REGULATORY CAPTURE: A REVIEW

Transcription

1 DOI: /oxre/grj013 REGULATORY CAPTURE: A REVIEW ERNESTO DAL BÓ Haas Scool of Business and Travers Deartment of Political Science, University of California, Berkeley 1 Tis article reviews bot te teoretical and emirical literatures on regulatory cature. Te scoe is broad, but utility regulation is emasized. I begin by describing te Stigler Peltzman aroac to te economics of regulation. I ten oen te black box of influence and regulatory discretion using a tree-tier ierarcical agency model under asymmetric information (in te sirit of Laffont and Tirole, 1993). I discuss alternative modelling aroaces wit a view to a ricer set of ositive redictions, including models of common agency, revolving doors, informational lobbying, coercive ressure, and influence over committees. I discuss emirical work involving cature and regulatory outcomes. I also review evidence on te revolving-door enomenon and on te imact tat different metods for selecting regulators aear to ave on regulatory outcomes. Te last section contains oen questions for future researc. I. INTRODUCTION Te economics rofession as devoted substantial effort to answering two broad questions. First, wy do we observe state intervention in economic life? And second, wat are te olitico-economic rocesses tat sae state intervention? In a broad sense, regulation encomasses all forms of state intervention in te economy, altoug a more narrow definition concerns te control of natural monoolies. Tus, te term regulatory cature also receives bot a broad and a narrow interretation. According to te broad interretation, regulatory cature is te rocess troug wic secial interests affect state intervention in any of its forms, wic can include areas as diverse as te setting of taxes, te coice of foreign or monetary olicy, or te legislation affecting R&D. According to te narrow interretation, regulatory cature is secifically te rocess troug wic regulated monoolies end u maniulating te state agencies tat are suosed to control tem. Most of te literature tat is exlicitly concerned wit regulatory cature as been develoed in te context of utility regulation, altoug a literature on 1 address: dalbo@aas.berkeley.edu I am grateful to Dieter Helm, two anonymous referees, Clare Leaver, Martín Rossi, and Justin Tumlinson for useful comments and suggestions. Oxford Review of Economic Policy vol. 22 no Te Autor (2006). Publised by Oxford University Press. All rigts reserved. 203

2 olitical influence as grown alongside it. Te dominant normative argument for te regulation of utilities osits tat natural monooly situations call for a sole firm. Ten regulation is needed to revent tat firm from exloiting its market ower (Demsetz (1968) callenged tis view; see Berg and Tscirart (1988) for a clear exosition of te economics of natural monoolies, and Joskow (2005) for a more comlete exlanation of te normative argument). Higly comlementary to tis argument is te view tat regulators will be motivated by te duty to rotect consumers from monoolistic abuse. Tis ersective on regulatory motivation came to be known as te ublic interest view (see, for instance, McCraw (1975) for an exosition). Eventually, observers of regulation came to callenge tis ersective. Even wen a regulatory body as been set u to revent monoolistic abuse, regulation ends u being catured by te firms it is suosed to disciline. Tis view was articulated in an influential aer by Stigler (1971), and since ten it as been refined and exanded in a variety of ways. Te urose of tis review is twofold: first, to rovide a tecnically accessible account of te main teoretical views on regulatory cature eld by academic economists, and, second, to rovide an overview of available evidence on causes and consequences of cature. Te scoe of tis review is broad altoug contributions focusing on utility regulation are emasized. Some of te work on cature overlas wit te literature on corrution. We touc on te latter wen connected to te roblem of te urcase of official favours, but abstract from tat art of te corrution literature dealing wit arassment or extortion by ublic officials. Tis review is structured as follows. Te next section discusses briefly te argument on regulatory cature ut forward by Stigler (1971) and te formalization of tese ideas by Peltzman (1976). Tis initial teory of regulatory cature is, in fact, common to oter areas of ublic olicy and, like many of te teory s develoments, it may be alied to te roblem of olitical influence as it is broadly understood. Peltzman (1976) made rogress by leaving a number of elements in a black box. In oter words, imortant links in te teory s logical cain are assumed to work in a articular way, witout our knowing weter tose assumtions are reliable. Two elements tat deserve to be robed furter are te recise nature of influence and te origin of regulatory discretion. Section III resents a tree-tier rincial agent model were influence and regulatory discretion are linked to te excange of favours and asymmetric information. Tis teory as a strong normative comonent. We briefly discuss te alternative common agency aroac. Bot aroaces emasize influence troug incentives tat can be construed as bribes, suc as direct ayments or lucrative ost-agency emloyment, and model regulators as a single actor. In section IV I discuss alternatives to influence troug bribes, suc as te rovision of information and coercion, and briefly review work studying influence over collective bodies. Section V discusses models on te revolving door enomenon, wic involves a tendency of regulators to favour industry wen tey ave an industry background or wen tey exect rewards in te form of future industry emloyment. Section VI switces attention to emirics. First, I discuss te scarce evidence on te effects of asymmetric information (or te lack of transarency). Ten I review evidence of a connection between cature and regulatory outcomes; I survey emirical studies on te revolving-door enomenon and on te otential role of regulators ersonal caracteristics. Lastly, I review evidence tat regulatory outcomes may resond to te metods used to select officials wo ave an imact on regulation, suc as regulators and judges. Section VII rovides a summary and igligts oen questions for future investigation. II. A SIMPLE MODEL OF REGULATORY CAPTURE (i) Stigler s Aroac Stigler (1971) advocated an economic teory of ow te regulation of business comes to be. Tis included, but was not limited to, te regulation of monoolies. Stigler s starting oint was te observation tat, as a rule, regulation is acquired by te industry and is designed and oerated rimarily for its benefit. An additional iece of data was tat regulation is not only observed in association wit natural monoolies, for wic a normative rationale exists. Many oter economic activities attract state 204

