Why Do We Regulate?

I came across an answer to this question the other day by Uwe Reinhardt at The New York Times economics blog. Professor Reinhardt tells us that “regulations are usually a legitimate response to mischievous games played by some parties in the private sector.”

If you’re not an economist, that statement may not strike you as especially odd. After all that’s what you would likely hear in just about any garden variety history class. Or sociology class. Or political science class. But then again, most historians, sociologists and political scientists have never mastered even rudimentary economics.

To understand economic regulation one must turn first to people with a bit more knowledge. Interestingly, the father of economics, Adam Smith, devoted a good bit of his treatise, An Inquiry into the Nature and Cause of the Wealth of Nations, to the subject of regulation of economic activity. Smith observed that the vast majority of government regulations serve no useful social purpose at all.

Far from protecting consumers, most government intervention in Smith’s day was designed to protect producers and other special interests. They served the interests not of buyers of goods and services, but of the sellers. Further, society would be much better off if these laws were simply repealed.

What about the modern era? It’s amazing how little things have changed.

Hollywood depicts the downside of regulation.

As Gabriel Kolko (one of the few historians who did understand regulatory economics) wrote in The Triumph of Conservatism, every major regulatory agency established in the Progressive era was established at the request of the regulated industry. There were consumer complaints of course. But the design and thrust of regulation primarily served the interests of the producers, not the consumers. This was also generally true of the whole slew of regulatory agencies created during the New Deal.

The first meat inspection law was designed to squelch competition and serve the interests of the large meat packers. The Interstate Commerce Commission mainly served as a cartel agent for the railroads and had the primary goal of making the railroads profitable. Trucking regulation was designed for the benefit of truckers. Airline regulation for the benefit of airlines. Agriculture regulation for the benefit of farmers. Franklin Roosevelt’s National Industrial Recovery Act allowed producers in every industry to set up a cartel backed by the force of law, until it was mercifully declared unconstitutional by the Supreme Court.

At the state and local level, one out of every three jobs now requires a license. Yet for the most part, regulation of the professions appears little different from the medieval guild system that Adam Smith criticized more than 200 years ago. As Milton Friedman pointed out in Capitalism and Freedom, there seems to be no legitimate justification for any of this. Perhaps there is a role for government as a certifier, but not generally as a regulator. Let the government inform you that I have no skills at barbering. But having done that, there seems to be no good reason to prohibit me from putting a bowl over your head and clipping around the rim.

While promoting a naïve “public good” explanation for regulation, Reinhardt acknowledges that there are special interest pressures. But he treats these as distractions, when in fact they are the main event. Virtually all interests are special interests, including consumers. There are no general interest lobbies. There are no general interest PACs. There is no organized group pushing for what economists call Pareto optimality. So why would you be surprised to learn that we don’t have it?

Health care, by the way is no exception to the general rule. As I pointed out years ago in Regulation of Medical Care, most regulation of medical care is pernicious. Almost none of it is designed to protect the patient and it makes costs higher, quality lower and access more difficult than would otherwise have been the case.

Here is the latest example of misguided health care regulation and here is a brilliant post by Bryan Caplan pointing out that life’s most serious problems are not regulated at all, including (to use Uwe Reinhardt’s term) the most “mischievous” behavior.

Most irritating of all, however, is professor Reinhardt’s practice of trying to explain regulation by the use of totally baseless (and theory-less) claims while completely ignoring a real theory of regulation that I have offered to readers on more than one occasion.

Comments (20)

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  1. Paul H. says:

    Excellent post.

  2. Vicki says:

    I like the video. Perfect imagery.

  3. brian says:

    Over-regulation can kill a small business before it even opens. In some states, the state liquor authority requires so many licenses for bar-and-grill-type establishments to open and operate that many owners give up during the process of getting all of the permits and licenses.

  4. Ken says:

    Agree. Uwe Reinhardt for some reason wants to romanticize government. That’s not usual for those on the left.

  5. John Garen says:

    Excellent. The political economy of regulation often gets lost in the debates . . . but it’s always crucial to remember.

