EBF 200
Introduction to Energy and Earth Sciences Economics

 

Rent-Seeking and Regulatory Capture

PrintPrint

At this point, I want to introduce another term that has a different meaning to economists and the general public.

This term is "rent." To a layperson, rent is a term that describes payment made in exchange for temporary use of something, such as an apartment, a store, a car, or a DVD (think Netflix). However, to an economist, rent has a different meaning. An economic rent is defined as a return to a factor that is greater than the return required to incentivize the use of that factor. This is another way of describing an economic profit. Remember that an economic profit is a situation where a business generates profits that are larger than the risk-free rate plus an appropriate risk premium. In the case of economic rents, it means that some factor of production earns more than it "should" in equilibrium. In a market setting, this means that more of that factor will be employed, and competition will drive down the return to some equilibrium whereby zero economic profits are being made.

Rents, like economic profits, can be thought of as "free money" - and everybody likes free money.

One of the most common uses of the term is as part of the phrase "resource rents," which refers to the generation of positive economic profits from extracting minerals from the earth. For example, if the risk-adjusted cost of bringing oil out of the ground is $20 per barrel, and a company is able to sell that oil for $100 per barrel, then we say that they are collecting a resource rent of $80 per barrel. In economic theory, because there is so much "free money" in extracting oil, then there should be a rush into the oil business, more oil produced, and the price falls to $20. In reality, this tends not to happen quite so neatly - mostly because we have a cartel that supports the price of oil at high levels by limiting supply.

Another way to think of rent, in a somewhat pejorative sense, is to think of "unearned" profits. It can be difficult, in a positive sense, to say what exactly "unearned" means - that word is a bit like "fair" or "equitable," in the sense that it has some sort of normative connotation. However, think of the idea that rent means positive economic profits - more specifically, economic profits that are in some way shielded from market forces, and therefore, not subject to the sort of competition that tends to make them vanish. Remember that economics is dynamic by nature, and the forces of innovation and entrepreneurship send people in search of economic profits, so they will always exist. However, in a theoretically free market, as soon as economic profits appear, competition follows and the profits eventually vanish. This is not a market failure, merely the nature of competition. It is only a failure if the person earning the rents is able to stop the forces of competition from driving the rents down to zero. If this happens in a market, we have a monopoly (or, more commonly, an oligopoly) and we have a market failure. However, as I have said in the past, a monopoly can only persist in one of three situations:

  1. Natural monopoly (infinitely downward-sloping marginal cost curve)
  2. Control of all of a resource (such as deBeers and the diamond market,or, for a while, China and the rare earth minerals market)
  3. Government protection from competitive forces

Today, we will talk about the third of these factors - using government to protect and maintain rents. This is another source of government failure, once again referring to government failure as actions by government meant to address market failures, but which generally end up leaving worse outcomes than before the intervention. That is, government trying to fix a problem, but only making things worse.

Rent-Seeking

Rent-seeking is a way of transferring previously-existing wealth to oneself by something other than voluntary trade. It typically involves a transfer of wealth, not a creation of wealth like that which occurs in a market with voluntary trade driven by utility and profit maximization. I will list a couple of examples of rent-seeking for illustration. Stealing is perhaps the “purest” example of rent-seeking. A thief takes what others earned without earning it. You may think that a thief invested time and energy in planning and executing the crime. However, it’s important to note that theft is simply a transfer of your stuff to me (should I steal from you), and that NOTHING IS CREATED. In a market transaction, buyers and sellers exchange goods for cash, and both sides benefit, so wealth is generated. In stealing, wealth is transferred, not generated. This is a rather extreme example, but it drives home the notion that rent-seeking is about transfers of wealth from one sector of society to another that are not the result of voluntary, mutually beneficial transactions, but instead are transfers of wealth that are effected by some sort of force. A mugger might hit you over the head and take your wallet, but when government takes wealth from one sector and transfers to another, there is the implied force that comes from the government having enforcement agents (police, prosecutors) to ensure that its wishes are carried out.

Now, putting aside the notion of simple theft, which is, in theory, opposed by governments, let us start to look at forms of rent-seeking that arise out of the seeking of favors from government. OK, so now we are talking about government power. Government has the power to pass laws, to write regulations, to collect taxes and to enforce the laws, regulations and taxes. Because members of government have lots of power, they have lots of favors to dole out, and it is the competition for these favors that forms the basis of rent-seeking. Firms are competing with each other, but instead of competing for customers by offering better products or better service at lower prices, they are competing for government favors. Instead of employing salesmen or engineers or factory workers, they are employing lawyers and lobbyists.

A lobbyist is a person who is employed by a company, or sometimes by an industry association, or by a union, or sometimes by a foreign country, who has the job of talking to politicians and bureaucrats, with the goal of having them pass laws and enact policies that are beneficial to the persons they are representing. The term "lobbyist" refers to the fact that these people used to wait "in the lobby" outside legislative bodies, waiting for the politicians to leave so that they could talk to them.

Any time or energy spent on gifts or bribes to government officials in exchange for government favors are rent-seeking. Let's say a firm is lobbying to obtain a lucrative contract, for, say, new airborne tankers - you know, the planes that refuel other warplanes in mid-flight. Once a firm has this contract, wealth is created by producing the tankers and selling them to the government. However, the resources the companies spend on acquiring the contract could have been productively used by the economy.

If you are not aware, the case of the new USAF tankers is a textbook example of rent-seeking behavior by suppliers: people have gone to jail, massive fines have been paid, a CEO lost his job, and the contract still remained unrewarded until 2010, after almost two decades of wrangling.