3 E. Dal Bó intervention, in te form of rice-fixing and entry control. In order to account for tese observations, an economic teory of regulation ad to secify te determinants of te suly and demand for regulation. Te demand for regulation would be connected rimarily to two features of te grou of beneficiaries. First, weter te beneficiary grou is large and, second, weter te grou as large stakes in regulation. Excessive grou size could amer successful organization of te beneficiary grou. Suc organization requires te resolution of te wellknown collective-action roblem. Tis roblem arises from te temtation tat eac otential beneficiary as to sirk is obligations in te common lobbying effort. (Tis ecoes Olson s (1965) view tat large grou sizes can inder collective action.) Large stakes could mobilize grou members and give tem an incentive to demand regulation. On te suly side, one would ave to ay attention to te macinery tat roduces regulation: te ublic sector, wic resonds to olitical ressures. Stigler viewed oliticians as otential suliers of regulation wo ursue selfis objectives, among wic one sould count te desire to augment teir ower. If ower deends bot on money and votes, te costs of regulation could include its otential to bring unoularity to te olitician tat romotes it. However, Stigler counted one factor tat could mitigate tis cost: te fact tat te very many voters tat are only marginally affected by regulation would ave oor incentives to be well informed about te regulation in question. Stigler illustrates is way of tinking troug a simle study of te regulation of trucks in te United States. By te late 1920s, trucks emerged as a cometitor to railroads on inter-city freigt. Railroads resonded by influencing ublic autorities to imose limits on te weigt trucks could carry in intercity auls. Stigler listed various factors tat sould affect te demand for regulation. (i) In states wit numerous farm trucks, railroads would ave a arder time overcoming te agricultural interests tat relied on truck services, making weigt limits less likely, or less stringent. (ii) Trucks osed less of a treat on long-aul freigts tan on sort-aul. So, states were te average aul is sorter would be associated wit stronger demand for restrictive limits by railroads. (iii) States wit better-quality roads would ave less of a reason to worry about truck weigt, so tat te friends of railroad interests would ave a arder time making te case tat weigt limits were urgently needed to kee roads usable. Stigler measured te degree of regulatory favours to railroads by looking at te weigt limits on four- and six-weel trucks by in eac state. Te exlanatory variables corresonding to te arguments in oints (i) (iii) were, resectively: te number of farm trucks er 1,000 labour-force members (by 1930); te average aul of railroad freigt (by 1930); and te ercentage of state roads of ig-tye (a iger-quality aved surface) by All tree exlanatory variables aeared significant in te cross-state regressions (excet for ig-tye surface on te six-weel trucks weigt-limit regression). It is wort noting tat Stigler s ideas were neiter tyical at te time tey were ublised, nor wolly witout recedent. Te idea tat economic olicy may not stem from a benevolent lanner (as in te ublic-interest view) was not as well establised in te mainstream economics literature as it is today. 2 Te Stiglerian aroac as been related to te Cicago view of ublic olicy, even wen it could be seen as comlementary to te emerging literature on ublic coice, wic was, in turn, associated wit te names of Bucanan, Tullock, and te Virginia scool. Tis literature focused on te role of olitical institutions in affecting collective decision making in te face of eterogeneous societal interests. Te view of ublic olicy emerging from te Stiglerian and te ublic-coice scool emasized te idea tat regulators could be swayed by secial interests. Tis idea ad an imact on a larger ongoing debate on te otimal size and scoe of government. On te microeconomics side, insigts due to Pigou and Samuelson justified state intervention: in te resence of externalities or ublic goods, te decentralized allocations determined by markets wit rivate roerty will be inefficient. 3 It was at tat stage tat Stigler s call for an economic teory 2 Tis was so even wen libertarian and Marxist mistrust for state-sonsored goals was far from new. 3 A counteroint was offered on te macroeconomic side. Te monetarist scool was beginning to uset te revailing views of te macroeconomy as a system in need of activist intervention. 205

4 of regulation was made. If regulators are te nexus of a set of secial-interest ressures, sould we call for even larger state controls in te oe of neutralizing te otential secial-interest bias? Or sould we roll back existing regulation and live wit market failures? A lot of te work in economics in te following decades can be organized in terms of te osition taken regarding tese questions, and we can view Stigler s roosed rogramme as an imortant ste towards answering tem. As indicated by Posner (1974), a roblem wit Stigler s aroac was te lack of clear imlications as to te rofile of grous benefited by regulation. Stigler emasized tat industries wit concentrated ownersi would ave an easier time at overcoming te urdles facing collective action. However, large grous could attract favourable regulation by vote-seeking oliticians. Wat consideration sould revail to define te rofile of regulated industries? (ii) Peltzman s Model Peltzman (1976) refined and exanded Stigler s ideas. He offered tree distinct formal set-us, te second of wic focuses on rice-entry regulation. Tis model rationalizes intervention in industries tat ave bot