7. The Perspective of Public Sector Economics on Regulation: Transaction Costs and the Agency Model

Public Sector Economics teaches us that a major reason for government regulation is internalizing externalities. Examples are environmental and safety regulations, prescriptions on working conditions and various types of permits which prevent businesses to make decisions at the costs of others. A common characteristic of all of the different types of government regulations is that they entail implementation costs, which, like taxes, distort efficient allocation in the ideal general equilibrium. These costs can be quite substantial but tend to be overlooked in the discussion and development of government policy. By applying the perspective of transaction costs economics, this chapter considers the costs arising from regulation in a principal/agent model. Three types of transaction costs can be distinguished, namely (1) monitoring costs of the regulator (principal); (2) bonding costs by the regulated private economic entities (agent); and (3) the costs of residual loss in case the result of the regulation is not in compliance with the targets set by the regulating authorities. These latter costs can be regarded as cost to society due to e.g. miscommunication on the aims of regulation, and are, of course, hard to quantify. Bonding and monitoring costs consist of both “hard” and “soft” transaction costs. Hard transaction costs are direct costs and are easy to quantify. Soft transaction costs are indirect costs and are hard, or even impossible, to quantify. The costs of residual loss are welfare losses and can be typified as soft transaction costs. The main benefit of regulatory measures is the avoidance of societal costs that would occur in a situation where regulation is meagre or absent. Therefore, it may be welfare enhancing if regulations are fashioned in such a way that net benefits are optimized. From that perspective the chapter looks at the possibility to select optimal regulation by means of a cost/benefit analysis.