Recommended Reading

If you are interested, I direct you towards the Wikipedia entry on the KC-X, which presents a good summary.

Because government favors (subsidies, long-term contracts, exemptions, etc.) increase the wealth of the recipients of these favors, those eligible (or potentially eligible) will compete for the favors. We can say that rent-seeking is an equilibrium behavior - we expect firms to do it because they stand to derive meaningful benefits from it.

Firms have the incentive to waste resources on gifts for the official who will decide the winner of the contract because the firm will ultimately be better off. However, society is worse off because some resources were put to less than their best use — society’s opportunity costs have increased because a path of action that does not generate the maximum amount of utility for society was taken.

There are several ways to try to deal with the problem of rent-seeking. Out-and-out bribery is illegal (Federal employees cannot even accept free lunch at McDonalds), but making political donations, or paying for senators to take trips to Hawaii to "present a briefing" to them is not illegal. There are technocratic solutions, such as establishing objective (rather than subjective) criteria for large contracts. Also, the press will gladly expose any scandal they can uncover in lieu of these rules.

However, there is a basic problem that means that rent-seeking is not likely to go away anytime soon: politicians and bureaucrats have power, and as long as they have power, and exercise it, then people will compete with each other for the benefits derived from the exercise of this power. The only solution to this is to reduce the amount of power that resides in the hands of government - something that nobody in government has any incentive to do.

The Distribution of Costs and Benefits

If it is clear that rent-seeking is a practice that costs society great amounts of wealth by competing with each other for government favors, then why does the public not band together to stop it? Well, since this is an economics class, you can expect an economic answer: because stopping it is usually not beneficial for members of the public, or, to put it another way, the costs of stopping this sort of behavior is generally greater than the benefits of doing so that would accrue to any individual.

Suppose as a Penn State student (which I was, a few years ago), I am hurt by $10/year by a new program to buy all tenured faculty members new office furniture. Furthermore, suppose it costs me $50 (in cash and opportunities) – to organize with all affected people to fight the new program. Facing these alternatives, as a greedy individual, I am simply going to put up with the new program. It doesn't make economic sense for me to fight the program, even though fighting the program will probably be beneficial to students in aggregate.

This is the problem of concentrated benefits and distributed costs.

  • You are less likely to protest a new industry tax-break if 300,000,000 people share the costs than if only 1,000 people share the costs.
  • When the group of people paying are affected enough, they will organize, in the form of protests, lobbies, campaign contributions, or political activism (i.e., running for office).

Specifically, the costs of organizing have to be less than the cost of the program on the affected group. Finally, if I am rationally ignorant to the new cost (I don’t directly know about it, and don’t question a lower paycheck), I won’t even consider raising an objection. In general, we see costs being spread over broad groups, and benefits concentrated on narrow groups. As the result of all this, we see small, highly organized groups gaining benefits, while the rationally ignorant masses pay!

Examples

The sugar industry maintains high profits because of the existence of import quotas - they do not have to compete with foreign competition because of rules put in place by the government. The end result is that sugar is about twice as expensive in the US as in neighboring countries. Because of this, everybody in the US pays a few more dollars per year for their groceries, but about 800 sugar-growing businesses benefit by hundreds of millions of dollars. Because the sugar industry gets such great benefits, they spend a lot of time and effort on politicians to make sure the import quotas stay in place.

Another interesting example is the case of Breezewood, PA. If you ever drive down to DC from State College, you will find out that you cannot simply exit from the PA Turnpike directly to I-70, but instead you have to drive through the middle of this town. There have been several attempts to build bypasses around the town, but this would hurt the merchants of Breezewood, who have been able to successfully lobby to stop any attempts by PennDOT to build a bypass. Because of traffic backups through Breezewood, everybody pays a little bit, but a few people benefit greatly.

The government has passed laws requiring that a certain percentage of the gasoline sold in this country contain ethanol. This has created an industry that would not exist without the government mandate, because ethanol is generally more expensive than gasoline. This benefits farmers in the Midwest who grow the corn to make ethanol, and it helps the agribusiness companies that manufacture ethanol. But everybody else pays because ethanol has less energy per gallon than gasoline; so our fuel economy drops when we burn ethanol-containing gasoline. However, this is something most people are unaware of.

There are many other examples of rent-seeking. One of the most common ways of using government to eliminate competition is what is referred to as "regulatory capture." This is the case where regulators end up acting in ways that benefit the industries that they regulate. Many government agencies are generally created with the high-minded notion of protecting the public from rapacious behavior of corporations. However, these corporations can use the government agencies to protect themselves from competition, most frequently by encouraging a set of regulations that makes it very difficult for newcomers to enter an industry. They use the creation of regulations as a barrier to entry. For example, building electricity power lines is a relatively simple and affordable process, and a 100-mile transmission line can be built in perhaps half a year. However, it takes at least five years of navigating the regulatory process to get permission to build a new power line. Because it is so expensive and time-consuming, we probably have fewer than the ideal (economically efficient) number of power lines, and companies that own existing power lines are able to benefit from the high costs of congestion that exist on existing power lines.

Large companies are especially good at using environmental regulations to squeeze out smaller competitors, because there are economies of scale that can be put to use. A company with 20 refineries can comply with regulatory paperwork a lot more easily than a firm with one refinery, because the big company is more likely to employ specialists who do the work for all of their refineries. The small firm has to train somebody to do the regulatory filings even if it is not their primary job, or, more likely, to hire an outside consulting firm to deal with the red tape, which can be considerably more expensive than doing it yourself. For this reason, the number of small, independent refineries has shrunk greatly since 1980, and now only a few large companies dominate the industry.