The Skeptical Regulator*
Modest Observations on Regulatory Policy
Release 2.1 n January 2004

Though the Fates forbid the Cubs from winning a World Series, economists from Chicago have enjoyed much more success. What began as an assault on the macroeconomic assumptions of Lord Keynes, ended up a thoroughgoing critique of topics as disparate as antitrust law, the family, administrative regulation, tax policy, trade and monetary theory. This is the "Chicago School" of economics - a term that is most often accompanied by either triumphalism or derision, depending on your point of view.

Notwithstanding acceptance or rejection of Chicago School conclusions or methods, the Chicago School view of regulation and competition policy must be reckoned with and understood.[1] A regulatory actor must withstand the acid bath of Chicago School-inspired skepticism to justify his mandate.To be precise, there are two major strains of the Chicago School critique, and they are somewhat at odds with one another.

First, consumer welfare stands alone as the goal of competition policy.[2] This consumer welfare branch of Chicago School economists and lawyers has seen its triumph in antitrust law. In antitrust, it is not an exaggeration to proclaim that "we are all Chicagoans now." [3] The consumer welfare standard predominates in antitrust law, and has decisively crowded out the "big is bad" and "competitor protection" abuses of antitrust law.

Chicago economists paired the consumer welfare standard with rigorous empirical analysis of the effects of proposed regulatory or antitrust action. Thus, the Chicago School analysis moved antitrust away from the fluctuating custom of sometimes valuing small firms, sometimes valuing multiple firms, sometimes valuing integration, and to always focusing on the data-described effects of policies or judgments on consumer welfare.

In the end, Chicago School antitrust analysis shrunk the field of plausible antitrust actions. Vertical integration and tying arrangements came more often than not to be explained as consumer welfare enhancing arrangements, as opposed to the bane of would-be trustbusters. Chicago Schoolers further pointed out that vertical integration, retail price maintenance, exclusive territories and exclusive dealing had positive, consumer-welfare enhancing aspects. This did not mean that, under the right circumstances, there could not be an antitrust violation. Rather, in antitrust parlance, cases migrated from being per se violations to being analyzed under the Rule of Reason.[4]

Further, valid price squeeze and predatory pricing antitrust claims became nearly extinct under the withering gaze of Chicago School analysis. Chicago School empiricism pointed out that, with singular exception, price squeeze and predatory pricing schemes could rarely succeed in practice.[5] Indeed, predation and price squeezes could almost only succeed if government regulation allowed them to by erecting entry barriers into the marketplace.

It has been widely observed that the Chicago School simply applied price theory to the practice of antitrust. Their assumptions were non-controversial. Firms act rationally to maximize profits. Demand curves slope downward. Resources move to where they can earn the highest return. A few simple assumptions applied scrupulously led to new understanding of areas as diverse as cartels, barriers to entry, predatory pricing and tying.

The Chicago antitrust revolution not only changed the legal doctrine, but also focused on the institutional realities. Courts and regulators have limited resources; they are subject to political pressures; the economic doctrines can be difficult, if not impossible, to apply in practice; mistakes are made; error costs are high; and regulation is costly. These realities gave rise to the second strain of the Chicago regulatory critique.

This strain asked whether regulation accomplished its stated purposes. Did administrative regulation constrain monopolistic behaviors? Did regulation serve consumers, or the regulated entities? What behavioral model best explains regulatory action in practice? As skeptical regulators, Chicago Schoolers found regulation wanting in most instances.

It all started when the resident economist at the Chicago School of Law, Aaron Director, sat in on an antitrust course. Director found a plethora of new and interesting problems for economists to study in the judicial explanations for the behavior of firms. But to his dismay, the judicial rulings often relied on ideas about a firm's behavior in conflict with basic economic tenets.

Director set to work. When his own research on a particular question proved unsatisfactory, Director would send the problems across campus to his economist colleagues. They too - scholars like Milton Friedman and George J. Stigler - found the economics of law, and particularly of antitrust law, fascinating. Thus, the tremendous influence of a good idea - consumer welfare and its application - began to shape a generation of professors, graduate students and law students. Soon enough, the Chicago school leapt beyond the boundaries of geography and spread throughout legal, academic and policy communities.

There are dozens of men and women, in a handful of disciplines, who offered ideas, wrote papers, inspired students and practitioners and created this school of thought. Chicago thinking was also greatly aided by the development of prestigious academic journals like The Bell Journal of Economics and Management Science and the Journal of Law and Economics, the latter of which found a home at the University of Chicago in 1958.

