Regulation consists of rules administered by government agency to influence economic activity by determining prices, product standards and types, and the conditions under which new firms may enter an industry.

In the U.S. the Interstate Commerce Commission was established and railroads were brought under economic regulation in 1887 to protect shippers - especially farmers - from monopoly power. A half a century later - during the great depression of the 1930's - numerous agencies were created for the regulation of a wide variety of other firms, including those engaged in finance, energy, and transportation. This wave of regulation reflected a belief that free markets were not working well rather than a concern about market power.

In general, free markets produce efficient outcomes. Because of informational frictions and externalities, however, there is a need for regulation. For example, asymmetric information can cause adverse selection and moral hazard, which are both examples of market failure situations, and regulators attempt to address.

A negative externality is a cost that a transaction or activity imposes on a party that is not part of the transaction or activity. Examples: pollution, loud noise, and blocked view. A negative externality could lead to a market failure. When production or consumption of a product benefits others, it is a positive externality.

Regulations can address both positive and negative externalities. For example, negative externalities should be taxed, and positive externalities should be subsidized.