Of Stranded Costs and Stranded Hopes.

• Author: MCCHESNEY, FRED S.

The Difficulties of Deregulation

Given the manifest inefficiency of government regulation, why is there so little deregulation? Of course, some deregulation, including the privatization of state-owned industries, has occurred in recent decades. The United States experienced a spate of high-profile deregulations from 1978 to 1980 in the natural gas, trucking, and airline industries (Crandall and Ellig 1997). In Europe, deregulation has occurred concurrently with, and often as part of, the privatization of numerous sectors of the economy.

But the observation that deregulation has occurred in some markets in some places naturally raises the question, Why has it not occurred in all markets, everywhere? In America, deregulatory passions have cooled, leaving the vast bulk of regulated industries untouched. If one added the failures to privatize industries such as the postal service and east-coast railroad service, plus the current to-and-fro over deregulating electricity supply in different states, the list of missed opportunities for deregulation would be even longer. Even that staunch free-marketer, Ronald Reagan, achieved little in the way of deregulation. And in some areas where government control of the economy fell during the 1980s (notably in telecommunications) the reductions have proven to be only temporary respites or are constantly threatened. Much telephone deregulation in particular has turned into reregulation.(1) The Contract with America announced by the Republicans in 1994 to reduce government regulation is now just a rueful memory.

Why is deregulation so hard to achieve? I shall suggest several reasons. Perhaps the most interesting ones pertain to the potential gains from deregulation, which, I maintain, are often smaller than they are believed to be. In short, deregulation may not be worth the candle.

Two preliminary points merit emphasis. First, the analysis here is positive. It attempts to explain as a purely descriptive matter why there is often little pressure for deregulation. No broad normative conclusion is advanced (or warranted) that deregulation is not a good thing or that it should never be attempted.

Second, no one positive explanation for the frequent lack of enthusiasm for deregulation suffices. One grand theory of deregulation would be more satisfying intellectually, but a single model cannot explain the difficulty of reversing regulation. This condition should hardly be surprising. After all, there is no unitary model of regulation, either, despite certain economists' habit of speaking of "the economic theory of regulation." Rather, economists have gone from a relatively simple model, which explained some regulation well and other regulation not at all, to a plethora of models developed in more ad hoc fashion to explain practically all forms of regulation (Aranson 1990). Greater coverage has been achieved at the cost of universality. So it is in explaining deregulation, or the lack thereof.

Regulation, Transaction Costs, and Deregulation

The Nature of the Problem

The issue of deregulation arises only when regulation has already occurred. Social scientists have extensively analyzed how and why regulation occurs (Aranson 1990; McChesney 1998).

In the simplest model, depicted in figure 1, producers seek regulation in order to raise prices from the competitive level [P.sub.c] to some regulated level [P.sb.r]. The higher price reduces the amount of the product purchased from [Q.sub.c], to [Q.sub.r]. Consumers lose in two ways. Area I (the "Tullock rectangle") represents the monetary transfer from buyers to sellers caused by the higher price.(2) Area II (the "Harberger triangle") is the deadweight consumer-welfare loss that results because marginal consumers forgo purchasing the product even though the price they are willing to pay exceeds the marginal cost (MC) of producing the product (Harberger 1954).

[Figure 1 ILLUSTRATION OMITTED]

Thus, regulation causes losses to consumers (areas I + II) that exceed the gains to producers (area I only). In effect, regulation represents a political-market failure. Buyerlosers would always be willing to compensate seller-winners not to be regulated. In a purely Coasean world of zero transaction (including information) costs, regulation would never occur. As in all Coasean analyses, to explain the outcomes actually observed--in this case, the fact that regulation does indeed occur--the analyst must focus on the nature of transaction costs (Wenders 1987; McChesney 1991). Why does the political marketplace malfunction so that consumers do not purchase the right to be unregulated?