small and large numbers of beneficiaries. It is tis second set-u tat is of interest ere. Te model comrises tree classes of layers: a olitician wo olds te coercive ower of te state, an undefined quantity of roducers, and an undefined quantity of consumers. Te olitician wants to maximize is majority or ower as given by M = M(,π), were is te rice aid by consumers and π is te rofits for roducers. Assume tat te olitician s majority decreases wit iger rices to consumers (ig rices are vote losers), but tat it increases wit te rofits of roducers (resumably because tose roducers vote, but also because tey can mobilize voters or oter elements of te community troug teir financial ower). Bot te ower-losing effects of iger rices and te owerincreasing role of rofits are assumed to be of marginally decreasing intensity. Formally, tese assumtions on te majority M(,π) take te form: M < 0,M π > 0,M < 0,M ππ < 0. Assume also tat te marginal effects of rices are uncanged by te level of rofits and vice versa: M π = 0. All suly and demand information is catured in te function π = f (,c), were c = c (q) are te roduction costs of firms. Assume f 0, f < 0,f c < 0. Te olitician ten cooses te rice e will allow roducers in order to maximize is majority M(, π) subject to te constraint π = f (, c). Or, Max M[, f (, c)]. Te first-order condition for tis roblem is M + M π df d = 0 M df d For a firm facing no cometitors, at rices lower tan monoolistic ricing, an increase in rice increases rofits (i.e. df /d > 0). Recalling te assumtions M < 0 and M π > 0, te first-order condition ten tells us tat, starting from a osition of monoolistic ricing (i.e. a relatively ig rice), te official will lower te rice to gain consumer votes until te marginal vote gain equals te marginal ower loss from dissatisfying roducers. Inversely, starting from a cometitive rice, te official will raise te rice to lease industry, u to te oint were te marginal value of te favours from industry equals te marginal loss of consumer votes. Tis effect will also benefit a multi-firm industry wen rices are fixed and enforced above cometitive rices. (In suc a case, te first-order condition above can be seen to reflect te interests of te entire industry, rater tan tose of a single firm.) Te model redicts tat regulation will tyically entail less tan 100 er cent roducer rotection but also less tan erfect rotection of consumers against market ower. Te olitical rice will usually lie between cometitive and ure monooly levels. Moreover, incentives for regulator entry aear igest wen industry is fully monoolistic or erfectly cometitive to begin wit, because te ower gains from moving rice towards a middle range are igest (tis is a result of te concavity assumtions on te function M). In oter words, monoolies suc as utilities will attract regulation, but not for te normative reason commonly acceted, but because a olitician can act as a broker tat trades moderate olitical losses wit roducers for a large olitical gain among consumers. In tis case, and as long as te olitical rice allows for te reosition of caital, te regulator s intervention is = M π. 206

5 E. Dal Bó beneficial for social welfare (understood as rofits lus consumer surlus). Te reverse of te icture of entrereneurial regulatory intervention is tat cometitive industries will attract regulation as well, because te initial marginal losses of ower owing to angry consumers can be small relative to te gains owing to grateful roducers. Examles of te latter tye of regulatory resence are wen te state engages in rice fixing in cometitive industries and wen it controls entry (troug licensures) in occuations. Te model can ten account for te aarent uzzle of regulation being resent in tecnologically diverse industries. Te main feature in Peltzman s model is tat te official aears to be trading off te benefits from favouring two different masters: consumers and roducers. However, little is said about ow tose benefits materialize. Neiter of te two stakeolders in te model is exlicitly considered an active, strategic layer. Moreover, no detail is given as to ow a olitician can equally deart from monoolistic or cometitive ricing. In te case of a natural monooly, for instance, a regulator may be limited by te fact tat e is suosed to leave te firm a reasonable rate of return, but allowing for iger rices may be denounced as a give-away to industry. Te following section covers models tackling tese limitations. III. PRIVATE INFORMATION AND COLLUSION IN HIERARCHICAL AGENCY (i) Overview One way to understand cature is by tinking of a tree-tier ierarcy comrising a olitical rincial (te government), a regulator, and an agent (te firm). Wy use a rincial agent model? Tis is te set-u used wen we want to analyse incentive roblems in detail. Te simlest ossible model would ave only two arties: a firm and a (otentially caturable) government. Can we justify comlicating te model by considering more layers? Te introduction of a tird element allows differentiation between te government and te regulator (te reader may tink tat a similar structure can be used to tink of a ierarcy featuring citizens, government, and te firm). Te extra layer (te regulator) allows one to analyse ow te olitical rincial migt want to resond to te risk tat its delegate may be catured. Tirole (1986) was robably te first to analyse regulatory cature in a tree-tier set-u. As I will resent it, te model as two building blocks. Te first is te model of regulation of a monoolist wit unknown marginal costs (Baron and Myerson, 1982). In tis set-u, te firm as rivate information on its costs. Tus, te government is unsure about ow muc of a cost reimbursement (or ow ig a rice) te firm sould be allowed. Te otimal best resonse for te regulator is to offer a second-best contract to te firm, one tat attemts to limit te benefit te firm derives from te asymmetric information. However, because te firm is valuable to consumers even wen costs are ig, and because costs are ig wit some robability, te contract offered to a firm wen te government does not know te state of nature necessarily leaves te firm some rents in situations wen costs are actually low. Te second building block, as roosed by Tirole (1986), ten furter develoed by Laffont and Tirole (1993, c. 11), assumes tat te regulator, wo secializes in learning about te industry, may find out te true costs of te firm. Ten te firm as an incentive to bribe te regulator into not telling te government wen costs are low. If te regulator says e as learned noting, te best ossible contract tat te government can offer te firm is one tat leaves rents to te firm. Te government ten as an incentive to offer te regulator a contract inducing im not to lie and simultaneously to offer a contract to te firm tat reduces incentives for collusion wit te regulator. (ii) Te Model In tis set-u, te firm as rivate information about te marginal cost of roviding a service to consumers, and te government wants to maximize an objective including consumer surlus. 