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G406, Regulation, Eric Rasmusen, erasmuse@indiana.eduSeptember 7, 2013

3-GovernmentFailure

Government as a Solution to Market Failure

It is not enough to analyze a problem and conclude, “If the government passes a law changing the quantity traded to X then surplus will be maximized.”The sociologist Max Weber said that what characterizes government is “a monopoly on violence.”

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Government Failure: Bad Objectives

A city councillor proposes that the barber guild be blocked from setting any price or punishing any barber who charges low prices, a policy which will reduce the price to the marginal cost of $10/haircut.

What will be the forces on each side of the fight over his proposal?

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The Barber’s Guild 4

Surplus

Under the monopoly, consumersurplus is A=.5(30)(30) = 450 dol-lars per day. Producer surplus isB=(30)(30) =900 dollars per day.Once the monopoly ends, consumersurplus will be A+B+C=.5(60)(60) =1800 dollars per day, and producersurplus will be 0. (Recall that thismeans that producers will still covertheir opportunity cost, but barely.

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A Price Floor

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Copper Price Floor7

Scenario 1.

1 million people each lose $100 from the regulation.

1,000 people each gain $2 million.

Total cost is $100 million. Total benefit is $2 billion.

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Scenario 2

1 million people each lose $1 from the regulation. 1,000 people each gain $200.

Total cost is $1 million.

Total benefit is $200,000.

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Two Big Ideas

1. The Tyranny of the Majority. If it comes to a straight vote, and intensity of feeling does not matter, the majority will win even when it feels less strongly.

2. Rational Ignorance. If an action has only a small impact on a voter, it is rational for the voter not to bother about it. He should remain ignorant of exactly what is happening rather than spend his time analyzing it, and even if he understands the situation, he should balance the costs of political action against the benefits.

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Situations Leading to Government Failure

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1. Is it hard to see who is hurt and who is helped by the law?

2. Are the benefits concentrated and the costs diffused? (or vice versa) 3. Are the benefits short-term and the costs long-term? (or vice versa)

Law-making is a market

Politicians are trying to sell themselves and packages of laws to voters.

They compete for votes, and consumers of laws provide them with votes, campaign contributions, and effort to persuade other people.

Since politics is a market, it is subject to market failure.

What are the sources of market failure?

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Good Government

It is possible to design a government to reduce the amount of government failure.

As with goods markets, the trick is to get the incentives right. Plato said that we will never have good government till the Philosophers become Kings. Confucius pretty much agreed.

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Bad Men in Good Government

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Now there are not more than ten truly merciful and faithful men in this country, whereas there are hundreds of official posts. So if only merciful and faithful men are selected for public service, the candidates will not be sufficient for filling all the official posts. In that case, those who maintain order would be few while disturbers would abound. Therefore, the way of the enlightened lord is to unify laws instead of seeking for wise men, to solidify policies instead of yearning after faithful persons. In consequence, as long as laws do not fail to function, the body of officials will practise neither villainy nor deception.

Han Fei,. Five Vermin: A Pathological Analysis of Politics

Don’t Trust Philosophers For such reasons, it is a common trait of the disorderly state that its learned men adore the ways of the early kings by pretending to benevolence and righteousness and adorn their manners and clothes and gild their eloquent speeches so as to cast doubts on the law of the present age and thereby beguile the mind of the lord of men…

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Han Fei,. Five Vermin: A Pathological Analysis of Politics

C.S. Lewis on Democracy

“There are two opposite reasons for being ademocrat.

You may think all men so good that they deserve a share in the government of the commonwealth and so wise that the commonwealth needs their advice. . . .

On the other hand, you may believe fallen men to be so wicked that not one of them can be trustedwith any irresponsible power over his fellows."

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The Original Gerrymander

lk;

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Mr. Gerry’s Descendants

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Congressional Districts 19

Regulatory Capture

It can happen that a government agency intended to regulate an industry to protect consumers becomes, over time, controlled by the very industry it is meant to regulate. This is known as regulatory capture . The standard example is the Interstate Commerce Commission, set up in 1887 and abolished in 1995. The Interstate Commerce Commission was established to keep railroad shipping prices low, but critics charged that it became an agency to protect railroads from competition from each other and from trucks. (Oil Rig inspection in the Gulf of Mexico?)

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The Louisiana Coffin Cartel

After Hurricane Katrina's damage, the 38-member Saint Joseph Abbey in Louisiana decided to make and sell coffins to support themselves. The Louisiana State Board of Embalmers and Funeral Directors told them not to.

The monks have won so far .

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The Oklahoma Court.

It said that if courts struck down special-interest laws, then: ``besides the threat to all licensed professions such as doctors, teachers, accountants, plumbers, electricians, and lawyers,… every piece of legislation in six states aiming to protect or favor one industry or business over another in the hopes of luring jobs to that state would be in danger. While the creation of such a libertarian paradise may be a worthy goal, Plaintiffs must turn to the Oklahoma electorate for its institution, not us.''

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Rentseeking Costs

Rational ignorance leads to another source of surplus reduction besides bad legislation: rentseeking costs. Not only does the legislative process result in surplus-reducing regulations: it does so at a cost.

The cost includes the lobbying costs to obtain regulations (proactive rentseeking costs) and the lobbying costs incurred to prevent regulations (defensive rentseeking costs).

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Schumpeter: Rational Ignorance

“Political questions take their place in the psychic economy of the citizen with leisure-hour interests that have not attained the rank of hobbies and with the subjects of irresponsible conversation.

These things seem so far off; they are not at all like a business proposition;

dangers may not materialize and may not prove so very serious; one feels oneself in a fictitious world.”

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Costs from Disguises

Another cost is the cost of disguising regulations so that the losers will not overcome their rational ignorance.

