Myths of Regulation

It would be inappropriate to jump into the middle of the modern debate about regulation and deregulation without first examining a bit of history. One of the dangers today is that a debate on regulation is beginning in government halls, in the university world, and in the major news media with a great deal of that discussion based on either erroneous or misconceived ideas about the historical beginnings of the kinds of regulation we have today. The debate itself focuses on the efficacy of regulation and on the possibility of deregulation.

Historically there were two kinds of proregulation arguments: one that is related to economics, and one that might be termed political or cultural. The historically first economic argument for regulation of industry was that in certain industries the nature of economic costs dictated that only one firm could survive, and we would have what is known as a natural monopoly. That was a particularly popular argument at the time the Interstate Commerce Commission began its regulation of railroads in the 1880's. Today we still hear the same argument for the regulation of telephone companies, airlines, and numerous other strongly regulated industries, particularly those characterized by rate regulation, that is, regulation primarily of the price that can be charged for a good or service, as opposed to regulation of other forms of business conduct.

A second economic argument for the necessity of business regulation became popular mainly in the 1920's. It developed largely from an academically popular criticism of the major economic work of Adam Smith, An Inquiry into the Wealth of Nations, the first systematic, integrated theory of economics.

Strictly as a device for helping his readers understand what he was talking about, Adam Smith used a simplifying assumption of markets in which consumers and producers have perfect information about everything. That is, consumers know the quality of all goods and the price of all goods, and producers know the exact demand for, and the cost of, producing goods. These assumptions dramatize a condition that came to be called "perfect competition." Now Smith was in no sense a fool, but by assuming that he meant these hypothetical conditions to describe the real world, his critics implicitly accused him of utter foolishness. And that is exactly what the writers and economic doodlers who have long waged a campaign against Smith's views do.

Smith's critics casually claimed that Smith believed everyone to have perfect information and that the whole theory of competition, free markets, and free enterprise was, therefore, built on this fallacious idea of full information. As a result, they said, we have to toss out the concept of competition altogether as a policy guide.

Recently an ingenious economist from UCLA, Armen Alchian, took the basic Smith approach and examined it in terms of an assumption of no, rather than full, information. That is, he asked what kind of a market system would we have if you made the simplifying theoretical assumption that people don't know anything at all. All they do is act. Ironically enough, he found that we would reach precisely the same "market" result that Smith had posited assuming full information.

This criticism of the competitive model, to get back to our topic, was one of many myths established or repeated in order to deny any respectable theory of free-market economics. You can see easily how it plays into the hands of those who want greater government regulation, especially such types as occupational licensing of physicians, lawyers, real estate agents, etc. California, for example, licenses dog trainers. Now obviously we can't have people just going out and entering into the business of training dogs. Who knows what damage would be caused if we had incompetent dog trainers? Well, I do. The damage that would be caused if they were incompetent is that they would rapidly go bankrupt. That's what always happens to incompetents in any field that's open to competent competition.

In Florida it was recently proposed to license lawn sprinkler installers. Obviously people are not intelligent enough to select a responsible individual to install such equipment. We can't trust the market to have displaced, and to continue to displace, those who do bad work. We can only expect that everyone will be taken in by the hoodlums and crooks that pervade the industry. What nonsense!

For the record, reliable empirical studies of industry regulation have proved time and again that the assumption of "mass idiocy" does not hold up. But we shall see later that there is a good political reason why the argument about consumer ignorance continues to be made. The opposing view doesn't serve the purpose of the people who want regulations, who want to restrict entry, and who want political power. As a result, they take the other argument. If I seem to be suggesting to you that there are some intellectuals who have other than the most straightforward and objective motives behind some things they teach and preach, well, that's because I believe that.

A closely related argument was that government regulation is necessary because the consumer—one poor little soul, by himself in the world of big business, high finance, and monopoly capitalism—does not have adequate bargaining power to deal with his supplier-adversaries. Ralph Nader especially loves to make the point: how could you expect an individual buyer of an automobile to compete successfully with General Motors when it comes to buying an automobile. He continues this argument regularly to this day, even though it has been carefully pointed out to him that it is nonsensical. The concept of competition doesn't refer to the relationship between buyer and seller at all. Competition refers to the relationship between all buyers on the one hand or all sellers on the other. General Motors doesn't want to compete with its buyers, it wants to cooperate with them. The same is true of any other buyer and seller.