4 In keeing wit te notation of last section, te firm s oerating rofits are π( ) = q ( ) C (q ( )), were q ( ) 4 Siller (1990) analyses a related roblem were Congress lacks information on te regulator s amount of effort directed at imroving regulatory outcomes. 207

6 is te demand function, is te allowed rice, and C = F + qc is te cost of rovision, were F is a fixed cost. Te marginal cost c takes one of two values in te set {c l, c }, were 0 c l < c. Marginal costs are determined by unredictable develoments tat are beyond te layers control, suc as oil discoveries, weater canges, etc. So, we will say tey are determined by nature. Nature icks low costs wit robability γ and ig costs wit robability 1 γ. In addition to aroving a rice, te government as te ability to make transfers T to te firm, wic are aid for by consumers. Te total ay-off for te firm is Π = π() + T. Te ay-off for consumers is teir consumer surlus minus teir tax ayments to finance transfers to te firm (we assume te government kees a balanced budget; te taxes aid by consumers equal te transfers to te firm). Te government seeks to maximize social welfare as given by S = s() T. Hence, te government would like to use transfers to reimburse te firm just for its fixed cost and set rices equal to marginal cost in order to maximize net surlus. Wen te government knows te realization of c, suc an arrangement is feasible. But it is not wen te government does not know te realization of c. Suose for a second tat te government as offered te full information contracts {[T = F, l = c l ], [T = F, = c ]}. Ten even wen costs are low te firm as an incentive to claim tat costs are ig and obtain better comensation. Te informational rent te low-cost firm would obtain in te asymmetric information regime is Π l = q( )( c l ) = q( )( c ) + q( )(c c l ) = q( )(c c l ) q( ) c, were c = c c l. Clearly, q ( ) c > 0, and te low-cost firm obtains a ositive rent owing to its informational sueriority. Te government can do better tan simly offer te full information contracts and ave firms obtain an informational rent wenever costs are low. One way of doing tis is to raise te rice tat is allowed in ig-cost situations, so tat lower demanded quantities will reduce te informational rent. Te roblem wit tis is tat it reduces consumer surlus wen costs are ig. Hence, te trade-off facing te government can be caracterized as being between lowering informational rents in low-cost situations and not reducing consumer surlus in ig-cost situations. Tere are many otential arrangements te government could coose from. However, te government loses noting by restricting itself to imosing arrangements tat are tailored to eac tye, wile resecting te condition tat eac tye sould ave incentives not to misreresent its rivate information. 5 Terefore, watever arrangement te government offers must entail, Π l ( l,t l ) Π l (,T ), wic is called te incentive comatibility constraint of te low-cost firm. Analogously (altoug not binding in equilibrium), te offered arrangement must give te ig-cost firm incentives for sincerity, i.e. Π (,T ) Π ( l,t l ). Simultaneously, te articiation constraint on te two tyes of firm is tat te government must offer terms tat will not induce any tye to sut down: Π l ( l,t l ) 0, Π (, T ). In fact, te government will offer te following arrangement, Π * * l = 0; Π = c + 1 = c. l l = q( γ γ ) c A sketc of te roof is in te Aendix. Two observations are wort making. First, in order to reduce te informational rent tat te firm gets in low states, te government raises te rice in igcost states by (γ/(1 γ)) c (wic reduces demanded quantities and tus te informational rent q( *) c). Note tat te government raises furter wen γ is ig, so te exected benefit of a reduced informational rent is ig, and te exected cost of a reduction in consumer surlus is small. Second, marginal cost ricing is reserved in te lowcost state and no rents are left to te ig-cost firm. 6 * c 5 Te revelation rincile (Myerson, 1979) imlies tat te otimization over all ossible arrangements can be reduced to one were te layer wit rivate information simly reveals its tye trutfully. See Laffont and Tirole (1993, c.11) for a comlete roof in a very similar context to tat resented ere. 6 Te solution is comleted wit te caracterization of transfers: T l = F + q ( *) c ; and T = F q ( *) (γ/(1 γ)) c. 208

7 E. Dal Bó Te government sould be interested in finding a regulator wo secializes in learning c in order to try more often to imlement first-best allocations. In tis way te government can save on rents left to te firm and on distortions in te ig-cost state. Suose, ten, tat wen te firm as low costs, te regulator learns it wit robability λ, and learns it in a way tat is verifiable to te government. Wit robability 1 λ te regulator finds noting. Wen costs are ig, te regulator can never learn anyting. 