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8.9 Regulation

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. Understand the trade-offs involved in the regulation of the economy.
  2. Understand some of the ways in which the government regulates economic activity.

The third area of government intervention in the economy is perhaps the most controversial: regulationGovernment intervention that prescribes economic outcomes, or requires, limits or prohibits some kinds of economic behavior and/or activity.. Regulation imposes both costs and benefits on consumers and businesses, and frequently represents substantial tradeoffs between economic efficiency and protecting people and the environment. Regulation both helps and hampers economic performance. Too much regulation can choke an economy, but it is also arguable that no regulation will allow too many market failures (and no amount of reading Ayn Rand will change that). People too often look at either the costs or the benefits; let’s try to consider both.

Regulation shows up in a variety of ways, from standardized weights and measures to workplace safety rules. Regulation imposes costs and benefits; it both helps and hurts economic performance. Ironically, a lot of regulation comes at the request of the regulated, oftentimes as a way to limit competition and create economic profits. More about all of this as we go.

Weights and measures is a good example of just what regulation does. Standardizing a pound—so that when you buy a pound of flour, you know you’re getting a pound, has costs and benefits. The cost is the equipment needed by the flour mill to be certain that every bag comes out the same. The benefit is lower transaction costs for the consumer—you don’t have to bring a scale with you to check the merchant’s measurement. But while most regulation does pretty much the same thing—lowering some costs while raising others—much of it is more controversial than the weight of a pound.

The Evolution of Regulation: Is That Any Way to Run a Railroad?

In the United States we have had economic regulation since colonial days, from standardized weights and measures to rules about who could do what to whom. The adoption of the U.S. Constitution, however, limited the ability of states to regulate commerce that crossed over their borders, in one stroke of the pen creating one of the world’s widest-ranging free markets. This played no small part in both the development of the nation and its growing wealth.

However, by the late 19th century, amid the industrial revolution, people began to notice various market failures, or at least the uneven rewards that markets sometimes dole out. Farmers, whose biggest problem was most likely too much debt and falling food prices (prices fell throughout the 19th century as productivity rose), clamored for regulation of railroads. They believed that railroads were charging too much to haul agricultural products. Railroads were the dominant interest group of the late 19th century—railroads were the only way to move goods east to west.

The power of railroads demonstrates my Third Law of Political Economy: Economic interests are politically dominant to the extent that they are economically dominant. And although the railroads were often badly run, they did enjoy high profits as long as they didn’t have much competition (and in the late 19th century, there were no highways, no airplanes, not even the Panama Canal). Because railroads were a dominant economic interest—you pretty much had to use them to ship anything—they had political power, particularly in northern and western states. That led them to dominate state legislatures, which at that time elected U.S. Senators. So railroads had a lot of pull in the U.S. Senate, which then as now could say yes or no to presidential nominations to the federal courts. Consequently, the courts consistently ruled that neither the states nor the federal government could regulate railroads, and railroad interests dominated national politics.

The railroads, Congress, courts and constituents battled it out in court and at the ballot box, until finally in 1887 Congress created the Interstate Commerce Commission. Over the next few decades, the ICC was given enough teeth to regulate the prices and practices of not only railroads, but also the trucking and bus industries, so that until the 1970s, there was little price competition among freight haulers. Unfortunately for the railroads, they became heavily regulated just when competition finally appeared, in the form of trucks, highways, aircraft, faster steamships and the Panama Canal. Railroads were hurt so badly by regulation that America’s rail system went from the finest in the world to one of the most pathetic, and only recently have rail firms begun to recover.

Airlines underwent a similar bout of regulation beginning in the 1930s, but they asked for regulation from the federal government to end “ruinous” competition and preserve the industry. For the next 40 years, only rich people flew, and the prices charged were the same for everyone. Airlines competed only on service, and only two new routes were approved at a time when the nation’s population was on its way to doubling.

Finally, in the 1970s, economists and policy makers began to realize that all this regulation had created a highly inefficient transportation sector, whose products and services were overpriced and whose businesses were badly run.

DeregulationThe move to reduce government regulation so as to encourage more economic efficiency and hence economic growth. came on in a big way in the 1970s and 1980s. This has made business more challenging for all transportation firms, but that’s what competition is supposed to be about, isn’t it? The transition has been painful; lots of airlines and trucking companies went out of business, and profits for the remaining carriers fell. The answer might have been to not regulate such businesses in the first place—where there’s room for competition, markets can usually sort things out—but hindsight is easy, isn’t it?

On the other hand, safety regulation has made workplaces safer and more predictable; environmental regulation has made the environment cleaner. Critics of regulation like to point to the cost of such regulation, but they never bother to add up the savings in workers who aren’t injured, in lakes and rivers that you can swim in again (and that don’t catch fire, as some did in the 1970s), and in lower health care costs from cleaner air. The fact that regulation sometimes goes too far doesn’t lead to the conclusion that zero regulation is better still. One only has to think of the recent problems with dangerously bad food imported from China to understand, for example, the importance of food safety regulation.

