Market Failures and Government Regulation: Is the Cure Worse than the Disease?
This lesson printed from:
Posted September 19, 1999
Author: William Luksetich
Posted: September 19, 1999
Updated: April 2, 2007
Economic efficiency is something much more than producing goods at the lowest possible cost. In involves providing individuals with the goods and services they desire, in the quantities, qualities, places, and times they desire them, with the least use of society's scarce resources. Economists argue that if markets are competitive, if accurate information is available, if resources are mobile, and if individuals engaging in the transactions bear the full costs and receive the full benefits of their transactions, economic efficiency will be achieved.
Economic efficiency is something much more than producing goods at the lowest possible cost. It involves providing individuals with the goods and services they desire, in the quantities, qualities, places, and times they desire them, with the least use of society's scarce resources. Economists argue that if markets are competitive, if accurate information is available, if resources are mobile, and if individuals engaging in the transactions bear the full costs and receive the full benefits of their transactions, economic efficiency will be achieved.
Markets rarely meet all these criteria, and when deviations from the ideal occur, the result is said to be market failure. Of course, most deviations from the ideal are minor and do not impose significant costs on society. But when deviations are significant there is often a call for government to do something about the problem. For example, markets can deviate significantly from the competitive ideal -- e.g., firms may acquire significant market power, undertake deceptive practices, collude, etc. Government has two tools for correcting this type of market failure: antitrust laws and economic regulation.
Antitrust laws forbid the use of certain practices that are detrimental to competition. Essentially, antitrust laws set up the rules of the game. If firms do not violate these rules, they are free to produce and sell their products as they see fit. This lesson is not concerned directly with antitrust issues; it is concerned with regulatory issues. Specifically, it is concerned with the costs and benefits associated with economic and social regulation. It will provide information about the costs and benefits of regulatory programs and how government imposes hidden taxes on consumers through its regulation of businesses.
The Minute will focus on information in one website: regulation.org. This website provides links to many other sites that provide surfers with a wide variety of viewpoints on the issues presented. The first three items under THE FACTS heading on The Regulation Home Page are concerned with general regulatory issues. Students should read these to prepare to answer the questions in the following section.
(Other items under THE FACTS heading, such as REGULATION HORROR STORIES AND OUTRAGES, and under THE ISSUES heading are concerned with specific regulatory issues. They are more appropriate to use in classroom discussion or for written assignments. Some suggestions for these assignments will be made in a subsequent section.)
1. What is economic regulation and how does it differ from antitrust legislation?
[Since the establishment of the Interstate Commerce Commission in 1887, economic regulation has taken a form whereby the number of firms in an industry is determined and the markets firms can serve are specified by the regulatory commission. Prices and rates of return are regulated and, importantly, entry into the industry is either forbidden or made very difficult by law. In this sense, economic regulation differs from antitrust legislation that does not prescribe in detail what firms are allowed to do and how that can compete.]
2. What is social regulation and how does it differ from economic regulation?
[Some social regulation is a result of firms not bearing the full costs of their activities. Other regulations are aimed at eliminating discriminatory practices against minorities. Still others are designed to protect us from ourselves, presumably because individuals are unaware of certain hazards or unable to assess risks associated with certain activities or products.]
3. Has there been any movement to change regulation in recent years?
[Research over the last 30 years shows that economic regulation has imposed substantial costs on the public, resulted in economic inefficiency, and decreased competition. Since the mid-1970s, deregulation occurred in trucking, aviation, agriculture, telecommunications, banking, and electricity. While some regulation has been reintroduced in the Bush and Clinton administrations, the deregulatory initiative continues to provide benefits.
There have been few efforts to repeal or reform social regulations. There is much evidence that any benefits achieved to date through social regulation could have been achieved in other ways at a much lower cost.
Critics do not disagree with the goals of the social regulation. They argue that rules are inflexible, expensive, and administered in a "command and control" fashion. In place of such rules, they advocate market approaches to solve these problems. Proponents of the current system have less faith in markets. Whatever their political persuasion, economists are in general agreement with the efforts of the reformers to deregulate or modify the current regulatory regime.]
The Importance Of Regulatory Policy
1. Why do we care about regulation?
[Briefly, the direct and indirect costs of regulation result in higher prices and increased costs of employing workers. These costs act as a tax on job creation and employment. They also cause a decrease in productivity. Moreover, regulation provides a way for politicians to carry out costly programs without direct taxation. The higher business costs that result from regulation are passed along to consumers in the form of higher prices (indirect taxation). To the extent that lower income individuals spend a greater proportion of their income on the goods and services affected, the higher prices are in essence a form of regressive taxation.]
2. Has there been a significant increase in regulation in the recent past?
[The third item on the regulation.org website, Key Regulation Facts and Figures, provides the answer to this question and the all of the following questions. Have students compute the percent increase in the number of pages in the Federal Register (36 percent between 1976 and 1978) and in The Code of Federal Regulations (89 percent between 1976 and 1978).]
