Politics, Transaction Costs, and the Design of Regulatory Institutions

Abstract:     
Providing a realistic framework for assessing the efficiency of government intervention requires viewing the government not as a monolithic entity but as a number of different government bodies, each with its own constituencies and regulatory tools. Providing a more complete framework for assessing the efficiency of government intervention requires moving away from the idealistic perspective typically found in the normative approach to traditional public economics, contend Estache and Martimort. Such a move requires viewing the government not as a monolithic entity but as many different government bodies, each with its own constituency and regulatory tools. Not only is the multitiered government limited in its ability to commit, but interest groups influence the regulatory process and impose significant transaction costs on government interventions and on their outcome.

Estache and Martimort discuss the nature of those transaction costs and argue that the overall design of the government is the result of their minimization. Among the points they make in their conclusions:

Safeguards built into regulatory contracts sometimes reflect and sometimes imply transactions costs which influence, or should influence, the optimal tradeoff between rent and efficient in ways practitioners sometimes ignore.

Most of the literature on transaction costs arising from government failures would agree that to be sustainable, regulatory institutions should be independent, autonomous, and accountable. How these criteria are met is determined by the way transaction costs are minimized, which in turn drives the design of the regulatory framework.

In practice, for example, if there are commitment problems, short-term institutional contracts between players are more likely to ensure autonomy and independence. This affects the duration of the nomination of the regulators. Short-term contracts may be best, but contracts for regulators typically last four to eight years and are often renewable. The empirical debate about the design of regulators' jobs is a possible source of tension. Practitioners typically recommend choosing regulators based on professional rather than political criteria, but that may not be the best way to minimize regulatory capture. Professional experts are likely to come from the sector they are supposed to regulate and are likely to return to it sooner or later (as typically happens in developing countries). On the other hand, elected regulators are unlikely to be much more independent than professional regulators; they will simply represent different interests. Practitioners and theorists alike emphasize different sources of capture and agree that one way to deal with its risk is to make sure the selection process involves both executive and legislative branches.

This paper - a product of the Regulatory Reform and Private Enterprise Division, Economic Development Institute - is part of a larger effort in the institute to increase understanding of infrastructure regulation.

Keywords: Government Organization, Regulation, Multiprincipal, Collusion

JEL Classifications: D82, L51

Working Paper Series