But if you make that argument, if you can say that the individual is helpless, then you have created the apparently logical foundation for regulation of an industry and for all manner of interferences with perfectly satisfactory private arrangements.

Two additional economic arguments have come to the fore in the last 10 to 20 years. They have played an important role in advocacy of some of the newest forms of government regulation and also some of the older ones. One of those arguments develops from what is known in economics as "externalities" and, unlike the other arguments, has a seed of validity to it. The point is that on occasion a contract between two individuals visits costs on third persons who cannot easily gain appropriate compensation.

The classic example of an externality occurs when an individual sells land to another on which to build a factory. The factory is built; it spews smoke out of its smokestack; the smoke falls down on the houses and on the freshly laundered clothes; and everybody has rings around the collars. They are very unhappy, but nobody pays their cleaning bills. At least that's the theory.

That theory is much used by those who want to expand their power to zone or regulate the use of other people's land and other private property. And it is not in their interest to examine carefully the economics of the externality argument to show, as I shall shortly, how basically insignificant it is.

Another argument with a seed of validity to it (not nearly enough, however, to justify the amount of regulation imposed in its name) is the so-called common-good problem. This has been particularly helpful to advocates of environmental planning and land- use restrictions for ecological reasons. The point is that if the fish in the sea are not owned by anyone, you make them yours by catching them. This necessarily leads to overfishing, and very quickly the entire "crop" will be taken and, instead of regenerating, it may disappear entirely.

That argument is used for a variety of purposes—the endangered species argument, the preservation of pristine forests or everglades, or whatever it is somebody wants to enjoy without owning. But I should point out that this argument can only be made in situations where private property rights have not been allowed to exist in whatever it is that is being preserved, a point to which I shall return.

These, then, are the strictly economic arguments for regulation, but there is a set of powerful practical or political arguments as well. In fact they were more important than the economic arguments in the 1930's when this subject occasioned a great legal debate in this country.

The first of these arguments was principally made at the Federal level during the period of the New Deal. Until about 1935 it was accepted legal doctrine that the Constitution of the United States delegated legislative powers exclusively to the Congress of the United States and that the Congress could not redelegate those legislative powers to anyone else. Consequently, from time to time, when Congress had tried to grant agencies so-called quasi-legislative powers, the courts declared the attempts unconstitutional. But by the middle of the thirties, the new argument began to find acceptance by the Supreme Court.

One of the principal arguments accepted by the Supreme Court to allow regulation was that Congress could not be expected to be expert on all the technical issues that it now had to confront. Since experts on questions relating to securities markets were needed to regulate securities issues, they upheld the constitutionality of the various Federal securities acts. Congress had no radio expertise; therefore, they upheld the constitutionality of the Federal Communications Commission; and so on right down the line until today. Courts still accept that argument.

There was an interesting second argument, too—that since the economy and technology had become so complex the courts were also unable to resolve all the issues arising under all the regulatory statutes Congress passed. As a result, a very peculiar doctrine emerged under which the courts assumed that the administrative agencies had the particular expertise necessary to make the rules and regulations that they formulated.

Just recently the courts have begun to back off a little bit from this proposition, but it is still very powerful. Now notice what it did. It created a "fourth branch" of government that is not elected, not subject to competitive market pressures, and not really subject to judicial review. Vet these three ideas—open markets, democratic controls, and the right of review by the courts—are the only three doctrines under which third-party power over individuals has ever been generally accepted as legitimate in our system of government.

Now I want to respond briefly or additionally to each of the arguments I have described.

First, let's look at the natural monopoly argument. Everybody seems to know that if you allow railroads to compete, one of them eventually drives out all of the others, leaving the farmers at the mercy of the monopoly capitalists on Wall Street who own the railroads.

Yes, everybody knows that—except that it happens not to be true. Not only is it not true of railroads, it turns out that it's not true of any of the other areas we term public utilities. The same argument is made for each of those: that they would degenerate into natural monopolies, and as soon as the natural monopolies formed, they would raise prices to the sky, a result to be avoided by a regulatory agency.

But this same legislation always provided that there should be only one of these companies in each market area. So why, if there was going to be a natural monopoly anyway, did we have to have that provision? Of course we didn't, and the real reason we got such provisions was to prevent the very competition that would have kept prices low and served the consumers well.