  6. Joe Barnett says:

    In defense of Uwe, perhaps he is referring to new government regulations rather than the initial decision, often taken generations ago, to regulate a particular area of economic activity beyond what the common law and commercial codes have done for centuries.
    New regulations are often a response to the actions by individuals and businesses to circumvent the old regulations — or a response to the perception that the old regulations made things worse.
    On the other hand, setting up a new agency to regulate a previously unregulated field of activity is usually advocated on the basis that the market (and the courts, the news media, consumers etc.) have failed or are incapable of keeping bad actors in check.

  7. Tom H. says:

    I like Hollywood’s depiction of the down side of regulation.

  8. Ray Wooldridge says:

    Regulation is a bit like gun control. It penalizes the good guys and doesn’t stop the crooks. Most of the fines only hurt shareholders who had nothing to do with the problem. Ray

  9. H D Carroll says:

    When it comes to regulation of health insurance, a focus on the vested interests should especially include government and regulators themselves. As a particular example is the current heavy interest by both federal regulators (HHS/IRS) and state regulators (NAIC) in stop-loss reinsurance of self-insured health plans. They like to couch their supposed socially redeeming purpose in the form of looking out for the public, etc., when in reality they are concerned with their own territorial power, and as with almost every similar setting, the “money” issue – i.e., loss of premium tax or other revenue, or that it will distort their own monstrous creation, the exchanges. And look at the mess they made of trying to regulate health insurance by controlling loss ratios – the huge cost in money and resources and energy spent trying to set up and administratively comply with those stupid regulations has generated a tiny percentage of total premium in the form of rebates, when merely requiring an appropriately detailed financial transparency on the part of health plans and insurers could have produced a better outcome due to market pressure. Some regulations are a necessary evil, but remembering the evilness should always be our reminder to keep it to a minimum.

  10. Uwe Reinhardt says:

    I can imagine that John’s “theories” and “empiricism” resonance greatly with a readership the bulk of which views laisser faire nirvana. (By the way, I recommend to them Afghanistan as a suitable domicile.)

    Not that kind of disciple, I consider John’s view naive and only half-way on the mark. Life is more complex than that.

    Few beholders of our regulatory landscape would deny that a good many regulations did come at the behest of producers or sellers who wanted to protect economic turf. I am sure every economist in every class points out that occupational licensure falls into this class.

    Similar, few economists would deny Stigler capture theory, which holds that regulations that originated from a sincere attempt to protect consumers or make markets work more efficiently and fairly eventually get captured by the regulatees. As my colleague in the Politics Department Nolan McCarty puts it in a recent paper, regulatory capture from the get go is more likely the more complex the activity to be regulated is and the less well public agencies are staffed up to write the required regulation.

    Thus there is no need to put yourself on such a high horse, John.

    But think, for example, the new regulations on financial transactions between producers of health-care products and physicians who prescribe their use. Concern over the misuse of these transactions –converting them into a form of bribery– emanated primarily from Senator Grassley’s office. The new regulations are onerous on both physicians and health product manufacturers. And you would be telling me that these regulations were urged by Sen. Grassley in his role as a shill for the industry?

    Taking extreme positions is fun and attracts attention. That is their positive side. The downside is that they can make you look very naive.

  11. Linda Gorman says:

    Let’s not overlook the fact that in the present era those who push for more and more regulation often are neither consumers nor producers–they are third parties who want to tell other people what to do because it moves them closer to their version or utopia, gives them status, or gives them money.

    As an example, consider the energy regulation flowing from the bogus global warming “crisis.”

    And it would be a mistake to think that those who pay for new buildings control the building codes. While there is no doubt that they initially saved lives, big chunks of current codes probably couldn’t pass a cost benefit test. They are so intricate and so draconian that beneficial building improvements are often put aside because codes would require too costly modifications in other areas, officious inspectors can cost businesses hundreds of thousands for minor mistakes by contractors, and the costs of new code modifications are out of scale with the benefits simply because people coming up with the code have to do something new to justify their existence.

