, went further with the special-interest theory: they suggested that the political process should be viewed as a market, where rent seekers demand regulation and policy makers supply it. Rent seekers will be most effective as they (1) offer the highest bid and (2) reduce the cost of the proposed policies to the policy makers.

A fourth theory can be labeled "money for nothing" (McChesney 1991): a policy maker may publicly make an argument for a new regulation that affects a group that has been not regulated so tar. The groups affected by the proposed regulation will organize themselves and lobby for or against it, which will allow the policy maker to extract rents.

Bootleggers and Baptists

The B&B theory (Yandle 1983, 1999, 2010) supplements the previous four theories. It explains how political coalitions can lower the cost of lobbying. The key insight is that different pressure groups that apparently have little in common may join forces to pursue targets that they share, although for different reasons. The theory is named after the archetypical case of bootleggers and Baptists in southern U.S. states: Baptists advocate Sunday closing laws (or wider restrictions) for bars and liquor stores on religious grounds; bootleggers see the same laws as a useful tool to shut down competition from legal agents. Baptists provide the moral high ground for the proposed regulation, hence making it more socially acceptable: in a way, they lower the cost of obtaining consensus, or, to put it in Coasean terms, they reduce the cost of political transactions. Bootleggers lobby policy makers behind closed doors and provide political support (as well as electoral support). One key feature of the kind of regulation that emerges is that while being "morally" acceptable to Baptists, it will create a window of opportunity for the bootleggers: the latter will support Sunday closing laws because they are in the position of directly benefiting from them, but they would not support a ban on drinking alcohol on Sunday. Generally speaking, these regulations are not aimed at correcting some potential failure of the market; rather, they are aimed at restricting competition. In other words, Baptists are interested in the intentions of regulation, bootleggers in its outcomes (I borrow this point from Milton Friedman [1975]).

Randy Simmons, Ryan Yonk, and Diana Thomas (2011) have contributed to the debate by framing B&B within the framework of "political entrepreneurship"--that is, the activity of maximizing profits by seeking political rents rather than providing valuable products in the market. B&B helps explain real-life regulatory processes. Yandle (1983, 1999, 2010) and Smith and Yandle (2014) provide several examples. Environmental regulation is a fertile ground for the theory' because it is where the interaction between vested interests and nongovernmental organizations can best be observed (Zywicki 2002): fuel-economy standards in the United States (Yandle 1999), carbon control (Buck and Yandle 2002), and nuclear-waste management (Darst and Dawson 2008). International trade also provides examples (Desombre 1995; Morris 2003). Other cases include tobacco regulation (Morriss 2008), e-cigarette regulation (Adler et al. 2016), marijuana-related land-use control (Kochan 2015), and timber regulation in the European Union (EU) (Sotirov, Stelter, and Winkel 2017).

To make a long story short, B&B suggests that the probability that a regulation will be adopted is greater when it is endorsed by groups with the characteristics of bootleggers and Bapusts. But how do these groups interact with each other? Smith and Yandle (2014) define four potential modes of interaction:

1. Covert, when bootleggers dress themselves like Baptists and try to hide their real goals behind the facade of public interest

2. Noncooperative, when the two groups act independently from each other without direct forms of cooperation (as was the case with the real bootleggers and Baptists)

3. Cooperative, when Baptists and bootleggers develop conscious forms of cooperation by recognizing their mutual interests (see also Shogren 1990)

4. Coordinated, when a policy maker kickstarts a debate on a new proposal for regulation, thereby offering de facto an opening to bootleggers and Baptists

   The Digital Economy: Some Case Studies

   Most of the literature reviewed in the previous section finds evidence of B&B interactions in the "old economy." More specifically, large companies generally play the role of bootleggers (because they have greater resources to invest in lobbying activities, as shown in--among other sources--Stigler 1971 and Philippon 2019). But what about the "new economy"? Digitalization and the development of information and communication technologies (ICTs) are generally credited for improving productivity and reducing transaction costs, which often result in greater competition.

   In an extensive review of the literature, Federico Biagi (2013) found that

1. The effect of ICTs on productivity is both direct (ICTs are embedded in goods and services and in technological improvements) and indirect (ICTs contribute to the generation, storage, and dissemination of knowledge).

2. ICTs are responsible in part for the acceleration in productivity growth observed in the United States in 1996-2006 as well as for the widening productivity gap between the United States and the EU.

   Bronwyn Hall, Francesca Lotti, and Jacques Mairesse (2013) show the complementarities between ICTs and research-and-development spending, with the former having a greater effect on productivity and the latter being more relevant for innovation.

   One way of understanding and rationalizing how the digital economy works is by focusing on transaction costs. Ronald Coase's seminal paper "The Nature of the Firm" (1937) explains that the cost of transactions determines the optimal size of firms and dictates their choices regarding vertical and horizontal integration...