Nearly 15 years ago, economist James L. Johnston offered a theory of regulation that could provide the intellectual foundation for a new round of deregulation initiatives.
Johnston observes that industries are most often regulated when three conditions are present: the product or service is subject to substantial shifts in supply and demand, supply reliability cannot be achieved through precautionary stocks or other market techniques, and substantial social costs are incurred when supplies are interrupted. The intended effect of regulation in such cases is to improve the stability of supply by encouraging extra investment in reliability.
Johnston’s theory explains why electric utilities and the supply of doctors, for example, are so widely regulated: electricity is difficult to store, and the social costs of a power blackout or a natural disaster causing thousands or millions of people to need medical care would be huge. It also explains why the emergence of new financial instruments (such as mutual funds and futures and options markets) and institutions (such as Underwriters Laboratories and J.D. Powers and Associates) makes regulation less necessary.
Johnston’s theory of regulation provides three things missing from the other theories: a criteria or test for determining when regulation may be necessary, a measurable objective for regulation (reducing the social costs caused by the interruption of supply of key goods or services), and a place to look for ways to avoid the need for new regulations or for signs that an industry has outgrown the need for existing regulations (when new technologies or market institutions emerge that can stabilize prices without government mandates).
Johnston showed how theory explains the prevalence of regulation in 11 industries ranging from airlines and drugs to telephones and electric utilities. I use Johnston’s reasoning to identify deregulation opportunities in six industries (two of them concerning health care).
