A new economic theory of regulation: rent extraction rather than rent creation.

• Date: 01 May 1999
• Author: Ginsburg, Douglas H.
• Published date: 01 May 1999
• Author: Ginsburg, Douglas H.

MONEY FOR NOTHING: POLITICIANS, RENT EXTRACTION, AND POLITICAL EXTORTION. By Fred S. McChesney. Cambridge: Harvard University Press. 1997. Pp. xi, 216. $35.

Once upon a time, people believed that the government regulated various industries in "the public interest." The idea was that certain conditions, such as "natural monopoly" or the ability to externalize significant costs, caused markets to fail and governments to step in to correct that failure.(1)

Economic regulation predicated upon market failure can be dated conveniently to the Interstate Commerce Act of 1887,(2) in which the Congress established the Interstate Commerce Commission to regulate railroads in the interests of shippers, principally farmers and small businesses.(3) The legal notion of "affectation with the public interest" dates back much further, of course;(4) and the concept of "market failure" was not introduced in those terms until a good deal later.(5) But it is a useful simplification to say that for roughly eighty years (1885-1965), the market failure story, couched in various terms, was widely accepted.(6)

Toward the end of that period, however, economists began to point out certain problems with the story. For example, some noted that there was no plausible claim of market failure in certain regulated industries, such as motor carriers and airlines, suggesting that regulation must be explained by some other factor.(7) And, in an industry in which the market failure story seemed facially plausible -- local distribution of electricity -- George Stigler and Claire Friedland cast doubt upon the assumption that regulation had any appreciable effect upon price.(8) Indeed, by the early 1970s, alternative explanations for, or ways of understanding, economic regulation were emerging with some frequency.(9)

The new learning that emerged in the early 1970s as "the economic theory of regulation" can justly be attributed to George Stigler, which is not to say that important refinements were not added by others. It proceeds from the historical observation that regulation was in many instances sought by, rather than imposed upon, the regulated industry, which is fundamentally inconsistent with the public interest story.(10) In the new learning, regulation, whether sought by industry or imposed upon it, "is designed and operated primarily for [the regulated firms'] benefit,"(11) and to the consumers' detriment. Regulation generates rents for the regulated industry, paid for by consumers, of which the politicians get a portion in the form of contributions from the regulated firms.(12) In Fred McChesney's(13) succinct synopsis of the Stiglerian model: "If expected political rents net of the costs of organizing and procuring favorable regulation are positive, then producers will demand regulation. If payments sufficient to compensate politicians for the costs of creating regulation are forthcoming, they will supply it" (p. 9).

In other words, regulation is an item of trade, supplied by politicians who traffic in the state's monopoly on the use of force, and demanded by producers who can use regulation to extract rents from consumers. Regulation occurs because consumers, being numerous and each having a small stake in preventing it, are typically not organized as effectively as producers and hence systematically lose in the legislative struggle.

The economic theory of regulation is as familiar and obvious to lawyers and economists educated in the last twenty-five years as was the market failure story to the immediately preceding generation. Now comes Fred McChesney, in Money for Nothing: Politicians, Rent Extraction, and Political Extortion, to say that the rentcreation story cannot stand alone; it is but a part of a larger and more powerful economic theory of regulation based upon rent extraction.

McChesney demonstrates first that the rent-creation model of regulation is deficient in several respects (pp. 17-19). As an empirical matter, it is incapable of explaining the great wave of health, safety, environmental, and consumer-oriented regulation that began to emerge in the late 1960s and continues even now. In those instances, regulation simply did not create rents for the regulated industry -- although it did benefit others, such as manufacturers of pollution control equipment, who may well have participated in the legislative process. Moreover, even well-organized industries were unable to resist the imposition of sometimes very costly measures while individuals, particularly in the case of environmental regulation, were able to organize effectively notwithstanding their large number and small stakes.

Second, and more fundamentally, the rent-creation model implicitly treats politicians as passive players: "they do not actively enter the market for rents with their own demands" (p. 17). This aspect of the model, no doubt a carryover from the "consumer-sovereignty model of private markets" (p. 17), closes off an area ripe for analysis. We all know that politicians need and actively seek out both votes and campaign contributions; economists can hardly ignore, therefore, the possibility...