7 Te timing of interaction is as follows. First, nature determines te firm s costs, and te firm learns it. Second, te government announces bot a wage to te regulator and regulatory contracts to te firm, bot otentially contingent on te regulator s reort. Tird, if c = c l, te regulator learns it wit robability λ (and te firm learns weter te regulator learned costs or not). Fourt, te firm and te regulator decide weter to collude. Fift, te regulator sends a reort to te government r {c l, }. Tis means tat te regulator, wen seeing tat c = c l, can reveal it, but can also claim to be uninformed, bot in tat situation and wen e really is uninformed. After getting te reort, r, wages and contracts are made available to regulator and firm. Note tat wen costs are low and te regulator learns tis is te case, a trutful reort to te government will induce te latter to offer te full information contract to te firm and not accet any claims tat costs are iger. Tus, te firm s informational rent evaorates. Hence, te firm as an incentive to ay te regulator a bribe u to te value of te informational rent in order to buy is silence. Te value of te informational rent is q( ) c. It is clear tat if te government wants to comete wit te firm and us te regulator towards onest reorting, a ayment conditional on r = c l sould be romised. Denote tis ayment w and assume tat te reservation wage of regulators is zero. Assume tat every dollar tat te firm may offer te regulator in side ayments costs te firm 1 + ψ. For te regulator to want to reort tat costs are low, te wage must satisfy, q( ) c w >. 1+ ψ Te benefit of reventing collusion fully is to gain full information more often. Te cost is te incentive ayments to te regulator and te otential distortions to te contract to be offered by te firm. We now assume tat deterring collusion is wortwile and focus on te consequences for equilibrium allocations. If a regulator is colluding wit te firm, e will always claim to know noting, and te robability of a low state is simly γ. Under a collusion-roof contract, toug, te regulator beaves onestly. So, te robability tat costs are low wen te regulator claims to be uninformed is γ(1 λ) γ(1 λ) µ P( c = cl r = ) = =. γ(1 λ) + (1 γ) 1 λγ We assume tat te government does not care about te income of regulators from a welfare oint of view, excet in tat it detracts from consumers income. Recall tat wen te government obtains no information, it will offer te second-best contract caracterized earlier, altoug taking into account tat te regulator claiming to be uninformed affects te erceived robability of te low state. Te second-best contract secifies marginal cost ricing for te low-cost firm but leaves rents in it, and tese rents deend on te rice cosen for te ig-cost firm. No rents are left to te firm in te ig-cost situation. Ten, exected social welfare, as seen by te government, can be written as EV = γλ{s (c l ) F w} + (1 γλ) {µ [s (c l ) T l (µ)] + (1 µ) [s (, µ) T (µ)]}, were T i (µ) (i = l,) denotes tat transfers are being determined in te second-best solution corresonding to te case wen te government as received r = and ence olds beliefs µ on te low-cost state. Te maximization of tis roblem yields, c (1 1 1 c. ) 1 + ψ Tis exression contains a familiar term, (γ/(1 γ)) c, wic is te distortion introduced in te otimal contract seen before, wen a regulator was not available. But te extra term, (1 ) 1+ ψ 7 I model regulatory learning as Armstrong and Saington (2005) do. Assuming tat te regulator can also become informed in te ig-cost situation comlicates notation witout adding insigt. = c + 1 γ γ γλ γ 1 γλ γ 1 c 209

8 imlies tat te distortion to te ig-cost rice wen a regulator is available will be smaller, even if te regulator is corrutible. Te arameter ψ migt be seen as a cature arameter. Wen it is zero, te firm as no difficulty saring te information rent wit te regulator. So, a dollar from te firm as maximum urcasing ower. In tat situation, te term ψ goes to zero, and te distortion-saving ower of aving a regulator wit learning caabilities disaears. Te rice set for te ig-cost firm converges to tat wen te government as no access to a regulator. Wen ψ is ositive, owever, te distortion savings increase. In te limit, wen ψ goes to infinity, te regulator becomes essentially incorrutible because even te smallest bribe is infinitely costly to te firm. In tat case, we obtain = c + 1 γ γ c (1 γλ γ c = c ) + 1 (1 λ) c. Te last exression indicates tat, relative to te case wit no regulator, te distortion is diminised in roortion to te amount of information brougt by te regulator (measured by te robability λ tat e is informed). Note tat te informational quality of te regulator also affects te solution. Wen te regulator is never informed (λ = 0), tings are exactly as wen te regulator does not exist, and te solution reverts back to te original one. If te regulator is always informed (λ = 1), te savings on ricing distortion are maximal. Note tat te ideal combination of a regulator tat is erfectly informed and incorrutible (λ = 1, ψ ) eliminates all distortion, yielding = c. Te reason is tat if te regulator is effectively incorrutible, and always alerts te government if costs are low, te roblem reverts back to one were te government is erfectly informed. At tis oint it may be useful to rovide a brief nontecnical summary of te model and findings. Te model relies on a few basic assumtions. Te regulated firm as suerior information about its roduction costs, and te government wants te firm to roduce as muc as would be convenient for consumers. Te firm, owever, cannot be forced to roduce wen doing so would trigger losses, so te γ γ remuneration allowed by te government must be sensitive to roduction costs. Tus, te government will want to aoint a monitor (te regulator) to mitigate te informational advantage of te firm. Te danger is ten tat te firm may temt te regulator not to disclose information tat would reduce te aroved comensation. Tus, regulators and firms may collude to kee te money owing from consumers even wen te revailing low costs would justify a reduction in comensation. Te scoe for suc cature of te regulator by te firm deends on te amount of information tat te regulator may obtain, and on ow easy te environment makes it to bribe regulators. (iii) Discussion Te model just reviewed offers a recise framework to understand ow asymmetric information is te source of regulatory discretion, making cature ossible. Te model also considers otimal resonses by te olitical rincial, and ow tese will affect imlemented allocations. Tis emasis may strike some readers as ertaining to a normative, rater tan ositive, aroac. It may also be argued tat te offer by te government of regulatory wages tat are contingent on te regulators reorts is imlausible. In te current model, te inability to offer contingent wages would eliminate te ossibility of combating collusion. Te literature as long considered alternative ways to use wages to figt cature. Becker and Stigler (1974) consider wages tat are not directly contingent on te regulator s actions. However, te wages are iger tan te regulator s alternative earnings and make te latter eager to kee is job. In combination wit above-market wages, te government could ten audit te reorts of regulators and fire tose wo are found to ave misreresented te firm s rivate information. Tis introduces a cost to regulators of engaging in wrongdoing, and a judicious coice of wages and auditing frequencies can contribute to mitigate cature. 8 A large literature as used similar ideas in connection wit crime deterrence and corrution control (on crime, see, for examle, Becker (1968), and on corrution see, for instance, Besley and McLaren (1993) and Ades and Di Tella (1997)). In real life, te scoe for using 8 On te role of external suervisors in collusive ierarcical agency, see Kofman and Lawarree (1993). 210

