Saturday, 2 January 2010

Efficient regulation

An obvious point about the world is that there is a hell of a lot of regulation out there. Why? Regulation of economic activity is ubiquitous around the world, there must be a reason for it. In a new paper Harvard economist Andrei Shleifer looks for this reason.
To a student of traditional Pigouvian (1938) welfare economics, such an extent of government regulation makes perfect sense. Markets fail, a Pigouvian would say, because of externalities, asymmetric information, and lack of competition, and governments need to regulate them to counter these failures. Regulation is ubiquitous because market failures are.
Such a view however has come under attack since, at least, Coase (1960).
This tradition holds that competition is merciless in driving firms toward efficiency, that markets exhibit tremendous ingenuity in dealing with potential failures, that contracts enforced by courts get around most externalities, and that even when for some reason contracts do not take care of all harmful conduct, tort law addresses most of the rest. The space left for efficient regulation is then very limited. From the efficiency perspective, the ubiquity of regulation is puzzling.
But the problem may be deeper than even Coase suggests.
In fact, it is even more puzzling than Coasian logic would suggest. In Coase’s view, contracts are a substitute for regulation. If potential externalities can be contracted around, no regulation is necessary. Yet, contrary to this prediction, we see extensive government regulation of contracts themselves. [...] The fact that contracting itself is so heavily regulated severely undermines both the Pigouvian and the Coasian theories of regulation.
For the Pigouvian tradition
The Pigouvian theory is undermined because market failures or information asymmetries do not seem to be necessary for regulation, yet those are seen by the theory as the prerequisites for government intervention.
As for the Coaseian
The Coasian position is undermined because free contracts are expected to remedy market failures and eliminate the need for regulation, yet regulation often intervenes in and restricts contracts themselves, including contracts with no third party effects.
Thus we see that the puzzle of ubiquitous regulation remains.

In reaction to this many economists would argue that regulation is driven not by efficiency but by politics.
Under the most prominent version of this theory, proposed by Stigler (1971), industries or other interest groups organize and capture the regulators to raise prices, restrict entry, or otherwise benefit the incumbents. Alternatively, regulation is just a popular response to an economic crisis, introduced under public pressure whenever market outcomes are seen as undesirable, regardless of whether there are more efficient solutions.
But there are problems here to.
[...] the political theories are not entirely persuasive, as they fail to come to grips with the fairly obvious facts [...] that regulation is ubiquitous in the richest, most democratic countries, with most benign governments, and seems to support the highest quality of life. Extensive regulation seems to be embraced in nearly all corners of these societies, which seems inconsistent with the view that regulation is inefficient.
So what is Shleifer's response to all of this?
In this paper, I revisit the case for efficient regulation. My basic point is simple. The case against regulation relies on well-functioning courts. Courts are needed both to enforce contracts and to provide remedy for torts, and hence are central to the basic private mechanisms for curing market failures. In so far as courts resolve disputes cheaply, predictably, and impartially, the efficiency case for regulation is difficult to make in most areas. Efficient regulation would be an exception, not the rule. But when litigation is expensive, unpredictable, or biased, the efficiency case for regulation opens up. Contracts accomplish less when their interpretation is unpredictable and their enforcement is expensive. Liability rules would not address market failures if compensation of the victims is vulnerable to the vagaries of courts. In short, the case for efficient regulation rests on the failures of courts.
So regulation is caused not by market failure or government failure but by court failure.

Arnold Kling raises a question,
The question that occurs to me is why regulation is supplied by government rather than by the private sector. If workplace safety regulation is more efficient than a system that relies on competition and contracts enforced by courts, then an entrepreneur could offer to set up a workplace safety standards body and earn fees from market participants for certifying compliance.
He argues that what Shleifer's paper fails to do is explain what determines the choice between private and government regulation. Kling goes on to say,
What I suspect is that government regulation emerges when some firms want to restrict entry from other firms. Regulations that restrict entry are likely to be harder to enforce when they come from the private sector, because the unwanted entrant has little incentive to comply. Only with government coercion can entry-restricting regulations be enforced.

To induce taxpayers to fund any sort of regulation, a broad public interest must be asserted. However, of the universe of regulations that might be given a public interest justification, the ones that will be enacted will be those that serve to protect incumbent firms from new entrants.
This seems a good point to me.

  • Coase, Ronald H. 1960. “The Problem of Social Cost.” Journal of Law and Economics 3: 1-44
  • Pigou, Arthur C. 1938. The Economics of Welfare. 4th ed. London: Macmillan and Co.
  • Stigler, George J. 1971. “The Theory of Economic Regulation.” Bell Journal of Economics and Management Science 2(1): 3-21.

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