Regulation: Sacrifice of the Intellect

Scarcely anyone interests himself in social problems without being led to do so by the desire to see reforms enacted. In almost all cases, before anyone begins to study the science, he has already decided on definite reforms that he wants to put through. Only a few have the strength to accept the knowledge that these reforms are impracticable and to draw all the inferences from it. Most men endure the sacrifice of the intellect more easily than the sacrifice of their daydreams. They cannot bear that their utopias should run aground on the unalterable necessities of human existence. What they yearn for is another reality different from the one given in this world...They wish to be free of a universe of whose order they do not approve.
(Ludwig von Mises, Epistemological Problems of Economics)

The idea of controlling citizens is as old as government. But the notion of “regulating” citizens, and markets, is comparatively recent. The definition of regulation is a set of one or more rules or standards that direct or restrict conduct, with some provisions for enforcing the standards by punishing violators. To be legitimate, regulators must stipulate some utopian benchmark, pinpointing a gap between the real world and the “optimal” activities of private groups. For the libertarian, regulation presents two sets of questions, raised by scholars as diverse as Friedman, Rothbard, Stigler, and von Mises

· First, even if this gap exists, can government close it? Or is regulation likely to make things worse? We would need a theory of “government success,” in addition to “market failure,” before regulation could be justified.

· Second, even if government could, in principle, improve the performance of the economy, should it be given the power to try?

A regulated market economy differs from socialism, where government owns the means of production. Metaphorically, supporters of regulation concede that private activity is the locomotive that moves the economy. But government regulators direct the train and keep it from overheating or breaking down. This raises the key question in understanding regulation: by what right can government use its coercive power to restrict the private activity of some citizens, for the benefit of “society”? To understand the argument regulation supporters make for this right, we need to examine the utopian point of reference, perfect competition.

Perfect Competition: The Nonexistent Benchmark

In “perfectly competitive” markets, prices accurately signal the relative scarcity of all valuable resources, including inputs such as labor and capital, and outputs such as consumer goods and services. Wherever price exceeds marginal cost (what it costs to produce the last unit) of production, resources flow frictionlessly into that industry, until the price is driven down, and all producers are earning zero profits at the margin. “Price equals production cost” is the hallmark of perfectly competitive markets, because it means all parties accept the pattern of transactions.
The perfect competition outcome is called “efficient,” because it implies zero waste. More technically, for the advocate of regulation, an efficient outcome is the idealized benchmark where there is no feasible reallocation of resources that could result in higher total output of goods and services. The comparison to perfect competition, and the associated concept of efficiency, is at the core of the rationale behind support for regulation. Inefficiency, or “market failure,” implies that regulation is needed, even when the ideal of efficiency is actually unattainable.

Market Failures
There are three main categories of market failure: (I) Information Asymmetry, (II) Natural Monopoly, and (III) Externalities.
I. Information Asymmetry: Citizens often don’t know much about products or services in advance. There are many examples of regulation in this setting. Licensing requirements, for example, ensure that airplane pilots can fly (and land!) planes. Likewise, drug regulations require that products are safe and effective before they can be marketed.
But where should draw the line? Why not regulate all activities where quality is unknown? Some restaurants are not very good, after all. Why not establish a “Federal Bureau of Indian Buffets,” and close down restaurants that serve bad vindaloo? Because the “problem” of information asymmetry is not really a market failure at all. Markets can handle this problem quite well. If you go to a restaurant, and gag on the vindaloo, you don’t go back. You tell your friends, or write a newspaper review. People stay away, and the restaurant closes.
Reputation and brand names are powerful, and general, spontaneous (market-generated) answers to information asymmetry. If you are traveling in another city, or even another country, and see a chain restaurant you recognize, you may eat there, because you know that the quality will be of a certain level: not great, but not terrible. Natives may not eat there, because they have local knowledge of even better restaurants, but brand names can solve the information problem fairly well for people who lack such knowledge.

II. Natural Monopoly Perfect competition means that all market participants are “price takers,” whose activities are so small that their impact on price is negligible. But what if some market participants are not price takers? The problem of “natural monopoly” occurs when an activity, such as the supply of electricity or sewer services, requires enormous up-front costs. The result is that only one producer can supply the “efficient” level of the good or service.
A common example of the up-front costs problem is electrical generation facilities, with the associated delivery infrastructure that includes wires, switches, and transformers. What prices should be charged by such enterprises? If they charge at marginal cost, or the cost of generating the electricity once the infrastructure is in place, they can’t pay for the infrastructure. But if they divide the cost over all the units of output, then price greatly exceeds marginal cost. Further, the cost per unit actually falls as production goes up, meaning that one large firm can produce at half the cost of two smaller firms with the same total capacity.
Local governments can either accept the higher costs of many inefficient firms competing, or suffer the higher costs of monopoly overpricing. The third way out is to regulate the monopoly, by mandating rates to be charged and the return that can be earned on investment.
But there have been arguments that regulation of utilities, though pervasive, is unnecessary and costly. If long-term contracts with private firms are bid competitively, the terms of the contract can easily include price and performance criteria. If the firm violates the contract, it forfeits the value of investments it has made in the long-term arrangement. The most important argument for this position is Demsetz, 1968, but this view has lately been given more credence by a number of states public utilities commissions.

