Welcome to your life, there’s no turning back. Even while we sleep, we will find you. Acting on your best behavior. Turn your back on mother nature. Everybody wants to rule the world. The song Everybody Wants to Rule the World was written by Roland Orzabal, Ian Stanley and Chris Hughes and recorded in 1985 by the new wave band Tears for Fears. Its lyrics detail the desire humans have for control and power and centers on themes of corruption. Control, power and corruption are keywords when it comes to government regulations, and the last decade was awash in regulations promulgated at the federal, state and local levels. In fact, the regulatory state was becoming so burdensome that The Economist magazine ran a feature in 2014 calling America the license raj and compared the regulatory burden to the insane red tape that dominates business in India.
We have written a lot about regulations because I believe that streamlining regulations is the easiest and most economically efficient way to increase economic growth and fairness in America. This is not just my opinion, it is also a major focus of the Trump Administration. That said, there are also many bright and intelligent people who believe that much more regulation is needed in America.
So what is the real economic argument for or against regulation and why the huge difference of opinion across the political spectrum?
Let’s start by looking at some general economic models which are arguably simple but that help us understand how regulations modify the economic machine. The standard microeconomic model for an industry (or for that matter a business) is that an industry produces more and more stuff until the marginal cost of production is equal to the marginal revenue made by selling that product. Marginal Revenue (in effect the price of a product) is set by supply and demand, and supply is determined by the marginal cost of production.
Marginal cost is an interesting animal. For most products, costs fall as more stuff is produced because there are fixed costs like buildings or machines that are allocated across the entire production run. But at some point, producing more starts to become expensive since more buildings need to be built, more equipment acquired, and less productive workers start to be hired.
Regulations of all types increase marginal costs overall. If a firm needs to pay higher mandated wages, or add environmental control equipment, or pay for a license, etc., the overall cost function rises, and marginal cost will equal marginal revenue at a lower volume of production. So in general, from an economic sense, regulations reduce production.
Lower production impacts both prices and overall economic welfare. Here we move to the old supply and demand functions developed by Adam Smith. In a given market prices are set at a point where demand and supply are equal. If the Rolling Stones are playing Barclay Center down the street from our office, more people will want to see the show than can fit, so demand for tickets will outstrip supply and prices will rise. Conversely, if I am going to the Barclay Center to play the kazoo, demand for tickets will be very small, and so too would be the price.
The same thing works for supply. If prices are high enough for tickets, the Stones might add another concert thereby increasing the supply. Conversely, at the price people are willing to pay to hear me play the kazoo, I may not play the Barclay Center but rather my conference room. Now, add in regulation. Were the Stones to have to pay for additional licenses, or higher minimum wages for roadies, or for expensive safety equipment were someone to pass out from seeing Mick Jagger, they will have higher marginal costs, and would have to sell tickets for a higher price. This would reduce demand and now they might not have to add a second show. So regulations reduce the amount of stuff available for consumers, and reduce the amount of money that the Stones can make on their tour.
From a very straightforward economic point of view, regulations are bad because they inevitably increase prices and reduce production of goods and services that people want, harming general welfare, particularly for those with the least resources available to them. It’s a simple truth; however, its also a simple truth that production for the sake of production is not always a good thing. That is because nearly every productive activity, from a Rolling Stones concert, to fishing, to the production of kazoos imposes certain costs that are not accounted for in the price of the product – and are therefore outside of the model.
Since these costs, or what economists call “externalities,” are not accounted for in the marginal cost equation, then the economy would be producing more stuff than it really should, or people outside of a market would be paying a burden that they should not bear.
Consider our Rolling Stones concert. Visitors to the Barclay Center will undoubtedly produce litter and pollution that will impact the neighborhood. The cost to clean up the litter or offset the pollution are not included in the price of the ticket, nor is money being given to the Sanitation Department to perform the cleanup. There will be extra crowding on the subway, causing delays for people traveling through the neighborhood. Hornswoggles could try to pawn off counterfeit tickets, pick-pockets could roam the neighborhood. All of these problems occur outside of the market transaction between fans and the Stones.
While it would be possible to include the costs to offset these externalities in the price of the ticket, and it would be possible for the Rolling Stones to send all of the impacted people a check, this would be extremely difficult to do. Rather, the government can intervene and adopt specific regulations or restrictions designed to minimize the impacts, or in some way provide benefits to the impacted people. Since people, being people, do not always behave in a civilized manner, a certain number of laws and regulations are always going to be necessary. Even God set down 10 regulations for Moses and his people to follow.
Regulations and laws, up to a point, help create the kind of civilized society that is necessary for an economy to grow. But regulations, like most things, have diminishing marginal returns. The first regulation requiring people not to throw chemicals in a river will have more of an effect than the one that tells them not to throw sewage in, which will have more effect than the one that regulates urinating in the river, which has more impact than the one saying not to throw stones in the river, which has more of an impact than the one saying don’t look at the river.
Since governments are designed to regulate, regulate they do, and in many cases the curve has reversed and the regulations being imposed not only have no return, they actually generate net costs. The hard part is to fairly determine if the regulation is valuable, particularly since the costs generally fall on a different group than the one that receives the benefits.
When regulations get to the point described in the song, even while we sleep, we will find you, it is likely that they have gone too far, but hey everybody wants to rule the world.