Arnold Kling

Courts Fail. Use Regulators

When Experts Fail... Are Economists Cheap? Or Just...

Andrei Shleifer examines why regulation might emerge.

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. 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. The puzzle of ubiquitous regulation remains.

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.

...Competition without courts and contracts does not do much.

Thanks to John Alcorn for the email pointer.

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.

An example that I refer to in Unchecked and Unbalanced is kosher certification. There are 600 different certification bodies around the world, none of them affiliated with the U.S. government.

Underwriters' Laboratories, which certifies electrical equipment, is another example of a private regulatory body. What Shleifer's paper fails to explain is what determines the choice between private and government regulation.

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.

[UPDATE: a reader emails me to suggest many Masonomics thoughts on this topic:

The point about regulation compensating for defects in the court system was also made by a "Masonomist", though on opposite day, here.
You can see Alex (not Axel!) make those criticisms of the court system on the videos for the AEI event for his book.

In his paper, Schleifer points out that while contracts should provide solutions to the same problems regulation is supposed to solve, regulation often restricts contracts themselves. Robin Hanson argues that we should be able to contract out of regulation.]

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COMMENTS (9 to date)
Alex J. writes:

He assumes that since we get so much regulation along withe so much wealth, it must be efficient in some puzzling way. On the other hand, we have lots of wealth, and this enables us to afford lots of inefficient regulation. The private interests of incumbent firms and the paternalistic anti-market bias of do-gooding rationally ignorant voters seems like enough to explain ubiquitous regulation to me.

Alex R writes:

Forget private regulation...what about private courts?
Also, his abstract begins with "Regulation of economic activity is ubiquitous around the world, yet standard theories predict it should be rather uncommon." Does Public Choice not count as a "standard theory"?

Eric H writes:

It might be because I haven't given it the most careful of readings, but I don't think the Coasian position is undermined because it "expects" that free contracts would "eliminate" the need for regulation; rather, the Coasian position is that free contracts may--may--be of lower cost and therefore preferable to state-enforced remedies.

Why burden Coase's position with something it never claimed? Read Coase's The Problem of Social Cost for more...

E. Barandiaran writes:

Arnold, indeed the judiciary often performs poorly. But its business is adjudication--the resolution of conflicts when someone fails to comply with contracts or laws. On the other hand, the purpose of regulation is often prevention: how to do something (authorization conditioned on meeting requirements as in professional licensing) and how to let others know what you are doing (information requirements as in food labels). Thus, to the extent that regulation prevents conflicts, it reduces the demand for adjudication. Regulation can fail however, and then it's not clear what its impact on adjudication is (if it fails miserably, it may increase conflict and the demand for adjudication).
To explain the increasing role of regulation we need a theory of the conditions under which prevention (actions to lower the probability of a wrong) is better than correction (actions to deal with the consequences of a wrong). This theory may be also useful to explain the choice between private and government regulation.

SydB writes:

"What I suspect is that government regulation emerges when some firms want to restrict entry from other firms."

Any evidence to support this assertion? Evidence other than anecdotes?

I have an alternative one: regulation emerges because markets are slow. That's why the military is not a market, but in fact a top down command system. Markets take time to adapt while regulatory commands can be pushed through the system almost immediately. Markets are more efficient over time but require time to adapt. This I suspect is also a source of regulation.

E. Barandiaran writes:

SydB, you've a very narrow view of what a market is. People have been organizing all sorts of activities without coercion for thousands of years. As a result there are all sorts of organizations with different internal structures that depend on the particular outputs expected by those controlling them. Most structures involve a high degree of hierarchy to ensure that the outputs are delivered. Contrary to what you believe markets do usually adjust much faster than any particular private or public organization (do you know how many times existing large organizations have been reorganized because of their continued poor performance?). By definition markets do not rely on coercion, and yes sometimes coercion is necessary.

Syd writes:

Barandiaran: I disagree. I think I have a reasonably broad view of markets. And I'm not anti-market at all.

The reason that the military is a command and not market organization is simple: command organizations can operate very quickly to address critical issues. Command structures, as the saying goes, can quickly get all the ducks in a row. And I'm not saying the military or command structures are efficient. They aren't. But they can be quick.

A market may take time to address a problem in society. When people are angry it is much easier to quickly regulate. Whether it solves the problem efficiently or effectively, it appears as if something is being done.

Markets may take time because they have to explore the solution space. But in some cases the one solution is apparent--e.g. a regulation to address shortcomings in meat processing--and then the problem is solved.

My main point: Mr Kling's narrative often involves bad people in high places, evil corporations, and the likes. But in the present case, it could be that many regulations do not originate from monopolistic corporations but from regulatory and political agencies that are honestly trying to solve a problem as quickly as possible.

Remember: I'm not saying it's necessarily right. But Mr Kling made an assertion about the world and I'm not sure whether it's true or not.

wm13 writes:

I certainly don't have a systematic theory of regulation, but one thing that promotes regulation is extreme price volatility (which is generally a product of inelasticity in either the supply or demand curve). Both producers and consumers seem to be happier with steady, above-market prices rather than volatile, market-clearing prices.

Why doesn't the market supply other solutions to price volatility, e.g., insurance, futures contracts? I don't know, but I would guess that there is an extreme information asymmetry in markets of this nature, to wit, lack of information about counterparty solvency, which makes it difficult to establish functional markets in protection against price fluctuations.

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