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The best kind of regulation

  • Published at 07:15 pm February 22nd, 2020
Leave it to self-regulation Bigstock

Why a market should regulate itself

We’re told that a certain level of regulation can be -- is -- beneficial to the economy. This is entirely true. The important questions though are not as yet answered by that statement. We need to know who is regulating and how they are doing so.

Take that economists’ model of a “free market.” We can play around with assumptions and outcomes and show that this will be the best of all possible worlds. Or that it won’t be, depending upon how we play with such things. But an important point about the model -- it doesn’t assume no regulation. It, instead, assumes no regulation by those who are not market participants, a very different thing.

That is, we’re assuming away regulators in offices telling people what they may do. We are not assuming that there are no rules, nor that no one enforces the rules. Rather, that those regulations are formed and enforced by those who are making the market exchanges. 

Some of these will simply be norms, things enforced purely by habit. When we buy rice or fruit at a market, do we have to take our own bag or do we get one from the stall holder? There’s no particular reason why it should be one way or the other, but there will be that standard process, that norm. It might even differ across places and products but any habitué will know what applies in that place at that time.

Rules will also be more vehemently enforced. The market stall which took your money and refused to provide the goods for it would swiftly be out of business. Partly because no customers would trust it, mostly because other stallholders would quickly drive it out of the area. No one wants to be selling where people will ruin the reputation of producers so badly. 

Then there’s regulation simply by consumer preference. It’s entirely feasible to have chilli-flavoured toothpaste and it might even have happened that someone tried to sell it. That it doesn’t generally exist today is because near no one would buy it -- other than at joke shops -- and that means it has been regulated out of existence by that consumer preference. 

This is regulation. It’s just that it’s not regulation by bureaucrats, which is how we normally think laws on what may be done are created. As to laws, perhaps that is how they’re created, but as to what happens in markets, we also have those other players. We, depending on how we spend our money, regulate what is on offer. 

So, if we, the buyers, regulate what is sold by spending our money on what we desire, and not on what we don’t, when isn’t this enough regulation? There are two slightly different answers to that.

One, which I discuss in a just-published paper, is that sometimes a market transaction affects someone not a part of that transaction. This is called “third party” effects, the usual example being pollution. I sell and you buy freshly grilled meat, and we’re both delighted. But it is the people with the open window above the barbeque who must suffer the smoke.

Because they are not part of the transaction itself, their actions can have no regulatory effect on it -- they won’t influence whether there’s smoke that is. At that point, regulations on smoke emissions outside windows -- or more realistically, in urban areas -- make good sense. Or even a tax upon using charcoal in urban areas. The costs of the pollution are now in the prices paid by the market transactors and thus, those costs are now part of the transaction.

Such third party costs are a valid justification for regulation from outside the market itself. This still leaves what the regulation should be -- a ban, a tax, an insistence upon a particular technology perhaps -- and that will depend upon the details of what is under discussion. There is no hard and fast law for what the rule should be even if we’ve now gained, with these third party costs, a rule as to when there should be some rule.

The second is that we humans are really very good at things we do repeatedly. We’re not so good at things we only do once or twice in a lifetime. If we get cheated by the rice seller, then that’s annoying, but we’re going to be doing it again in a day or two and we’ll go elsewhere. Through the repeat iterations, we quickly regulate those daily markets. This is why we have no need of regulations upon toothpaste flavours -- even if the chilli-flavoured one appeared, it would quickly vanish again.

However, there are those things we do only rarely. Buy a house, take out a mortgage, sign up for a pension plan -- hey, why not get married? -- and so on. We might do these things only once in a lifetime, in fact. 

And at this point, our ability to learn and thus tame the market through repeat iterations isn’t there. So, there’s a good argument for greater regulation of the sales of such things. It’s too easy to cheat us, so we need more protection from the law.

The original contention, that regulation can make markets better, is entirely true. It’s just that we’ve got to be careful about how and why. Only when we’ve gained our justification for regulation will we get those two right. 

Essentially, regulation from outside the market is only needed when we are dealing with things that have one of the two features: Effects that spill over to those not part of the transaction, and things that we don’t do very often. Things that are just the direct voluntary interaction of buyer and seller, and in commonplace transactions, we can leave to self-regulation.

A market that regulates itself, or one that is regulated by the participants in it, is not an unregulated market; it’s just one not regulated by those outside it. 

Tim Worstall is a Senior Fellow at the Adam Smith Institute in London.

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