In a market system, regulations are designed to prevent or rectify market failures that inhibit fair exchange, such as monopoly or transactions with hidden costs. Because regulations reduce profits to those possessing unfair advantage, these advantaged corporations (whether individuals, companies, or other collective organizations) are motivated to influence regulators. Regulatory bodies created to protect the market are instead co-opted to advance the interests of the corporations they are charged to regulate. This wide-spread influence, known as "regulatory capture," has been recognized for over 100 years, and according to expectations of rational behavior, will exist wherever it is in the mutual self-interest of corporations and regulators. Under the assumption of economic rationality, a theoretical analysis suffices to determine where regulatory capture will occur. Here we model the interaction between corporations and regulators using a new game theory framework explicitly accounting for players' mutual influence, and demonstrate the incentive for collusion. Communication between corporations and regulators enables them to collude and split the resulting profits. We identify when collusion is profitable for both parties. The intuitive results show that capture occurs when the benefits to the corporation outweigh the costs to the regulator. Under these conditions, the corporation can compensate the regulator for costs incurred and, further, provide a profit to both parties. In the real world, benefits often far outweigh costs, providing large incentives to collude and making capture likely even when strict rationality may not apply. Regulatory capture is inhibited by decreasing the influence between parties through strict separation, independent market knowledge and research by regulators, regulatory and market transparency, regulatory accountability for market failures, widely distributed regulatory control, and anti-corruption enforcement. We discuss the impact of integrity of the regulator in the analysis, relaxing the rationality assumption. We also discuss various ways regulators themselves may seek opportunities to benefit.
CAMBRIDGE (Oct. 1) — In a market system, regulations are designed to counterbalance the unfair advantages of corporations. But what happens when the people in charge of the regulations are co-opted by powerful corporations that stand to lose money from those regulations? Regulators and corporations both make a profit and the public loses—that’s what happens. It’s called regulatory capture.
A new analysis by researchers at the New England Complex Systems Institute – Dominic K. Albino, Anzi Hu, and Yaneer Bar-Yam – reveals that this teaming up of regulators and corporations is in fact a very economically rational move for both parties. When the corporations stand to gain billions of dollars and the regulators only stand to lose millions (if they even get caught), the best approach is simple: the two parties communicate, decide collectively to collude, and split the profits.
The research uses a new game theory framework that demonstrates the incentive for regulators and corporations to collude, and shows that regulatory capture is virtually certain when the benefits to the corporation far outweigh the costs to the regulator (which happens a lot).
"It’s hard to maintain integrity when the monetary benefits are so high, especially when the harmful consequences are not obvious even when they are severe, as happens often in the financial sector," says Bar-Yam. "We need to make the consequences more clear and the process of collusion more difficult."
The authors suggest several steps for mitigating this situation. Isolating the regulators from the corporations would inhibit communication and the ability to set up a deal. This isolation would need to take place over entire lifetimes, to prevent the “revolving doors” phenomenon which provides delayed but real gratification to colluders (it is common for regulators to work for corporations before and/or after their work as regulators).
Another idea is to increase the transparency of the consequences and the visibility of both regulations and regulator-corporation interactions. This would involve promoting independent research to report the effects regulations have on the market. Finally, the authors argue for widely distributed regulatory control, to make it harder for individual colluders to come to quietly lucrative agreements.