9 E. Dal Bó wages and monitoring to deter regulatory favours is limited. Te stakes are so large tat, fines being infeasible and monitoring being imerfect, te required wages would be astronomical. Tus, more comlex institutional resonses may be required. One ossibility is te searation of regulatory owers so as to lower te stakes in collusion (Laffont and Martimort, 1999). Anoter ossibility is to level te laying field by incororating te different stakeolders into te bureaucratic design of regulatory decision-making (McCubbins et al., 1987). (iv) An Alternative Model tat does not Rely on Private Information Berneim and Winston (1986) introduced te common agency model of influence, wic as a more ositive angle. In tis set-u, multile arties offer rice lists for different favours or allocations tat te official, or common agent, may set. Tose arties comete, offering suc scedules reflecting te rices tey are willing to ay for different olicy coices, and ence tis model is built uon a menu auction. Tis model allows a more recise caracterization of te nature of influence in situations were tere is cometition for olicy favours, as originally studied by Peltzman (1976) and Becker (1983). In te common-agency set-u tere is no asymmetric information, and te origin of te discretion of te official remains unmodelled. Te model features multile equilibria wic may be inefficient. 9 Grossman and Helman (1994) extended te common-agency model to analyse trade olicy determination, wile sticking wit quasi-linear ay-off functions. We comment later on emirical investigations insired by tis model. Dixit et al. (1997) furter extended te common agency set-u to consider general ay-off functions, wic allows us to analyse situations were income effects matter. IV. ON THE INSTRUMENTS AND TARGETS OF INFLUENCE Te cature models reviewed so far assume tat firms will rovide incentives to regulators, and tat regulators can be tougt of as single erson. Two imortant questions are weter te rovision of incentives is te only, or even te most relevant, instrument of influence, and wat aens wen te target of influence is a collective body. Tis section ten begins by discussing te rovision of information as oosed (or in addition) to incentives. A related matter is tat te tye of incentives used in te models of section III can, broadly seaking, be understood as bribes. So an additional question arises as to wat form of incentives can be understood tat way, and weter oter forms of incentives may lay a role. Te second art of tis section ten discusses alternative forms of influence tat do not exclusively rely on te rovision of incentives tat can be construed as bribes. Finally, te tird art of te section briefly discusses work studying influence over collective bodies. (i) Are Incentives te Only Instrument of Influence? A literature in olitical science and economics as analysed te rovision of information, rater tan incentives, as a form of exerting influence. Calvert (1985) rooses a articular model of informationrocessing were te known bias of an advisor (or interest grou) cannot be fully undone by te receiver of information (say, te regulator). 10 Tis model yields tat te decision-maker may in fact refer to use biased advisors, muc as wen regulators receive information from firms and oter layers of te regulatory game. Te benefit of aving a biased advisor is tat it can become a more credible source in extreme situations were a mistake would be articularly costly. Austen Smit and Wrigt (1992) offer a model were tere are two, rater tan one, sources of information. In teir setu, two interest grous may make costly searces for information and ten offer messages to a decision-maker. Altoug te model is intended to cature informational lobbying to win over a legislator, te set-u can el exlain situations wen firms and consumer advocates offer information to try to affect a regulator s decision. For examle, tese stakeolders may commission costly consultants to 9 Equilibria tat are trutful are also efficient. Trutful equilibria involve trutful strategies in tat te scedules of rices offered by interest grous must reflect te sae of tose grous ay-off functions. Tis class of equilibria coincides wit te set of coalition-roof equilibria. 10 Te bias does not merely affect te exected levels of advice, but also te sae of te robability distribution over ossible advice messages. 211

10 rovide industry-secific studies. In tis model, messages need not be trutful, but te regulator as te ossibility, at a cost, of verifying te information e as received (ossibly by commissioning furter consulting). For some arameter values it is sown tat none, one, or bot interest grous may acquire information wit ositive robability and ten submit messages to te regulator. Moreover, tere are regions of te arameter sace were te regulator ends u making erfect decisions. Lomann (1993) tackles te (very different) question of weter mass olitical action can convey information. Tis set-u is different from te revious ones in tat signalling is costly. In er model, engaging in te activity tat may ultimately convey information is costly in itself; in oter words, te cost is te message. Altoug te connection wit regulation is tenuous, te basic message of er model is useful: by engaging in costly actions (suc as commissioning consulting tat may be in itself