This is, of course, my opinion, and you needn’t agree. At a minimum, regulation represents a lot of tradeoffs. Regulation imposes costs and benefits on everyone. Costs are higher for producers, which they usually pass on to consumers. On the other hand, some costs are lower for producers because, if they’re adhering to the law, they should face lower legal costs, and their costs won’t be different than their competitors if everyone faces the same regulations. Costs for consumers, in terms of safety and predictability, also are lower. The same is true for regulation of workplace safety—higher costs in terms of compliance, lower costs in terms of fewer work hours lost to injury; and for pollution and environmental damage—higher costs for meeting pollution requirements, for both producers and consumers, and lower costs for society from less environmental damage and health problems.

Electric Dreams: the Life and Times of Regulation and Deregulation

From the time Thomas Edison figured how to make a practical electric light bulb, electricity had a huge impact on human existence. In a few decades, we went from a world lit only by fire (to borrow the historian William Manchester’s phrase) to one where people could and did stay up later, because there was light. How to accommodate this new wonder in terms of business models and regulation quickly became a lightning rod issue for both business and government.

As we’ve already discussed, public enterprises such as power and water districts arise in part because they are what are called natural monopoliesA situation where the market would appear to be better served by only one firm.—the market is more efficiently served by one provider. That’s because it wouldn’t make financial sense for firms to build a separate set of water, power or sewer lines every time a business or homeowner switched from one provider to another. Natural monopolies such as these tend to be regulated—state agencies rule on pricing decisions by private firms that are natural monopolies; in the case of public firms such as a local water district, they have an elected board of directors who can be unelected if they don’t do a good job of both maintaining the system and keeping rates low. For much of the 20th century, this was the prevailing wisdom.

Whereas deregulation of airlines made flying a lot cheaper for everyone, some deregulation hasn’t worked as well. Deregulating trucking and airlines was a success for consumers if not for the deregulated firms. In the midst of the euphoria over deregulation, some folks began to argue that traditionally regulated monopolies such as electric utilities also could be deregulated.

What changed? During the first half of the century, electric rates fell as generating became more efficient. Utilities, usually regulated at the state level, didn’t have to go state utility commissions to ask for rate hikes. (Utilities had in fact sought state-level regulation so as to avoid tangling with big-city political machines, who could and would just say no to business.) So even though they weren’t always very well run (such as including the cost of their political activities in their electric rates, which was pretty much illegal all over the country), no one complained because electricity only got cheaper. But as technological improvements reached a plateau, costs stopped falling at a time when electric service was expanding and population was booming. By the 1960s, rates were rising. Consumers complained, and eventually got state legislatures to fund consumer advocates. Now, when utilities asked for rate hikes, there was somebody there who could tell the state utility commission that perhaps this rate hike wasn’t justified. By the 1970s, utilities started losing rate cases.

And so they sought deregulation, arguing that it was possible to have competition for electric service (through a somewhat complicated method called “retail wheeling,” by which the electricity in your outlet came from the same generator, but somebody else got paid for it). More than 20 states toyed with the idea, and about a dozen went for it.

It didn’t work all that well. In the most egregious example, the state of California saw its electric rates soar and rolling blackouts become a regular feature of the electric landscape. Electric generating firms (surprise!) said they had to pull generating equipment off line for maintenance (thus restricting supply and raising the price). California’s system was particularly badly designed—firms bid into the market with offers of service, and the highest price bid was the price that everybody got. Seven electricity suppliers eventually all pled no-contest to charges of rigging the market.

But even outside of California, things haven’t gone so well. Prices generally have risen and there isn’t much competition, except for the largest consumers of electricity. Why? Simple supply and demand. A residential household just doesn’t buy enough electricity to make it worth a generator’s while to spend the time and money to win that account. And you probably don’t spend enough on electricity to make you want to shop around. (The promise of deregulation was competition and cheaper electricity. But some states went so far as to institute temporary price caps—limits on the price of electricity—and some even barred people from switching electric suppliers more than once a year. So, what kind of market needs a price cap? And what kind of market is it if you can’t shop around?)

When to Regulate?

What we might learn from all of this, once again, is that where’s room for real competition, markets can work. But where there isn’t, some regulation might be in order. The other, overall point to understand is that the government plays a large role in the economy, and that regulation is one part of that. We should at least ask who is hurt and who benefits from any given piece of regulation; what are the costs and benefits of regulation; and does this regulation address a market failure or simply interfere with the efficient operation of the market? So, for example, I tend to think that gasoline price regulation (which people call for every time the price goes up at the pump) merely interferes with an otherwise functioning market, whereas air traffic safety regulations tend to ensure that airlines have no temptation to cut corners in order to make more profits. But you, as always, will have to make up your own mind on this.

Key Takeaways

  • Regulation imposes both costs and benefits on consumers, producers and on society as a whole.
  • Regulation can be used to limit competition, which can raise prices. It also can limit prices where there wouldn’t otherwise be competition.
  • Businesses sometimes oppose but sometimes seek regulation.


  1. Think of an economic activity in your area. How is it regulated? (For example, food safety regulations that impact the college cafeteria.) What would it mean if it had more or less regulation?
  2. Should governments impose more or fewer regulations on economic activity? Why?
  3. What is the rationale for regulating a business? When might that be a good idea or a bad one? What kinds of things might we think about when thinking about regulation?