Public interest theory is an economic theory first developed by Arthur Cecil Pigou that holds that regulation is supplied in response to the demand of the public for the correction of inefficient or inequitable market practices. Regulation is assumed initially to benefit society as a whole rather than particular vested interests. The regulatory body is considered to represent the interest of the society in which it operates rather than the private interests of the regulators.
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Assumptions
This theory assumes that markets are extremely fragile and apt to operate very inefficiently (or inequitably) if left alone. The government is assumed to be a neutral arbiter.
The public interest view holds that governments regulate banks to facilitate the efficient functioning of banks by ameliorating market failures, for the benefit of broader civil society. In banking, the public interest would be served if the banking system allocated resources in a socially efficient manner (i.e. “maximizing output and minimizing variance” ) and performed well other functions of finance.
Criticisms
Public interest theory is usually contrasted with public choice theory that is more cynical about government behaviour and motives, and sees regulation as being socially inefficient. Moreover according to Stigler regulation can be captured by incumbent firms to protect the market from the entry of competitors. Critics believe this will only occur when the public demands a better allocative efficiency.