irrelevant) an interest grou suc as te firm may signal its rivate information about te aroriateness of a articular olicy. (ii) Wat are te Incentives Provided by Industry? As suggested by te model reviewed in section III, one ossibility is for firms to offer outrigt bribes. Anoter ossibility is money ayments wit olitical use, suc as camaign contributions to oliticians wit electoral goals. In te case of regulators witout electoral ambitions, a muc talked about form of incentive is te romise, tacit or exlicit, of future lucrative emloyment in industry. Te twin facts tat regulators ave often ad industry jobs before, and sometimes end u in industry after teir tenure, is referred to as te revolving doors enomenon. In section V I discuss some teoretical contributions regarding tis enomenon and I review evidence about it in section VI. Anoter ossibility is tat firms may attemt to influence regulators troug negative incentives, suc as treats, tacit or exlicit, of lowering teir utility. Tis could be attained troug direct ysical unisment. Altoug eras not so relevant for economies were te rule of law is well establised, tis form of incentive to officials is more widesread in some emerging economies (see Dal Bó and Di Tella (2003) for some examles). Firms may eras more often be able to sread negative rumours about te cometence of a regulator, wic may damage te latter s career. Also, tey may destabilize a regulator s gri on is job by oen confrontation, wic may raise te olitical costs for government of backing u te regulator. Indeed, Hilton (1972) argued tat in real life te main objective of regulators is to minimize comlaints by firms, or keeing regulated firms from squawking. However, wen it is known tat regulators may be influenced troug otential comlaints from firms, te observation of suc beaviour may simly indicate tat te regulator is erforming is duties well. Tus, te ower of squawk to damage te regulator is not a logically foregone conclusion. Leaver (2002) offers a model were regulators may take more or less aggressive stances toward firms, and bot ositions may be rigt or wrong deending on te state of nature (say, cost levels facing te firm). Because regulators do not exactly know te state of nature, tey may make mistakes and urt firms unnecessarily. Regulators come in two tyes: smart and dumb. Te latter are more likely to make mistakes, and te market will learn about mistakes wen firms squawk. Wen regulators concerns about reutation are strong, tere is a Bayesian erfect equilibrium were two tings aen: firms comlain against mistaken toug olicies, but not against generous ones (even if mistaken). Less able regulators, fearing tat firm comlaints may damage teir reutation, are generous to te firm some of te time, even wen aving information indicating tat a toug olicy is called for. Te overall message is tat te ossibility tat firms may comlain ublicly about toug regulatory decisions buys firms some regulatory slack. Te incentive-based models reviewed so far assume tat a secial interest suc as te regulated firm will use eiter bribes or some form of coercive inducement. However, tere is no reason to suose tat firms will restrict temselves to using only ositive or only negative incentives to influence regulators, if bot instruments are available. Dal Bó et al. (2006) offer a model were an interest grou offers bot bribes and treats to officials in its attemts to influence ublic olicy. Tree main imlications follow from tis model. (i) Wen firms ave a way of imosing disutility on regulators, tey will save on rewards by 212

11 E. Dal Bó simultaneously treatening otential retaliations, rivate or olitical, against te regulator. (ii) Relative to a world in wic firms cannot exert coercive ressure, te ay-off to regulators is lower. If ay-offs determine cometence, cometence in regulation will be lower wen coercive ressure is feasible. (iii) Wen retaliations are feasible te cost of influence is smaller. Hence, even wen te gain in rofits from a rice favour may not be as large, influence may be affordable. Terefore, regulatory cature may be more revalent in countries were regulators are less rotected from violence or from firm-originated rumours, as would be te case wen te rule of law is weaker or wen regulatory job stability is lower. If te term lengt of regulatory ositions is a roxy for relative stability, one would exect longer-term regulators to feel more insulated against firm retaliations tat damage te market value of regulator s reutations. Te section on emirics resents evidence on te connection between term lengts and regulatory outcomes. Imlications (ii) and (iii) togeter imly tat countries wit more revalent cature will ave less cometent regulators. (iii) Influence over Collective Bodies Te literature on influence over collective bodies is relevant for regulation bot wen regulatory agencies are run by boards and wen legislatures affect regulatory olicy. Tis literature as been mainly associated wit concerns about te cature of legislators. Denzau and Munger (1986) attack te roblem by focusing on a single legislator wo faces a roblem analogous to tat studied by Peltzman (1976): on te one and, a secial interest may offer rewards suc as camaign contributions, but on te oter, constituents may unis a legislator wo sells out. Te autors ten indicate tat a secial interest will tyically face legislators wit varying rices, and tat te urcaser of legislative favours will try to assemble a majority of minimum-cost legislators. Snyder (1991) was robably te first fully to model te vote-urcasing decision of an outsider wile considering a multi-member legislature. In equilibrium, an otimizing rincial will direct its resources to legislators wo are not friendly enoug to vote for te rincial s roject, but wo are at te same time not unfriendly enoug to become too exensive. At te same time, te outside interest will limit wat it asks for in order to lower te costs of influence. In is model, assing a bill will tyically require bribing entire blocks of legislators, suggesting tat influencing larger bodies will be tyically more exensive. Neeman (1999) studies a multiagent contracting roblem under uncertainty and alies it to voting. He sows tat in very large voting bodies a member will attac a small robability