Why so much government?

Regulation of economic activity is ubiquitous around the world, yet standard theories predict it should be rather uncommon. I argue that the ubiquity of regulation is explained not so much by the failure of markets, or by asymmetric information, as by the failure of courts to solve contract and tort disputes cheaply, predictably, and impartially.

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 cure 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.

This is Andrei Shleifer, from a new NBER working paper. He makes a number of persuasive points backing his case:

- Regulation is more pervasive when it comes to complicated activities, where generalist judges have particular difficulty arbitrating predictably
- Regulation has grown over time, which might have to do with the growing complexity of activities
- Societies that exhibit high level of trust have less regulation
- Common law countries tend to rely less on regulation than civil law countries
- With the rise of corporations, inequality between the injured plaintiffs and the injurer is too vast to allow for fair arbitatration in courts

Of course, just because expensive courts could explain regulation doesn't mean they do so fully; yet this is a deep and important insight which, as they say, changes everything. This is a very important paper.

Additional extracts, including killer arguments, under the fold.

Government regulation is extensive in all rich and middle income countries. It transcends not only levels of economic development, but also cultures, legal traditions, levels of democratization, and all other factors economists use to explain differences among countries. There is surely a lot of variation across countries, but it pales by comparison with the raw fact of ubiquity. Why is there so much government regulation?

To a student of traditional Pigouvian (1938) welfare economics, such extensive 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.

This view, however, has lost much ground over the last half century, under relentless intellectual pressure from the law and economics tradition originating with 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.

In fact, it is even more puzzling than the 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. Employment terms are delineated in contracts, yet these contracts are heavily regulated by the government. Purchases of various goods, from homes, to appliances, to stocks, are governed by detailed contracts, yet these contracts too are restricted by government mandates. The regulation of contracts goes much beyond mandatory disclosure, which suggests that asymmetric information is not at the heart of the problem. The fact that contracting itself is so heavily regulated severely undermines both the Pigouvian and the Coasian theories of regulation. 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.

These considerations have led many economists to accept the position 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 (Hart 2009). Yet the political theories are not entirely persuasive, as they fail to come to grips with the fairly obvious facts which opened this paper, namely 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.

When problems recur often enough that repeated utilization of courts is too expensive or unpredictable, regulation might be a socially cheaper alternative. This would be so if the regulator is the ultimate decision maker, but even if in the end the judge must decide, regulation can delineate the issues that must be addressed. It might be more efficient for the legislature to specify the rules than for courts to sort out the threshold of liability in distinct situations. This argument makes the strong prediction that regulation should be more efficient in the more common situations. Mulligan and Shleifer (2005) test this prediction. They find, in cross-sections of both US states and countries, that higher populations are associated with more extensive regulation. They argue that the regulation of a particular area requires a fixed setup cost, which can be amortized over a higher number of disputes that comes with more people. With small populations, litigation, while idiosyncratic, is rare enough that fixed costs are not worth paying. This approach might also explain why we see regulation in areas such as workplace safety, where contracts and torts are readily available: disputes occur often enough that standardized regulation is cheaper, and more predictable, than idiosyncratic litigation.

Regulation would also be more common in situations where facts are complex, and fact finding requires expertise and incentives. As the society develops, this criterion might apply to a growing range of activities. This observation might explain the basic fact of growing regulation over time. It might also explain why we see regulation in financial markets or in complex industrial activities. [...] expertise and motivation of the regulators were the crucial arguments for the expansion of regulation in the US (Landis 1938).

[...] regulation might be particularly relevant in situations of inequality between the injured plaintiffs and the injurer. The rise of regulation might be intimately tied to specialization and the rise of large corporations as organizational forms. Thus, while courts or similar methods of dispute resolution might work when disputants have comparable resources, they fail when inequality of weapons becomes overwhelming. This, too, might account for the ubiquity of regulation, including the regulation of contracts between parties with different resources, in the modern world. In fact [...] this might be the reason for regulation of so many basic aspects of consumption and employment.

When it comes to a comparison of patterns of social control across countries, many additional considerations come into play (see Djankov et al. 2003).    Different societies might have different levels of expertise, and hence comparative advantage, at regulation, or litigation, or perhaps other forms of social control. For example, as Glaeser and Shleifer (2003) have argued, poor countries might experience severe failures of all public administration, including both regulation and litigation. In these countries, free markets might lead to the most efficient outcome, even when market failure is pervasive. In more developed countries, in which the capacity to administer laws and regulations is higher, stronger government intervention, whether through courts or regulators, becomes more attractive.

One crucial determinant of the actual choices is specialization. In a series of papers written with Simeon Djankov, Florencio Lopez de Silanes, and Rafael La Porta (e.g., La Porta et al. 2008), I have argued that countries from common and civil law legal traditions exhibit different regulatory styles. Relatively speaking, common law countries tend to rely on private orderings and courts, while civil law countries, particularly French civil law ones, rely more heavily on regulation. We see these differences empirically across a broad range of activities, from the regulation of product and labor market, to the regulation of legal procedure, to military draft. Such specialization in the forms of social control might be efficient, as each legal tradition perfects its approach, or it might be just a consequence of hysteresis. Whatever the ultimate cause, we see substantial variation the reliance on regulation and litigation across legal traditions.

More recently, Aghion, Algan, Cajuc, and Shleifer (2009) found that another factor shaping a nation’s reliance on regulation is trust. High trust appears to be a substitute for regulation. In high trust societies, individuals do not expect to be mistreated by other individuals or firms, and hence support a lower level of restrictions on others in the form of regulation. In low trust societies, in contrast, individuals do expect to be mistreated by others, and hence support greater restraint of business activity through regulation. Aghion et al. argue further that these approaches to regulation are self-fulfilling: when levels of regulation are low, people choose to act civically because civic behavior opens up more attractive entrepreneurial opportunities, which would otherwise have been limited by regulation.

These aspects of institutional choice, like Stigler’s emphasis on politics, are part of a broader picture of institutional evolution. Yet one point remains central in conclusion: efficiency should not be ignored in considering which institutions survive. In the rich countries in particular, the case for efficiency of courts as opposed to regulators is often tenuous.

by datacharmer | Tuesday, January 19, 2010
  | | Why so much government? @bluematterblogtwitter