[Economic Report of the President (2004)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]

 
Chapter 7

Government Regulation in a
Free-Market Society


An important reason for Americans' high standard of living is that
they live in a free-market economy in which competition establishes
prices and the government enforces property rights and contracts.
Typically, free markets allocate resources to their highest-valued
uses, avoid waste, prevent shortages, and foster innovation. By
providing a legal foundation for transactions, the government makes
the market system reliable: it gives people certainty about what
they can trade and keep, and it allows people to establish terms of
trade that will be honored by both sellers and buyers. The absence
of any one of these elements--competition, enforceable property
rights, or an ability to form mutually advantageous contracts--can
result in inefficiency and lower living standards. In some cases,
government intervention in a market, for example through
regulation, can create gains for society by remedying any
shortcomings in the market's operation. Poorly designed or
unnecessary regulations, however, can actually create new problems
or make society worse off by damaging the elements of the market
system that do work.

The key points in this chapter are:

  Markets generally allocate resources to their most
valuable uses.
  Well-designed regulations can address cases where
markets fail to accomplish this goal.
  Not all regulations improve market outcomes.


How Markets Work


Free markets work through voluntary exchange. This voluntary
nature ensures that only trades that benefit both parties take
place: people give up their property only when someone agrees to
exchange it for something that they value more highly. In most
transactions, sellers receive money rather than goods in exchange
for their property. Sellers then use that money to become buyers in
other transactions.

What ensures that producers are providing the commodities that
consumers want? Market prices play the critical role of
coordinating the activities of buyers and sellers. Prices convey
information about the strength of consumer demand for a good, as
well as how costly it is to supply. By conveying information and
providing an incentive to act on this information, prices induce
society to shift its scarce resources to the production of goods
that are valued by consumers. In this way, markets usually allocate
resources in a manner that creates the greatest net benefits
(benefits minus costs) to society. An efficient allocation is one
that maximizes the net benefits to society.

In general, efficiency requires that the price of a good reflects
the incremental cost of producing that good, including the cost of
inputs and the value of the producer's time and effort. In this way,
prices induce consumers to economize on goods that are relatively
expensive to produce and to increase their purchases of goods that
are relatively inexpensive to produce. A key advantage of
free-market competition is that it generally leads to a situation
in which price equals incremental production cost. This outcome
occurs because in a competitive market environment, a seller who
charges a price above the cost of production will be undercut by
competitors, including new entrants. In contrast, if prices are
artificially high because of limited competition, consumers will
buy less of the good than they would if they faced the competitive
price. Furthermore, some consumers who would benefit from buying
the good at a competitive price may not buy it at all.

When market conditions change, prices usually change as well and
signal buyers and sellers to modify their behavior. For example,
if a disruption in the gasoline supply were to occur and prices and
behavior remained unchanged, there would not be enough gasoline
supplied to satisfy consumer demand at predisruption prices. The
result would be a gas shortage. To eliminate this shortage, some
form of rationing would be required to ensure that the quantity of
gasoline demanded by consumers matched the quantity of gasoline
provided by suppliers.

In a market economy, rationing is done by prices. As prices of
gasoline increase, two changes in behavior typically occur. First,
consumers as a whole reduce their consumption of gasoline, and
second, producers as a whole increase the quantity of gasoline
available for sale. These aggregate changes are the result of many
individual decisions. For example, some consumers may carpool,
others may cancel trips, and some may be willing to spend more on
gasoline to continue on as before. On the supply side, producers may
ship gasoline from areas not affected by the supply disruption,
refineries may increase production, and firms may lower inventories
of gasoline in storage. Eventually, prices increase to the point at
which the reduced quantity of gasoline demanded equals the
increased quantity of gasoline supplied. In a market economy, all
of this happens without any centralized control mechanism.


Market Imperfections


Sometimes markets do not allocate resources efficiently. Under such
circumstances, it may make sense for the government to intervene
in markets beyond providing a legal foundation for market
transactions. Chapters 8 and 9, which deal with energy and the
environment, discuss some regulations designed to address two such
market failures--externalities and market power. These chapters
look at both the benefits and potential problems that can result
from imposition of regulations.

Poorly designed or unnecessary government regulations can actually
reduce society's overall well-being. The possible costs of
government regulation include the costs imposed on consumers and
producers, impeded innovation, and unintended negative consequences
such as the creation of unforeseen barriers to competition. It is
essential to consider whether the costs potential regulations
impose on society are greater than the benefits society receives
from fixing any market failures.