The conventional answer focuses on the relative organizing costs of the potential winners and losers from regulation. Consumers are more numerous than producers, so they have a greater incentive to free-ride on the efforts of others to fight off onerous regulation. Hence, producers work harder to get regulation than consumers do to oppose it. Likewise, individual consumers lose little if each pays $1 more for a widget. An individual consumer therefore has little incentive to fret about regulation. In contrast, the producer who sells a million widgets a year at the higher price cares intensely about the extra $1 million he will earn under regulation. Finally, with only a $1 loss at stake, consumers may be rationally ignorant of regulation's potential impact on them in the first place (McCormick, Shughart, and Tollison 1984).

In any particular case, it may be unclear which (if any) of these factors--greater free-riding, disaggregated losses, and rational ignorance among consumers--truly explains the particular regulation under scrutiny. For present purposes, the important point is that the very existence of regulation indicates that some impediment to informed, low-cost contracting exists. The onset of regulation attests to some contracting failure in political markets.

A Possible Solution: Demand-Driven Deregulation

It follows that deregulation will not come about unless the market-failure reasons for regulation abate. But it is far from likely that conditions will change in any important way. Given economies of scale in production--one specialized supplier can produce many more of an item than a single consumer will want--producers of any given product will practically always be fewer than consumers of that product. Producers therefore will almost always face less free-riding than consumers and therefore will be more intensely interested in maintaining regulation than consumers will be in removing it. Rational ignorance among consumers will not change as long as consumers' stakes are so small. "To the extent that regulation persists, equilibrium indeed must be inferred" (Crew and Rowley 1988).(3)

Here, then, is the first reason why so little deregulation occurs. The very fact of regulation indicates the presence of conditions sufficient for its existence--conditions such as producers' superiority in numbers and knowledge, plus their more intense preferences. Those conditions are unlikely to change in most markets, although, of course, they might change. In a careful cross-sectional regression model, deregulation of state telephone services has been shown to be a function of differences in interest-group variables across states (Kaserman, Mayo, and Pacey 1993). Likewise, one frequently hears (among economists at least) that airline deregulation occurred because it was increasingly easy for consumers to see (i.e., increasingly difficult for them to remain ignorant) that regulation increased air fares. So many instances of nonregulation provided information about lower fares that consumers' growing knowledge finally tipped the balance against continued regulation. Moreover, those who stood to gain from deregulation, regular airline customers, are a much smaller, more intensely interested group than consumers generally.

Still, it is hard to believe that American consumers are any less informed now about the effects of, say, Food and Drug Administration (FDA) drug regulation than they were of the effects of airline regulation in the 1970s. The problems of drug regulation--the extraordinarily time-consuming and expensive process of getting the FDA to approve a new drug, the fact that other countries approve drugs faster with no apparent impact on drug safety--are reported frequently in the popular media. Those seeking access to specific drugs (e.g., Laetrile some years ago) are often a relatively small, intensely interested group. Thus, although the "changing-conditions" model furnishes a plausible theory of deregulation after the fact, it does not provide a convincing, predictive model ex ante.(4)

One final aspect of the demand-driven deregulatory sequence must also be recognized. The very existence of regulation not only indicates that proponents of regulation outweigh opponents politically, but it sets in motion a process that over time increases the number of those favoring continued regulation. Even those who initially might lose from regulation are often brought into the rent-creating deal later, and then switch from being opponents to being proponents of regulation. Union workers, for example, will demand at the collective-bargaining table a cut of firms' regulatory rents, and they can get their cut because by shutting down the firm they would prevent the firm's owners from getting the rents promised by regulation (Rose 1987). Regulation might hurt labor generally, by reducing production and therefore the demand for labor services, but organized workers share with firms' owners the rents created by regulation and therefore join the owners in opposing deregulation. Similarly, telephone regulation has involved considerable cross-subsidy of residential customers by business firms, with the result that home telephone customers oppose deregulation in the telephone industry (Kaserman, Mayo, and Pacey i993). Those who specialize in rent-seeking (e.g., lawyers...