The political economy of (de)regulation: theory and evidence from the US electricity industry

The choice of whether to regulate firms or to allow them to compete is key. If demand is sufficiently inelastic, competition entails narrower allocative inefficiencies, but also smaller expected profits, and thus weaker incentives to invest in cost reduction. Hence, deregulation should be found where cost reduction is less socially relevant and consumers are more politically powerful, and it should produce lower expected costs only when investment is not sufficiently effective. These predictions hold true under several alternative assumptions and are consistent with data on the deregulation initiatives implemented in 43 US state electricity markets between 1981 and 1999 and on the operating costs of the plants that served these markets. Crucially, these empirical results help rationalize the slowdown of the deregulation wave and are robust to considering the other determinants of deregulation emphasized by the extant literature, i.e. costly long-term wholesale contracts and excessive capacity accumulation.