to being ivotal and sell er vote cea. Dal Bó (2000) seeks to unveil vulnerabilities of collective bodies to outside influence tat will oerate even under certainty, and ten studies otential remedies. He considers te ossibility tat a lobby may make offers tat are not only contingent on te way an individual committee member acts, but also on te way oter members do. Tis flexibility tends to allow a lobby acting unoosed to cature committees of any size at no cost. Te main rotections against tis vulnerability are committee members tat can enforce cooeration among temselves, committee members tat are accountable to outside arties, or secret voting. Bennedsen and Feldmann (2002) extend te literature on informational lobbying to te case were te target is not an individual but a collective body, suc as a legislature. In teir model, an interest grou wants a articular ublic good rovided (say, environmental rotection). Te legislature is made u of reresentatives coming from districts tat ave different valuations for te ublic good. Tey sow tat a lobby may ave an incentive to generate information on wat districts would benefit te most from te ublic good. Tis information will allow an agenda-setter a more finely tuned coalition-building strategy tat relies on ig-valuation districts. Tis minimum-cost coalition made of ig-valuation districts leads to te aroval of iger levels of te ublic good desired by te lobby. Wen arty coesion is very strong in a legislature and legislators vote in large blocks, te eterogeneity of districts cannot be easily exloited by an agenda-setter seeking to form a minimum-cost coalition. Tus, arty coesion in arliamentary democracies (as in Euroe) dilutes te incentives to direct informational lobbying efforts at legislators. As a result, informational 213

12 lobbying sould target regulatory bodies more eavily in countries dislaying ig arty coesion in legislatures. V. REVOLVING DOORS emloyees tat seem to ave industry interests more at eart. Ten, regulators may try to signal teir aeal to industry by being lenient to it. In tis last situation, a ro-industry regulatory bias is more of an instance of te collateral damage of a free circulation of uman caital. Te fact tat many regulators come from industry, or end u tere, as long been tougt to be a source of bias in regulatory decisions. In keeing wit te rest of te aer, tis section uses a ublic utility lens, but te toic of te revolving doors is more general and te models reviewed ere can certainly be tougt to ave imlications for oter areas of regulation. For examle, defence rocurement officials may go to work in te defence industry, government ealt olicy-makers may eventually take jobs wit rivate ealt comanies, tax officials may become cororate tax advisers, etc. Te list of ossible moves from te ublic to te rivate sector (and vice versa) is, indeed, long. Te cannels troug wic industry emloyment may affect regulatory erformance are multile. An imortant distinction is weter suc emloyment is eld before or after regulatory involvement. Coming from industry may induce regulators to make roindustry decisions because of te regulator aving been socialized in an industry environment. Tis in turn may yield different cases. In one extreme, we migt find fairly irreflexive, artisan ro-industry tyes; on te oter, well-meaning individuals wo tend to see te concerns of industry as more legitimate, salient, or relevant to general welfare, because tose are te concerns tey are most familiar wit. An examle of te latter case migt be a erson wit industry background wo worries about te fact tat low rices may discourage investment, and in turn urt future consumers. 11 Te ossibility of ost-regulatory emloyment is different: regulators may bias teir decisions in order to enance teir cance of future emloyment in industry. An exlicit quid ro quo may exist, wereby lenient regulation is rewarded wit future emloyment in industry. At oter times, firms may mainly ire former regulators because te latter ossess valuable skills and not because suc iring is art of a reward sceme. Still, given skills, firms may refer Te set-us exlored so far illuminate a way in wic osterior emloyment in industry may affect regulatory decisions: suc a ossibility acts like a covert bribe and induces lenient decisions toward industry. Having exlored models in sections II and III tat can el rationalize te negative side of te revolving doors, I now review more otimistic views. Te remainder of tis section exlains in detail te arguments in two aers using te view tat te revolving doors may not only allow industry a larger ool of uman caital; te revolving doors may even induce better regulatory outcomes. Te first of tese two aers is by Ce (1995). He considers a ierarcical agency model à la Tirole (1986) and rovides tree different treatments. In te first, it is assumed tat regulators may invest in uman caital during teir tenure. Two forms of caital are available: tecnical caital, or exertise, and lobbying caital, or contacts. Te first tye of caital reduces te marginal cost of monitoring te firm, wile te second does not. Wen industry future emloyment is associated to firms wanting to obtain tecnical exertise, ten regulators will want to obtain suc exertise. Tis will in turn lower a regulator s costs of monitoring te firm. Under te otimal contract laced by te overall rincial (te government, say), tis lower cost of monitoring translates into better regulatory outcomes and lower informational rents left to te firm. Tus, oening te revolving doors would in tis case encourage te acquisition of useful exertise by regulators. However, if firms emloy former regulators because of teir contacts and otential lobbying usefulness, ten oening te revolving doors may ave te oosite effect, namely tat of discouraging te acquisition of useful exertise. An imortant emirical question is ten wat is te rimary drive beind firms emloying former regulators: exertise or lobbying otential? 11 Tus, one could argue tat very ars regulation may reduce investment and affect caacity to serve future consumers. Navarro (1982) studies te cost of caital and te rankings of Public Utility Commissions (PUCs) from te oint of view of stockolders. Firms under te watc of ars PUCs aear to face iger cost of caital. 214