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. Regulation can best be understood as the imposition of a set of rules or standards that direct or restrict conduct, with provisions for punishing violators. To be legitimate, regulators must stipulate some utopian benchmark that displays the gap between the real world and the optimal activities of certain groups. For the libertarian, regulation presents two sets of questions raised by scholars as diverse as Milton Friedman, Murray Rothbard, George Stigler, and Ludwig von Mises. First, even if this gap exists, can government close it or is regulation likely to make things worse? To ascertain whether this gap may be closed, we need a theory that allows us to determine “government success,” in addition to “market failure,” before regulation could be justified. Second, even if government were able, in principle, to 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, they argue, should direct the train and keep it from overheating or breaking down. This notion raises the key issue 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 supporters of regulation make for this right, we need to examine the utopian point of reference: perfect competition.
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 the marginal cost of production, resources flow into that industry until the price is driven down, and all producers earn 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.
This perfectly competitive outcome is efficient because it implies zero waste. More technically, for the advocate of regulation, an efficient outcome is the idealized benchmark where no feasible reallocation of resources could result in higher total output of goods and services. The alternative to perfect competition, and the associated concept of efficiency, lies 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.
There are three primary categories of ostensible market failure: information asymmetry, natural monopoly, and externalities.
Information asymmetry holds where citizens are unaware of the nature of products or services in advance of their purchase. 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 the line be drawn? Why not regulate all activities where quality is unknown? After all, some restaurants are not good. Why not establish a “Federal Bureau of Indian Restaurants” and close down those that serve bad curries? In point of fact, 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 curry, you do not 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 spontaneous market-generated answers to information asymmetry. If you are traveling in another city, or even another country, and you see a chain restaurant you recognize, you might eat there because you know that the quality will be of a certain level. Natives may not choose to eat there because they have local knowledge of better restaurants, but brand names can solve the information problem fairly well for people who lack such knowledge.
Concerning the issue of natural monopolies, perfect competition implies 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 occurs with respect to electrical generation facilities, with its associated delivery infrastructure that includes wires, switches, and transformers. What prices should be charged by such enterprises? If their charges are set at marginal cost—that is, the cost of generating electricity once the infrastructure is in place—then they are unable to pay for the costs of 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 lower cost than 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 (and deadweight losses) of monopoly overpricing. The third possibility is to regulate the monopoly by mandating rates to be charged and the return that can be earned on investment. However, strong arguments have been put forward that regulation of utilities, although 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 was made by Harold Demsetz in 1968, but this view has lately been given more credence by a number of states’ public utilities commissions.
With respect to the problem of externalities, the model of a perfectly competitive economy 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 individual incentives may be distorted.
Suppose, for example, someone dumps raw toxic wastes into a river. This scenario is an example of an externality, where one’s action affects others, but those affected have no voice. The dumper considers only his own small costs of tipping barrels into the river, while he ignores the “social” costs of his actions—downstream poisoning and cancer. This ability to ignore a real cost appears to be a particularly apt example of market failure.
It is important 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 Ronald Coase has suggested, a failure to specify property rights and to provide 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.
Prices give signals about the value of resources, commodities, and activities. The unregulated market is the most efficient and impartial animating principle the world has ever known. It does not 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 even exacerbate the problem. As George Stigler (1971) 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.
Equally important, 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. Thus, regulation often sets 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, revise organization charts, pass new regulations, and create new agencies and scrap old ones. This temptation should be resisted.
Coase, Ronald H. “The Problem of Social Cost.” Journal of Law and Economics (October 1960): 1–44.
Demsetz, Harold. “Why Regulate Utilities?” Journal of Law and Economics 11 (1968): 55–65.
Mises, Ludwig von. Bureaucracy. New York: Libertarian Press, 1994 .
———. Epistemological Problems of Economics. New York: New York University Press, 1981 .
———. Human Action. New York: Fox & Wilkes Press, 1997 .
Niskanen, William. Bureaucracy and Representative Government. Chicago: Aldine-Atherton, 1971.
Rothbard, Murray N. Power and Market: Government and the Economy. Menlo Park, CA: Institute for Humane Studies, 1970.
Stigler, George. “The Theory of Economic Regulation.” Bell Journal of Economics and Management Science 2 (1971): 3–21.
Originally published .