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This theory of economic regulation is rooted in perception that government must step in to regulate markets in instances when markets are unable to regulate themselves. These so-called "market failures" occur where the price mechanism that regulates supply and demand breaks down, forcing government to take action.
Natural monopolies and external costs (a.k.a., "externalities") are the most prominent types of market failure. Natural monopolies occur when the fixed costs of supplying a good are so great that it makes sense for only one firm to supply that good. Public utilities like the delivery of electricity or water/wastewater services to your home usually require so much money to build the necessary infrastructure (erect utility poles and lay pipelines) that no company would take on the task without confidence that it would control a sizeable portion of the market.
The problem is that the monopoly businesses that arise from this situation tend to use their market power in ways that can be highly detrimental to the community at large. This is where governmental regulation becomes important.
Externalities occur when the costs or benefits of producing a good or service are not fully incorporated into the price. Economists often cite air pollution as a cost incurred by almost any sort of economic activity, but which is often ignored when determining the prices. When the polluting activity is very concentrated, as in a manufacturing plant, the costs to the surrounding community can be considerable. Yet, without governmental regulation there is nothing that compels the plant to either minimize the environmental impact or otherwise compensate the community for bearing that part of the cost of production.
These sorts of market failures, along with the general need for mechanisms of regular public disclosure by business, make regulation critical if the public interest is to be protected. In this view regulation results from the need to protect the public from the negative impacts of such market failures and other harmful business behavior. A glimpse of how the executive bureaucracy protects the people can be seen in the video interview in the Justice System chapter in which student interns describe their experiences working in the Attorney General's office.
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