Mid-month, March 2026

Incentives in the public sector

Recall that the mid-month posts are brief looks at topics I find interesting. They may or may not be related to behavioral economics, the subject of my monthly posts that appear on the first of each month.

Essay 7: We shouldn’t be surprised when politicians behave like humans

Although it might be hard to believe at times, politicians are humans too. As such, they respond to incentives.

For many years, economists worked with models of the economy based on three “actors:” consumers, producers (also called “firms” or “companies”), and the government. In these models, consumers and producers interact in the marketplace, and the role of government in these models is that of overseer and regulator when things go wrong.

How might markets go wrong? A classic example is something called an externality, and pollution is the textbook case. A producer makes and sells electric spaghetti forks and consumers buy them. But the production process creates pollution, which falls on people who live near the factory. The economic activity has consequences that fall on third parties—not the producer, not the consumer, but the people living near the factory. Pollution is “external” to the transactions between the producers and consumers.

The pollution is a cost to the nearby residents, but the producers don’t pay that cost. Because the producers (predictably) don’t include external costs in their calculations, the market is distorted—the cost of production is understated. The role of government in these models is to correct for externalities.

Key: The models assume that the government—or more accurately the people in government—act in an unbiased way to make these corrections.

There is a substantial literature on how to address externalities, but our focus here is on the assumption that government officials—let’s think of them as regulators—are motivated to act in the best interests of society as a whole.

James Buchanan received the Nobel Prize in Economics for challenging this assumption. What is known as “public choice theory” describes regulators as people who pursue their own self-interest.

As I argued in Essay 5, models are useful if they describe and/or predict. Public choice theory is a model that predicts self-interested behavior on the part of regulators. One specific prediction that comes out of this model is the concept of “regulatory capture.”

Regulatory capture occurs when an industry has undue influence over its regulators. Capture occurs in several ways. First, the industry (its lobby) showers gifts on the regulators. Yes, there are rules about this, but there are workarounds. To keep the gifts coming, regulators might go easy on the regulations.

Second, industry executives might become regulators. One could argue that such a regulator has a greater understanding of the industry than someone who has never worked in the industry. True, but it might also be the case that they will treat the industry with less scrutiny because they are friendly to the industry.

Third, regulators sometimes move to industry. The possibility of making such a move, which likely includes a much larger paycheck, might influence the regulator to be less harsh in the hopes of getting a lucrative industry job.

So there is a “revolving door,” through which people move from industry to regulation and vice versa.

Sam Hornblower writes (emphasis added):[1]

My Businessweek investigation also uncovered a pattern of the FDA bowing to political pressure and its reluctance to revisit past errors. And the FDA reviewer who cleared OxyContin’s approval later took a job at Purdue [a pharmaceutical company].

Consistent with public choice theory, Milton Friedman, also a Nobel Prize winner, observed that finding the right people to serve as regulators is not the solution to self-interested behavior by government officials. Of course, it makes a difference who regulates—some people are more self-interested than others—but that does not entirely solve the problem.

Thus, an important insight from public choice theory is the importance of institutional structures that provide incentives consistent with desired outcomes, rather than relying on people to behave in ways that are not always in their best interests.

The challenge is that the people in a position to change institutional structures are those who—more or less—benefit from the current setup. What incentives do they have to make changes?

I would be most interested in hearing from you, the reader, your thoughts about how to bring about changes that reduce the incentives for public officials to misbehave (broadly defined).

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[1] Here (link). Behind a paywall for non-subscribers.