This point has been carefully studied in the case of the railroads by one of the better-known "new left" historians, Gabriel Kolko. Another historian, William Hawley, in The New Deal and the Problem of Monopoly, studied the entire range of industries that came to be regulated during the 1930's. In every case, he found, politicians argued that they had to regulate in order to protect the public, while in fact these were finely orchestrated and carefully manipulated programs in which the firms in the industry told the public they were against regulation while doing everything they could to secure government regulation of their industry in order to cut down the amount of competition.

Now it's no accident that we saw a spurt of this in the 1930's, a period of severe depression in which competitive pressures became more intense and some firms had to be "shaken out." Even firms that had been able to operate efficiently in the 1920's, if they operated at a higher unit cost than others, would be competed out of the market as the aggregate demand declined. And as competition became more intense, it became worth more to people in an industry to "buy" government protection.

There's an old argument by critics of American business that firms inevitably form private cartels to avoid competition. Yet one of the most interesting byproducts of the work of writers like Kolko, Hawley, William Appleman Williams, and other historians with irreproachable left-wing credentials, is their "discovery" that these firms were never able to make their private cartels and monopoly devices work unless the government would aid them in the effort. If the government would stay out of what came euphemistically to be called "government regulation of business," the public got the benefits of competition. It actually got all the benefits that were theoretically claimed for free markets, benefits that could still be had today—even though only rarely are people let in on the news that that is what most benefits consumers.

Let's turn to the second major argument, the lack of consumer information. There are several aspects to note about this. First is that information is, in and of itself, a valuable economic commodity. That is, your knowledge about textiles will help you make more intelligent decisions about the jeans you buy, or the blouses, or shirts, or whatever. Knowledge of the technology of automobiles will help you make more intelligent decisions about which car to buy, and so forth. But that knowledge, and other kinds, is not free. Some of it you pay tuition for when you go to college. Part of it you pay for when you buy specialized books and magazines. Part of it you pay for in the form of hiring experts who are'well informed in different fields. Part you pay for through what we nontechnically, yet correctly, call "experience."

When you go to experts—doctors, plumbers, or what have you—what you are buying is their information; and believe me, it is not free. Nor is there any reason why it should be treated as a free good. Yet the regulators' argument about the lack of consumer information fundamentally suggests that information should be converted by the government into a free good, even though that cannot actually be done.

First of all the government cannot acquire all the information necessary. This is so for a variety of reasons, but the most important thing for us to notice is that the private market for information works with extraordinary efficiency. In recent years we have had some fascinating studies of markets for information, though the areas in which they have been studied are fairly esoteric. The principal work has been done in connection with the stock market, but the fundamentals for all markets are basically the same.

If you buy a share of stock in a company, you need information to make an intelligent choice about that stock and to make some prediction as to whether it is appropriate for your portfolio or your investment purposes. In terms of the economics of information, that is no different from knowing whether a particular automobile is a Maserati that can go 130 miles per hour or a Datsun that really has to chug if it goes more than 45. Each serves its purpose, but you have to have information to know which is more appropriate.

These studies of the stock market indicated something that startled many observers. That was that information is so rapidly disseminated in the stock market that the price of any commodity or of any stock is always the "correct" price, given everything that could be known at a given moment about that stock. This theory, now widely accepted, is known as the "efficient market hypothesis."

Now economists have begun to extend those studies into other areas, and they're finding that the same thing is true. What does that mean? That the argument about whether people have accurate information was really a weak and unnecessary argument. In fact, in an open market in a competitive system—and I might add, only in a competitive system—there is an external benefit consumers receive free of charge that is of tremendous value, the price, the "correct" price of every economic good. Imagine what it would cost you to gain accurate information about the relative prices of all goods if there were no markets.

The point is that you can rely on open and free markets to correct any mistakes that occur in the price of any commodities that you buy. That means that you can go buy an automobile and not worry very much about knowing anything about horsepower or catalytic converters, carburetors, manifolds, exhausts, or a whole lot of things I do not know a thing about myself. Go pick what looks and feels good to you. You can then be confident, within certain limits, that you are not being cheated, simply because the market for information is working and it only requires a few people in the market to correct any mispricing that might occur on any commodity.