III. Public Goods/Externalities The perfect competition model assumes that all consequences of consumption and production choices are internal, meaning they only affect those involved in the exchange. If there are other effects, for which no compensation is made, then the individual incentives may be distorted.

Suppose, for example, someone dumps raw toxic wastes into a river. This is an example of an externality, where one’s action affects others, but those affected have no say. The dumper considers only the small costs he incurs (just tip the barrels into the river). But he ignores the “social” costs of his actions (downstream poisoning and cancer), causing a market failure.
This is a good point to step back, and ask again why it is that government action is necessary. What, in the case of the toxic waste dumper, is the source of the “externality”? Is it really a failure of the market, or is it (as Coase 1960 would suggest) a failure to specify property rights and a system of legal recourse based on torts, class action suits, and compensation for damages?
In fact, the libertarian answer to most market failures is to specify property rights more clearly, and make it less costly for people to arrive at accurate prices on their own.

As Ludwig von Mises noted in Human Action:

It is true that where a considerable part of the costs incurred are external costs from the point of view of the acting individuals or firms, the economic calculation established by them is manifestly defective and their results deceptive. But this is not the outcome of alleged deficiencies inherent in the system of private ownership of the means of production. It is on the contrary a consequence of loopholes left in the system. It could be removed by a reform of the laws concerning liability for damages inflicted and by rescinding the institutional barriers preventing the full operation of private ownership.

Regulation often makes the problem of market failure worse, because regulated markets always, by design, transmit biased or noisy price signals. Robbed of the organizing principle of accurate prices directing resource allocation, some other kind of judgment (in this case, that of a bureaucrat or regulator) must be substituted for private investment. Regulated markets generally beget more regulation, but perform no better (and often worse) than the “failed” market process that regulation was designed to correct in the first place.

Real Markets, Real Regulation

Prices give signals about the value of resources, commodities, and activities. The unregulated market is the most efficient, and the most impartial, animating principle the world has ever known. It doesn’t discriminate, and it directs resources to their highest valued use. The problem with regulation as a response to market failures, even with the best of intentions, is that government rarely “gets prices right.”

Without the “best of intentions,” regulation may make even exacerbate the problem. As George Stigler points out,

…As a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit…. The state has one basic resource which in pure principle is not shared with even the mightiest of its citizens: the power to coerce…. These powers provide the possibilities for the utilization of the state by an industry to increase its profitability.…The state—the machinery and power of the state—is a potential resource or threat to every industry in the society. With its power to prohibit or compel, to take or give money, the state can and does selectively help or hurt a vast number of industries. (Stigler, 1971, pp. 1-4).

So, if market failures having to do with industry structure, information asymmetry, or externalities are regulated, the “regulations” may be designed by precisely those industries ostensibly bound by the new rules. Regulation is setting the wolf to guard the henhouse.
In real markets, it may simply be impossible to regulate, or redirect, the forces that lead investors, producers, and consumers to act the way that they do. Even if one could imagine an alternative, ideal system, regulation is at least as likely to lead away from that goal as toward it. But the chimerical ideal of “efficiency” is what motivates much of what regulators do. If actual policy falls short (and it always will) of the idealized vision of the regulator, it is tempting to try to reform government agencies, to revise organization charts, to pass new regulations, and to create new agencies and scrap old ones. This temptation should be resisted.

References
Coase, Ronald H. “The Problem of Social Cost,” Journal of Law and Economics, (October 1960): 1-44.
Demsetz, Harold. (1968). “Why Regulate Utilities?” Journal of Law and Economics. 11: 55-65.
Niskanen, William. (1971). Bureaucracy and Representative Government. Chicago: Aldine-Atherton.
Rothbard, Murray N. (1971). Power and Market: Government and the Economy. Kansas City: Universal Press Syndicate.
Stigler, George. (1971). “The Theory of Economic Regulation.” Bell Journal of Economics and Management Science. 2: 3-21.
von Mises, Ludwig. ([1933]1981). Epistemological Problems of Economics. New York: NYU Press.
von Mises, Ludwig. ([1944]1994). Bureaucracy. New York: Libertarian Press.
von Mises, Ludwig. ([1949]1997). Human Action. New York: Fox and Wilkes Press.