A small part of this is the care given to the wording and explanation of regulations so as to mislead the public as to their costs and benefits.

The bigger part, however, is the need to actually change the form of the regulation to disguise its effect.

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Government Failure: Poor Performance

Since the costs and benefits of government actions flow to third parties there is little incentive for the decisionmakers to expend effort.

Outside pressure lead to rentseeking.

The government falls between the Scylla of interested rentseeking and the Charybdis of disintererested incompetence.

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Independence?

If government officials are completely insulated from rentseeking, that means they must also be completely insulated from punishment or reward.

Think of appointed U.S. Federal judges, elected state judges, and Japanese career civil servant judges.

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Three Categories of Public Servants

Elected officials such as the United States President.

Bureaucrats who are appointed by the elected officials and who can be fired by them, e.g., the Secretary of the Treasury.

Bureaucrats who spend most of their careers in government service (e.g., FBI agents)

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Three Types of Officials

1. Careerist. Their loyalty is to the agency.

2. Politician. Their loyalty is to whoever can promote them.

3. Professional. Their loyalty is to their profession.

All three would like to do a good job, but for different reasons. All three can be either political appointees or civil servants.

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Governments vs. Corporations: Goals

The problem is not just that the government is large and bureaucratic. Many U.S. corporations are larger than entire countries.

A corporation has the advantage that its goal is simple and its owners agree on it: to make profit. A government has a harder time measuring costs (what is the cost of a lower speed limit?)... and an infinitely harder time measuring benefits (what is the benefit of a reduced rate of marijuana use?),

.

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Governments vs. Corporations: Governance

In a corporation, the shareholders elect a board of directors which has the power to run the company subject to the by-laws.

The board of directors chooses an executive to run the company, and he chooses subordinates to help him.

If the board fails to do its job properly, the shareholders elect a new board, or someone buys out enough shareholders to acquire enough votes to choose a new board or merge the company with another company.

Nonprofits?

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The Three-Part Test for Regulation

1. Is there market failure?

2. Is there a regulation that would solve the market failure better?

3. Would there be government failure if we tried to pass the regulation?

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Separation of Powers

The legislative branch makes laws---statutes.

The executive branch carries out statutes--- including making regulations, specific rules.

The judicial branch interprets statutes and regulations.

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Making Regulations: Administrative Law

A regulation is like a law, but Congress doesn’t have to approve it.

Every regulation is supposed to be a mere implementation of a Congressionally-passed law.

If Congress passes a law that says dangerous substances must be kept to safe levels in the workplace, the executive branch must decide how much to limit benzene, if at all.

This gives a lot of power to the President.

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Checks on the Bureaucrats

Congress has passed laws to constrain the executive branch in how it makes regulations. A major goal is to make sure that regulation-making is transparent : it proceeds slowly and openly with enough time for anyone who might be affected to comment.

Also, citizens can appeal to the courts.

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How Regulations Are Made-1

1. Congress passes a law. (Everyone must eat enough ham)

2. The agency proposes a regulatory rule, notifying OMB. (Each person must buy a certain amount of ham each month or be fined.)

3. The agency sends a specific rule to OMB, together with a Regulatory Impact Analysis (Each person must buy a $5 of ham each month or be fined $50.)

4. OMB has at least 60 days to comment and then approve or reject. (OMB says it should be $6/month, not $5.) 5. The agency publishes a Notice of Proposed Rulemaking in the Federal Register.

6. The agency listens to public comment for 30 to 90 days. (Meatpackers suggest $10/month; vegetarian association suggests $2.)

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How Regulations Are Made, Continued

7. After the comment period closes, the agency decides whether to revise the rule. (It decides to go to $7/month.) 8. The agency sends the revised rule to OMB for a month of consideration and approval or disapproval. 9. The agency publishes the final rule in the Federal Register. 10. After 30 days, the rule goes into effect. The agency starts enforcing it.

11. Maybe somebody objects to the rule and takes the agency to court. (Statutory: $7/month is not ``enough ham'', because Congress meant more than that. Constitutional: The entire law is beyond the power of Congress because it does not involve interstate commerce.)

12. Later, the agency may re-evaluate the rule, and possibly change it. (After 20 years, inflation means that $7/month is no longer ``enough ham''. )

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The Federal Register

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The Chevron Doctrine

If a regulation has gone through the formal process and someone questions in court whether the regulation is a correct application of the statutes, the courts give the benefit of the doubt to the regulation.

This is known as administrative deference, or the Chevron Doctrine.

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The Two-Part Test

``If the intent of Congress is clear, that is the end of the matter; for the court as well as the agency must give effect to the unambiguously expressed intent of Congress.

If the Court determines Congress has not directly addressed the precise question at issue, the court does not simply impose its own construction of the statute . . . rather,… If the statute is silent or ambiguous with respect to the specific question, the issue for the court is whether the agency's answer is based on a permissible construction of the statute.''

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The Home Concrete Case

What should be the statute of limitations for reporting too low a number for your capital gains profit?– Three years, like most things; or six years, like “omissions from income” Since the 1950’s everybody has thought that if you include but misreport your capital gains, the limit is 3. Recently, the IRS has claimed 6. The IRS lost 13-0 in Tax Court.

Then it passed a new regulation saying it’s 6 years.Then on appeal, it pointed to the new regulation

and claimed Chevron deference. The Supreme Court ruled 5-4 in favor of the taxpayer.

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2011-SEC Proxy Rule court case

“Here the Commission inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commenters.”

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How to Think about Government

(1) Remember the Three-Part Test for Regulation. (2) A government is not one godlike person, who makes decisions for the public good. It is a group of regular people, motivated both by duty and by personal objectives. Once you understand that in your bones, you will both be more suspicious of politicians and bureaucrats, and more sympathetic to them.

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