3. Has the cost of regulation increased as a result of the proliferation of new regulations?
[The direct costs of regulation, the costs of operating the regulatory agencies, are not very large. Significant economic deregulation began in the Ford administration and picked up speed during the Carter administration. The decrease in the direct costs of regulation continued through most of the 1980s. Since 1988, the direct cost of regulation has increased and in real dollar terms is significantly greater than 20 years ago. The indirect costs have been enormous, as documented in the Key Facts and Figures section of the website. There is a link to the Office of Management and Budgets study on the benefits and costs of regulation. Of particular interest is Chapter II of the study. It concludes that the benefits exceed the direct costs of regulation; however, once the indirect costs are taken into account there are only few cases in which the benefits of regulations exceed the costs.]
4. Has the distribution of the costs of regulation changed?
[In 1977, 67 percent of the costs of regulation were because of economic regulation, 12 percent because of environmental and risk regulation, and 21 percent were paperwork costs; by 1995, the same regulation cost categories were 34, 33, and 33 percent, respectively.]
5. Which businesses are hit especially hard by the costs of regulation?
[Small and medium size businesses, as measured by number of employees, bear significantly larger per-employee costs of regulation than do large businesses. Clearly, this is detrimental for new businesses, i.e., it does increase the costs of entry and tends to diminish competition.]
Activities that may be more appropriate for research and classroom discussion
There has been significant deregulation, specifically economic deregulation. What have the effects of deregulation been? [Consumers have received significant benefits from deregulation. There are brief, general summaries of these effects at the end of this third section of the website. In the natural gas, airline, telecommunications, trucking, and railroad industries, prices have fallen, service quality has increased, most consumers have benefited from deregulation, and consumer choice has improved. The right-hand column of the homepage is titled "Issues." For an excellent example of the effects of economic deregulation have students click on "airlines." Under this title are links to a number of studies dealing with deregulation in specific industries. Two of the studies, one by the Brookings Institution and a second by the Heritage Foundation, come to virtually identical conclusions. Have students compare the results of the studies. Brookings is generally considered a liberal "think tank"; Heritage is generally considered conservative. Economists devoting their efforts to studying the effects of economic regulation do agree on at least one issue: economic regulation has been detrimental to social welfare. Other sites under Economic Issues/Industry Regulation will document similar results of deregulation in other industries.]
What are the Costs of Environmental and Risk Regulation? [Peruse the material at the end of Key Regulation Facts and Figures, including the links that are listed at the end of the section. Here you will find data on the risks of various activities and the costs per life saved of the different regulations. Ask students their opinion of whether the reduction in risk is worth the costs of reducing that risk]
As economists, we can point out the benefits and costs of different activities. If the benefits of an activity exceed the costs of that activity, it does not necessarily mean we should undertake that activity. For example, research by economists indicates that the imposition of the death penalty for criminal homicide will reduce the homicide rate. This does not mean that the death penalty is the best way to reduce homicides.
It is relatively easy to point out the benefits and costs of economic regulation and to be very confident in recommending the proper policy to follow: "get out of the economic regulation of business and use antitrust policy to maintain competition." With environmental and risk regulation, finding the optimal public policy is more difficult. Frequently, this type of regulation is based upon both bad economics and bad science. Nevertheless, regulation occurs and its costs and benefits are frequently ignored. Under the Issues column on the homepage, students can access various studies dealing with the benefits and costs of environmental and risk regulation. Good economics and good science are both needed to develop good public policy. Good economics involves properly ascertaining the benefits and costs of activities. Good science involves determining the risk involved in activities. Good public policy requires an assessment of the net benefits and the risks.
The deregulation movement has not affected areas such as consumer product safety, worker health and safety, the environment, or any of the other areas that fall under the social regulation heading. It is not possible, therefore, to document in general terms the benefits and costs of environmental and risk regulation. Consequently, the effects of this type of regulation are best covered on a case by case basis in classroom discussions or written assignments.
Recently, the insecticide DDT has come back into the news. There are calls for a complete worldwide ban on DDT by 2007. Have students access the Junk Science site listed below. Access the September 3, 1999 article from the Economist magazine concerning banning the insecticide DDT on the Junkscience: Archives - September 1999 page .
While the article is somewhat sympathetic to the banning of DDT, the scientific evidence certainly does not support of the ban. The scientific evidence is found at the same place. Click on the reference "100 things you have to know about DDT." Read also the September 2, 1999 article by Ken Smith titled "Save Malaria Now." Have students note the benefits and the costs of the proposed ban. Ask whether the scientific evidence supports the proposition that the benefits of the ban exceed the costs.
Many other articles presented in the junkscience.com website would also be appropriate for classroom discussion. Have students read the articles about proposed legislation concerning a chemical or product -- e.g., anti-smoking campaigns, science, and politics (Sept. 2, 1999), toxic pollen as a threat to Monarch butterflies (Sept. 9, 1999). Discuss whether the scientific evidence supports the legislation and whether the benefits of the legislation will exceed its costs.
Other websites concerning issues such as the risks associated with global warming, clean water, and food and drug regulation can be found under the Issues column on the regulation.org homepage and on the junkscience.com homepage. Assignments dealing with the science, economics, and politics of global warming, etc., could provide stimulating classroom discussion.