SIMILAR TRIANGLES AND THE THEORY OF REGULATION: A REJOINDER TO QUlGGlN

by BRIAN DOLLERY

In a thoughtful comment on my paper (Dollery, 1994) on the timing of microeconomic reform in Australia, John Quiggin (1995) employs my diagrammatic Figure 1 (Dollery, 1994, p. 88; Quiggin, 1995, p. 87) to draw entirely different conclusions from those offered in the original analysis. Figure 1 below reproduces the earlier diagram using Quiggin's (1995, p. 87) notation:

FIGURE 1

Figure 1 illustrates gross monopoly rental accruing to producers in a regulated industry, together with associated surplus and welfare losses, both before (MC') and (MCZ) some cost increase. Using Figure 1, Quiggin (1995, p. 86) argued as follows:

"Elementary school geometry shows that all the ratios ab/AB, ad/AD, ae/AE, de/DE, bc/BC and cd/CD, oa/OA and Ob/OB are equal. It follows that the ratio of final to initial monopoly profit abcd/ABCD is equal to the ratio of final to initial deadweight loss cde/CDE, the ratio of final to initial consumer burden abce/ABCE, the ratio of final to initial consumer surplus Obc/OBC and the ratio of final to initial total surplus Oacd/OACD. We have therefore proved:

Result: Assume constant marginal costs and linear demand. Then all ratios involving deadweight loss, monopoly rent, consumer surplus and total social surplus are unchanged as a result of an increase in costs."

'Department of Economics, University of New England, Armidale NSW 2351.

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Quiggin (1995, p. 87) then goes on to generalise the implications of his analysis for explanations of microeconomic reform based on private interest theories of regulation:

“The implications of this result for the private interest theory of regulation are clear. Any private interest model in which the regulatory outcome is deter- mined by the relative gains and losses of different interest groups will yield the prediction that a reduction in monopoly profits generated by an increase in costs will have no effect on the regulatory outcome. Thus, to the extent that the experience of the 1980s can be represented by Figure 1, private interest theories of this kind would fail to predict the deregulation that took place.” These conclusions are diametrically opposed to my earlier analysis

based on Figure 1. I drew the following implications from an analysis of Figure 1. Pointing out that area abcd is smaller than area ABCD, I argued as follows (Dollery, 1994, p. 88/89).

“...[Total] gross rents accruing to regulation have fallen. Moreover, if the actual costs of maintaining regulation remain the same, then the net rents to pro- ducers derived from regulation will have decreased. Accordingly, the demand for continued regulation of the industry by direct and indirect beneficiaries of gross rents will decline. In addition, given the reduction in consumer surplus, countervailing pressures on the suppliers of regulation from consumers will intensify. The abolition of regulation altogether will generate large gains for consumers from former producer rents and deadweight losses, which should translate into political gains for legislators. Set against these gains will be the loss of rent accrued from producers in the industry. If the net outcome to pro- ducers and providers of regulation represents a relative decline in the return of regulation, then we can anticipate a decrease in the demand for, and supply of, regulation to the industry in question.” Quiggin (1995, p. 87) criticises this analysis on grounds that “in this

model, the cost of securing favourable intervention is fixed and inde- pendent of the gains and losses involved”. Moreover, he believes that this generates larger problems for the private theory of regulation (Quiggin, 1995, p. 87):

“Unfortunately, the success of this model in predicting deregulation is not matched in other areas. A fixed cost model would imply that the level of regulation should be higher in large industries than in small ones and in large jurisdictions than in small ones, the difference in regulation associated with size effects would swamp any intertemporal variations. Furthermore, a fixed cost model is difficult to derive from any underlying theory of rational behaviour.” Quiggin’s (1995) specific argument against my interpretation of Figure 1,

and his more general dismissal of the predictive capacity of the private interest theory, rest on his assumption that my argument is based on a fixed cost of regulation across all industries which is independent of the gains and losses involved. Like Don Quixote who attacked windmills because he mistook them for evil giants, Quiggin assaults a creature of his own creation. Nowhere do I make or imply any such assumption. All my argument requires is the observation ‘I.. .if the actual costs of maintaining

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regulation remain the same.. .” (Dollery, 1994, p. 88) in the given industry in question. Moreover, in so doing Quiggin (1995) manages to misrepresent the main thrust of the private interest theory of regulation, of which my argument around Figure 1 is merely an example. Whilst this theory has been spelt out in detail often enough, a few salient remarks from some of its leading exponents may serve to underline the point. Thus Peltzman (1989, p. 20) has summarised the ways in which the economic theory of regulation (ET) can explain deregulation as follows:

“In the Peltzman and Becker versions of the ET, two kinds of economic change are conducive to deregulation: (1) the gap between the regulated equilibrium and the one plausibly characterizing deregulation of the industry MITOWS, so continued regulation becomes pointless, or (2) the wealth available for re- distribution becomes too small to provide the requisite payoff to regulation. These two forces can be related. For example, a lower demand for the regulated industry‘s produce may bring regulated price closer to marginal cost, and it will lower the potential producer rents from regulation. However, I argue that the second force - decreases in available wealth - is empirically more important.” Similarly, and with particular obvious significance to my argument

“The producers will continue to support regulation, because it promises some rents. But if the rents are too small to finance politically effective support, the political process will seek greener pastures. Producer requests for a free or even cheap lunch will not be honoured.” (original emphasis]. Finally, No11 (1989, p. 48) has emphasised that the private interest theory

of regulation can explain both regulation (which Quiggin apparently does not dispute) and deregulation (which Quiggin does dispute) using precisely the same logic:

“The Chicago theory of government has three essential components. One is that changes in the opportunities for using the coercive power of the state to capture rents leads to institutional change. initially, the theory focused on using regulation to increase the imperfection of markets in order to capture monopoly rents. But the theory is symmetric. Peltzman focuses on how the erosion of opportunities for monopoly rents can lead to deregulation.” (emphasis added).

couched in terms of Figure 1, Peltzman (1989, p. 20) has noted that:

REFERENCES Dollery, B.E. (1994). “The Timing of Microeconomic Reform in Australia”, Economic Papers”,

Peltzman, S. (1989). “The Economic Theory of Regulation After a Decade of Deregulation”,

Noll, R.S. (1989). “Comments and Discussion”, Brookings Papers on Economic Activit~?

Quiggin, J. (1995). “Similar ll-iangles and the Theory of Regulation”, Economic Papers, 14(3),

13(3), pp. 84-90.

Brookings mpers on Economic Activity: Microeconomics. pp. 1-41.

Microeconomics, pp. 48-58.

pp. 86-88.

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