Implications of Second-Best Theory for Administrative and Regulatory Law: A Case Study of Public Utility Regulation
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Compared to early twentieth century policy analysts, we have available today extensive tools of "comparative institutional analysis,'' increasingly sophisticated economic models,3 vastly increased and widely distributed computing power, and gigabytes of data. Despite all this, we simply have not come to grips with the implications of second-best theory for regulatory interventions. Moreover, policy must address not only the economic implications of second-best theory but the legal and political implications as well: policymakers must consider the interaction of potential shortcomings of the legal and political tools available when they design the solutions to be implemented with those tools. The failure to confront second-best theory's implications is rooted in the foundations of the regulatory state--an inappropriate confidence in our ability to forecast the impacts of regulation and precisely calibrate regulatory interventions. This overconfidence is based on three, interconnected factual assertions: (1) technical expertise can design solutions to social problems; (2) legal constraints can ensure technical expertise is properly applied; and (3) political institutions will produce legal constraints which correctly guide and restrain technical experts. All three are false. The reasons why the challenge of second-best theory has been ignored are varied. An "engineering" approach to economics based on first-best analysis is seductive in many respects--it relies on elegant mathematical constructs whose solutions are intellectually gratifying and demanding, it allows economists to play important roles in public policy debates, and the analysis leads to (relatively) clear answers. Institutional details can be assumed away and the intellectual history of the discipline safely ignored, vastly simplifying economists' lives. Second-best analysis, on the other hand, is messy and requires thorough knowledge of the details of the actual operation of the economy and society. Perhaps public choice analysis explains a great deal about academic life as well as about governments. For whatever reasons, policymakers and analysts have largely ignored second-best theory. In particular, the implications of second-best theory are ignored by those analyzing and designing regulatory policies justified largely by goals related to economic efficiency, as in utility regulation. Second-best theory suggests an important limitation on regulatory policy: because the ultimate impacts of regulatory actions are difficult and expensive to discover, we must be cautious in acting to "fix" what we perceive to be "inefficiencies." We should be modest about our ability to understand the world, our ability to design legal institutions which can implement solutions, and our political institutions' capability to produce laws. In particular, we should be suspicious of claims that regulatory actions will enhance economic efficiency. One important role for public policy, aside from preventing fraud and the use of force, is to disrupt rent seeking behavior. This does not mean there is no room for policy; it does mean that there is much less room than appears from much of the legal and economic literature. In the next section, I describe the public utility regulatory problem which I will use as the basis of the analysis. In the following sections I examine each of the three assumptions described above and show why they are false. In the final section, I suggest an alternative approach.