The third argument for regulation was the unequal bargaining power argument. This is related to the monopoly argument, and it is fascinating because it is widely believed today that we have more monopoly and greater concentration of industry than we have ever had before and that we are faced with an industrial ogre system that threatens to capture and enslave us all. One hears this all the time. Certainly any time that Ralph Nader is on the news that is what he is saying. That is what John Kenneth Galbraith is saying in all his books, and 90 percent of college textbooks, whether in economics or other fields, seem to be saying the same thing.

Unfortunately the writers of textbooks are not held to very high standards. We do not have a real market operating for these books, or better quality would be assured. But, you see, few universities or colleges really treat students as consumers. Professors make their way in this world by selling themselves to other professors, not to students. What they want in order to get their salaries higher are offers from other schools. They don't get those necessarily by giving students the truth; they get them by writing things that other professors want to hear. That's why you hear the phrase "publish or perish," and any professor who doesn't follow that dictum stays where he is. That's because colleges are nonprofit institutions, outside the market sphere. But I want to return to the large corporations that are supposed to be threatening us so much.

First of all, there's not a single study done in 20 years that has proved that the degree of industrial concentration in the United States today is worse than it was in 1900. Most studies indicate concentration to be less than it was in the early 1900's.

What has happened, of course, is that the scale of everything is larger. Clearly in 1900, whatever the incipient or infant predecessor of I.B.M. or General Electric was, it was a much smaller company than it is today. But in 1900 we had a population of approximately 40 to 50 million people. There was no Federal income tax and hardly a Federal budget worth mentioning. There was nothing like the economy of today.

Here, then, lies one of the illusions that so bedevils sound economics and makes it so easy for critics of free markets to fool large numbers of people. To each individual the size relationship between himself or herself and these large companies seems to be getting worse and worse. But that is not a valid test. You don't go out and fight with General Electric. That's not how G.E. got big. They got large by making and selling things that people wanted and doing it more efficiently than their competitors. They were profitable and their profitability was the mark that they were properly serving the public—not the opposite, as is so often taught.

The word "profit" somehow has become a swear word in our country today, and that is one of the most ironic things of all, since profit is literally the only decent measure we have of the real social productivity and public benefit provided by any business. It indicates that the public is willing to give up the wealth it has to buy something the public prefers to all other goods or services.

There is another aspect of this as well. If concentration had been increasing—and concentration meant monopoly—we should expect to find in those industries that are fairly highly concentrated—such as aluminum, automobiles, steel—a rate of return higher than in noncentrated industries. That is what monopoly signifies, and if it doesn't mean that, it doesn't have any significance at all.

But it turns out that there is no correlation between industry concentration and profitability, none whatever. Concentration ratios have nothing to do with profitability. This business—that the Federal Trade Commission in particular has been involved with for many years now—of arguing that concentration ratios in industry signify monopoly power is simply wrong. There is no economic logic to it, and I could cite the evidence and give you logical proof of my proposition. Yet, I must tell you and you should know that 99.99 percent of the best-educated people in America believe just the opposite. That is to be deeply regretted, but it is nonetheless true.

And now the externalities argument. There is a grain of economic logic to it. There are externalities. That's been converted, however, into a fantastic new array of regulations—the whole field of pollution controls, ecology, population controls, and others. Recall that the classic argument is that of the factory pouring smoke on the houses nearby. I suggested earlier why that argument for regulation, though logically correct, is fundamentally insignificant.

The concept of an external cost is that of a cost involuntarily placed on a third person by people who negotiate to do business only between themselves. The argument for regulation suggests that the third person is powerless under the law to do anything about this. But that is not and never has been true. The law of trespass, the law of nuisance, and the general law of torts have long provided remedies for just this kind of problem, though there are certain modern problems for which the older law did not provide a remedy. Smog created by numerous autos is an example, but the alleged classic problem of the smokestacks in fact is not.