The aforementioned George Stigler was a great empirical economist. He began in an area known as industrial organization, the realm of economics that studies monopoly behavior, and his first article on the topic of government regulation was published with Claire Friedland in 1962. In What Can Regulators Regulate? The Case of Electricity, Stigler and Friedland found that the regulation of electricity prices only had a tiny effect on those prices. Stigler's work relied on empirical evidence.[6] The force of his career was to show that the effects of regulation could be measured and examined. He gave meaning to the Chicago School emphasis on real-world effects over theory.

Not content to study only the effects of regulation, Stigler also helped give rise to a more systematic study of the causes of regulation. Contemporary to fellow Nobel Laureate James Buchanan's pioneering work in public choice economics, in 1971 Stigler published The Theory of Economic Regulation to present evidence for his theory of a competitive market for regulatory favor. Seeking to understand if the state regulates industries simply to reduce the harmful effects of monopoly, Stigler concluded that governments do not accidentally create monopoly in industries. Rather, they too often regulate at the insistence, and for the benefit, of interest groups who turn regulation to their own ends.

Empty standards increase the cost and uncertainty of regulation. Writing about the antitrust Rule of Reason - which certainly has echoes in the "public interest" standard - Judge Easterbrook wrote:

When everything is relevant, nothing is dispositive. Any one factor might or might not outweigh another, or all of the others, in the factfinder's contemplation. This formulation offers no help to businesses planning their conduct. Faced with a list of such imponderables, lawyers must engage in ceaseless discovery....Litigation costs are the product of vague rules combined with high stakes,...[7]

In the end, courts and regulators have very crude tools to understand complex economic phenomena. And the imposition of those tools, particularly under the aegis of a broad, contentless standard can have costly and long-lasting consequences.

To be sure, the Chicago School has its limits. While its assumptions account for the general case of economic behavior, "post-Chicago School" thinking has pointed out [and gotten tenured] by raising the exceptional cases where anticompetitive behavior can make sense to a firm. As Judge Richard Posner has stated:

The Chicago School's approach is skeptical...about the gravity of the danger to competition posed by unilateral firm action.... The approach emphasizes both the difficulty of squashing competition...and the danger that heavy-handed antitrust enforcement may suppress a practice that seems anticompetitive but actually is efficient. But skepticism is not the same as denial.[8]

The Chicago School's triumph in antitrust law is underscored by the fact that the current debate is between Chicago School and post-Chicago School economic and legal scholars. Its inroads into the administrative regulatory world have been far more limited.

What can Chicago School analysis offer to regulators? Two things: First, focus on consumer welfare, properly understood. Antitrust doctrine has rich lessons for administrative regulation, counseling many places where regulation should retreat (price and quality control, for instance), but also teaching that regulators should pay attention within a narrow bound where incumbent firms' incentives break down. Second, be aware of institutional limitations and error costs. Regulations are costly and regulatory errors are costlier still because of their durability. In short, be a skeptic.

- The Skeptical Regulator

Next up for The Skeptical Regulator: Public Choice: Captive Regulators and Rentseeking.

Footnotes

* The Progress & Freedom Foundation debuted The Skeptical Regulator in July 2003. The periodic essays are authored by president Raymond Gifford and other fellows at the Foundation. Send comments to regulator@pff.org

[1] Foundational pieces include: Robert H. Bork, The Antitrust Paradox (Basic 1978); Aaron Director and Edward Levi, "Law and the Future: Trade Regulation," 51 Northwestern L Rev 281 (1956).

[2] See, Raymond L. Gifford and Kent Lassman, "Consumer Welfare, Competition & Market Processes," The Skeptical Regulator Release 1.3, October 2003. The essay can be found here.

[3] See for example, Richard A. Posner, "The Chicago School of Antitrust Analysis," 127 U Pa L Rev. 925 (1979) where the author's general conclusion is that it is "no longer worth talking about different schools of academic antitrust analysis."

[4] See generally, Frank H. Easterbrook, The Limits of Antitrust, 63 Tex L Rev 1, 7, 10-11, 27-28 (1984).

[5] Richard A. Posner, Antitrust Law 2d Ed. 214 (Chicago 2001).

[6] George J. Stigler, The Citizen and the State: Essays on Regulation, 114-88 (Chicago 1977).

[7] Easterbrook, supra at 12.

[8] Posner, supra at 251.