  12. Mark Glasgow says:

    This post appears contradictory to previous statements on this blog in regards to the effects of regulations on the private sector. You assert that producers clamor for regulatory action as a means to fence off the industry for their own self-interest. Yet repeatedly, you have decried the regulatory burden that businesses shoulder in attempting to produce, claiming that they suffer enormous losses in compliacne costs. This leaves me in a state of confusion.

    Also, I would like to add that the informational role you advocate is, IMHO, woefully inadequate. Such a mandate would leave the state in an entirely reactionary role, addressing problems only after they have been allowed to cause numerous and substantial social ills. Making use of the example of the barber, what’s the realistic timeframe for the barber 1. giving a bad haircut, 2. having the customer complain to your information-gathering government agent, 3. having that agent collect further customer reviews to determine if the bad haircut was anomolous or standard, and 4. finding the prior, communicating this information to the public at large? In the time it takes to go through such a process, the barber has given hundreds of bad haircuts, and America is the land of the Beatles bowl cut.

    Apply this logic to the medical device or drug sectors (where we trade bad haircuts for medical fatalities), and we see the obvious benefits of a government that is preemptory rather than reactionary. I, for one, would prefer a government that, to the best of its ability, stops problems before they manifest themselves. Hence licensing instead of certifying, and preempting rather than reacting. Again, IMHO.

  13. wanda j. jones says:

    John and Friends…

    Uwe tends to stand above the fray. He does not seem to have direct experience with the day to day life of a regulated provider or health plan. When there is a new category of regulation, such as the HIPAA privacy act, it is not a matter of a few paragraphs that any literatre person can grasp, it is several hundred pages of dense regulation that only another attorney can even read, much less interpret. So, the affected company has to hire a “Director of Privacy Management,” and give that person a budget for travel to conferences about the law, consultation with an attorney, and for accountants and medical data experts who can set up a scanning and reporting system to verify that every jot and tittle has been covered. Multiply this one act by several dozen and you have serious money being spent just on the administration of compliance.

    Moreover, there is an aspect of regulation that was unknown even 20 years ago; the tendency of the government to send in a huge squad of FBI agents to acquire all possible records, removing them from the premises, often without a strong indication that there is some wrong-doing.

    The only quality assurance regulatory process that the healthcare sector respects for its professionalism is the Joint Commission. It is private, not government, and uses experienced healthcare executives for its site visits, not lawyers and accountants.

    Obamacare is the Niagara of regulations. 165 new agencies, tens of thousands of new IRS agents. And with all of this, the government will say that providers have raised their prices too much.

    There needs to be a book, John, on the pernicious tendency of governments to regulate prices, whether of providers or health plans. We have had rate regulation for decades. A few states still practice it, and those that do tend to have higher prices (New York) than those that do not. Only Maryland appears to have good results. Several states (Washington and others) closed it as they found their providers already offered prices below the national average. A limit (10%) starts out as a ceiling but soon becomes a floor.

    There also needs to be a book about regulation of buildings, as it has reached particularly costly levels, especially here in California, as our hospitals attempt to comply with the Seismic Safety act.

    The core of such regulation should be limited to techniques for assuring patient safety only. Regs are a way of memorializing best practices. The downside of such regulations is that they hold back innovation that could actually work better. Our hospital construction code was reformulated back in 1973. (It’s updated frequently, however,)

    Good topic to revisit periodically.