All you need is a free market, and the factory problem gets solved automatically. There is a phrase for that: internalizing the externalities. What this means is that in almost every case of an externality, one or the other party actually undertakes to bear the costs or in fact is forced to by the nature of the situation. In the classic example of the smokestack, let's suppose that the houses were there first and the law says that smoke polluters are liable to their neighbors for any loss suffered by the latter. To completely control the smoke, as is often required, let's suppose, costs $10 million. Now let's suppose that the owner of the plant says that he will have to close the plant down if it costs that much. Instead, he asks every home owner on whom the smoke falls what they would take for having smoke dropped on them. Some of them say $10. Some say $100. Some of them with sinus problems say $1,000 and some of them say the full price of their house. The factory owner adds the whole thing up and finds that he can either buy the houses or the right to pollute his neighbors for half a million dollars, which, of course, he would do, thus internalizing that "true" cost. It's true that this represents an increased cost of making the product, but quite properly an adjustment has been made to the people being injured.

Now let's suppose the law allows polluting. Now the neighbors go to the factory owner and offer him up to half a million dollars to stop polluting them with smoke. If he refuses their offer, he has added an implicit cost of that amount to his production costs, and the effect of implicit costs in economics is precisely the same as that of explicit costs. So the goods will sell for more than would otherwise be the case and his cost advantage vis-a-vis his competitors will be the same in either case, though clearly the allocation of a one-time cost in the two situations is quite different.

In neither case is there any economic justification for outlawing the smoke altogether or changing any existing rule. It should be noted, however, that in each case, whichever is the lower-cost method of dealing with the problem will be the solution adopted voluntarily.

The most ironic example of ill-founded regulation in this area is the peculiar one of zoning boards making absolute decisions whether they should allow people to live near airports with noisy jet airplanes. In some cases they have said that people can live there and that the jets will have to use different runways. In other cases they have said the jets can use the runway and that the people would have to move. Consider deaf people. Why shouldn't they be allowed to live in an area where noisy jets are flying over and to buy houses at an especially low price. This ironic example demonstrates dramatically that if you do not regulate the market, you'll normally get better results.

The argument for regulation based on needed expertise is perhaps the phoniest of all. This is because usually there is no expertise as such in the areas to be regulated. That is not to say that there are not specialists; but the two are not the same. At the Atomic Energy Commission there are some fine physicists; in the Food and Drug Administration there are some quite good biologists, nutritionists, chemists, and other experts. But the essence of economic regulation is not technical expertise. It is a combination of the technical expertise and economic judgment, and the latter does not exist apart from the collective wisdom of the marketplace.

This leads to precisely predictable ironies in regulatory policies. The Securities and Exchange Commission, which regulates stock markets and the stock brokerage industry, has existed since 1933, or nearly 42 years. It has yet to have an economist on its staff. It is staffed by, and its policy decisions are made 100 percent by, lawyers, none of whom ever received a day's training in law school or in practice to equip him to make the expert economic judgments Congress wanted the SEC to make about securities.

About the same thing is true in the Federal Power Commission, the Federal Communications Commission, and the others. The Federal Trade Commission does have a few economists, but their intellectual record is not an enviable one. Most other agencies do not, even though their primary function is called "economic regulation." The expertise argument for regulation will not hold up in fact or theory.

The expertise that regulators do have is a peculiar one, and it is important to understand it if you are to know what this whole "fourth level" of government is all about. The expertise they develop is expertise in running their own little bureaucratic empires, not subject to voter control, not subject to market control, and not subject to judicial review. They become expert at whom to know, how to fill out pieces of useless paper, how to keep looking busy, how to get the maximum budget from their congressional committees, whom to do favors for, whom to hit in the head, and whom to make enemies out of. That's what they become expert at, and believe me, they are good at it.

The Securities and Exchange Commission—like the IRS, currently in the news for spying on some political enemies—has in recent years been used by Presidents to "get" political or personal enemies. And the field is so complicated that, like Internal Revenue, there is no one engaged in any financial matters who has not technically violated some SEC rule or regulation. These agencies are political bludgeons that can be used abusively at any time with no legitimate constraining force to limit their behavior.

Thus, in conclusion, we can see that there does not exist a single valid argument for the desirability of the typical modern government regulation of private enterprise. Actually this should not be too surprising. The nature of all these arguments is to augment political power over the private sector, and the interest of the politicians lies in doing just that. But the less we are fooled by such demagoguery, the better chance we have to preserve our own personal freedom.

Henry Manne is director of Law and Economics Center at the University of Miami, REASON's "Spotlight" featured Manne and his work in the May 1976 issue. This article is adapted from his contribution to the C.A. Moorman Memorial Lectures at Culver-Stockton College (Canton, MO).