    Wanda J. Jones, MPH
    New Century Healthcare Institute
    San Francisco

  14. Robert Kramer says:

    WHEN DID ADAM SMITH MAKE THESE STATEMENTS? THE DELIVERY OF MEDICINE SHOULD LET PEOPLE WHO ARE SCAMMING THE SYSTEM OR PRACTICING POOR MEDICINE, OR SELLING DRUGS TO THE PHYSICIAN BASE NEED TO BE IDENTIFIED AND HAVE PUNISHMENT SEVERE ENOUGH THAT ONCE THEY ARE RETURNED TO SOCIETY THEY WILL THINK TWICE BEFORE COMMITING THAT KIND OF BEHAVIOR AGAIN. it is the same old story, John, it matters little who makes the complaint, how they did it, whether it be by a government agency, or the local medical society, is far less important than the punishment meted out has significant teeth in it to effect a change by the culprit. This is where our local “policing agencies” fall short. I reference a recent summary about a physician who was not only practicing bad medicine, writing scripts that were contraindicated and unnecessary and continuing to perform his surgical procedures that were not only poorly performed, but had no relevance to the patients problem. Yet in their wisdom the state society mandated that he not preform his this procedure, that he go back for refresher training, and then he could return to practice.

    Dr. Bob Kramer

  15. DPR says:

    I’ve recently learned (via my wife) a lot about the nascent industry in “Life Coaching”, and I realized the term really arose because a guild of professional psychologists has legal control of the word “therapy”, so they just invented a new term and skirted around their rules. Professional therapists are, of course, apoplectic about this, especially since they had to go through all the trouble of getting a PhD. I think it’s hilarious.

    My other favorite (in other words, most hated) examples of regulation as a favor to industry groups:
    – Have to get an eye exam every year in order to keep buying contact lenses. Obviously I would be a huge threat to society if my scrip changed and I bought the wrong lenses. (My optometrist defended the law, saying that elderly people in particular would be at risk if they didn’t get periodic eye exams, and the reason THAT is in the public interest is because the public pays for their health care. Talk about a slippery slope of justification…)
    – Have to get an emissions test periodically, when roadside tests (those trucks that shoot a laser through your exhaust and look through a spectroscope for the results) are far more cost effective and accurate.
    – The group that lobbies the hardest for ever stricter DUI laws, MADD, is also the group you have to pay to take the classes if you get caught. I would not be remotely surprised to find out that MADD is a huge contributor to police unions.

  16. Frank Timmins says:

    Excellent post John. H.D. Carroll touches on a relevant point specific to health insurance. To expand a bit I would point to the hundreds of state mandated benefits that complicate and raise the cost of insurance with little if any benefit to the consumers. These mandates can be typically traced to lobbying by specific special interests involved in providing healthcare products and services rather than any type of public outcry.

    Mark Glasgow writes “You assert that producers clamor for regulatory action as a means to fence off the industry for their own self-interest. Yet repeatedly, you have decried the regulatory burden that businesses shoulder in attempting to produce…”

    Mark, you miss the point entirely here by viewing “business” as some kind of coordinated monolithic segment of society. Not only is that a short sighted approach, but it doesn’t recognize that businesses are for the most part unrelated independent enterprises operated for the purpose of providing varied products and services and turning profits. Part of that process is trying to gain competitive advantage over rival businesses, and if one can do so by gaining advantage through preferential government assistance it will usually accept that advantage. Those rival businesses do indeed shoulder the regulatory burden. We should not concern ourselves with the motivations of the business (asssuming it did not bribe or otherwise coerce special treatment). Rather we should be dealing with the ill advised government bureaucracy that enabled the advantage through “force of law”. Sometimes the regulations harm all producers of products/services, but as John Goodman points out, seldom does the consumer reap any benefit.

  17. John Seater says:

    I have read Ewe Reinhardt’s original post, this blog, and the comments on both, including Ewe’s. Ewe’s original post has no content whatsoever, just a vague discussion of vague notions of vague market failures. Of course regulation can be justified in the face of a substantial market failure. However, I am aware of literally *no* substantial market failure in the health sector except those imposed by some level of government. If Ewe disagrees, I would like him to specify the inherent market failures that he believes exist in the health market and document their size. I am a macroeconomist, not a health economist, so I have only an incomplete awareness of the literature in the field. I have read a few articles on the topic but not many. Perhaps I have missed something. However, I have been asking for examples of market failures in the health sector that were not put there by the government and so far have received no reply. At this point, my presumption is that there are none. Neither Ewe’s blog entry nor his comment above on John’s post offer anything to make me doubt that presumption.

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