Regulation and Externalities


Externalities (also known as spillover effects) can lead to a
situation in which the price of a commodity does not reflect its
full incremental cost to society. A negative externality exists
when the voluntary market transaction between two parties imposes
involuntary costs on a third party. For example, a power plant
might produce and sell electricity to consumers to both their
advantage, but the production process might emit air pollution
that negatively affects the population. The costs that this
pollution imposes on the population might not be considered when
the firm decides where to locate a plant, which technologies to
use, or how much electricity to produce. It could be that if these
costs were taken into account in the same way as all of the other
costs of producing electricity, the plant might be relocated to a
place where its pollution would affect fewer people, the firm
might put greater emphasis on pollution-reducing technologies, or
the plant may not produce as much electricity. The existence of a
negative externality can lead to an outcome that is worse for
society than one that takes the externality into account.

As discussed in Chapter 9, Protecting the Environment, in many
cases the best remedy for externalities is to define property rights
and allow the affected parties to transact privately to achieve a
mutually beneficial outcome. Sometimes, however, establishing
property rights can be expensive. Even with clearly defined
property rights, it may be costly for affected parties to
collectively agree on a mutually beneficial transaction. Under
such circumstances, other forms of government intervention may be
appropriate, including taxes, subsidies, and direct regulation.


Addressing Externalities Through Taxes


One approach to dealing with externalities would be to levy a tax
(known to economists as a Pigouvian tax) on market participants such
that the amount of tax collected equals the incremental cost of the
externality. For example, if a power plant's emissions are easy to
monitor and the costs of pollution are easy to assess, the tax on
each unit of pollution could be set equal to the cost of the
externality. Alternatively, if the amount of pollution is not
easily monitored, the tax could apply to each unit of production
(each kilowatt produced by the plant, for example) rather than the
pollution itself, and could be set equal to the additional external
cost of pollution from each unit of production.

In general, taxes distort economic activity (see the discussion of
the income tax in Chapter 4, Tax Incidence: Who Bears the Tax
Burden?). However, proponents of Pigouvian taxation argue that it
can improve the allocation of resources by forcing producers and
consumers to confront the full costs of production. Indeed, some
advocates of the use of such taxes go further and argue that
revenues from Pigouvian taxes could be used to finance a reduction
in the rates on other taxes that do distort behavior, such as the
income tax. This idea is sometimes called the double-dividend
hypothesis because it increases efficiency in the market with the
externality and in the markets that are distorted by the income tax.

This argument must be viewed with caution. To see why, recall that
Pigouvian taxes drive up the prices of the goods that are produced
using technologies that involve pollution. The increase in prices
reduces the buying power of households' incomes. This is effectively
a decrease in the real wage rate because a given dollar amount of
wages buys fewer goods and services. Put another way, Pigouvian
taxes are, to some extent, also taxes on earnings. If the labor
market is already distorted because of an income tax (as is the
case in the United States and other industrial economies), the
Pigouvian tax makes the distortion worse. In some cases, the added
distortions in the labor market can actually outweigh the gains
from correcting the externality. The desirability of Pigouvian
taxes as a policy instrument must be determined on a case-by-case
basis.


Addressing Externalities Through Limits on Quantity


Another possible problem with Pigouvian taxes is that determining
their magnitude can be challenging because it may be difficult to
measure the amount of pollution, as well as the value of the damage
it causes. Moreover, the appropriate tax may change with market
conditions. If, for example, the cost of the externality increases
with output, the optimal tax would need to go up if output
increases.

It is also difficult to know beforehand the tax level that will
reduce emissions by the desired amount. Moreover, as the economy
changes, the tax will need to be adjusted to maintain the desired
amount of emissions reduction. A system in which a firm must own a
government-issued permit for each unit of pollution addresses these
problems because the government determines the number of permits to
create. A cap-and-trade system, which allows firms to trade these
permits, accomplishes the environmental goal at least cost.


Addressing Externalities Through Subsidies


Another option for dealing with externalities is to subsidize
alternative behaviors that do not produce the negative externality.
For example, concern over externalities from fossil fuels has led
to government subsidies of some alternative sources of electricity,
such as wind and solar power. However, such subsidies have some
limitations. First, using the example of electricity, subsidies
encourage overconsumption by keeping the cost of electricity below
the level that market forces would set if the costs of the
externality were taken into account. Second, subsidies raise some
difficult administrative issues. In particular, the government
needs to identify all the behaviors that should qualify for a
subsidy. In the case of the power plant that emitted pollution, a
fully efficient policy would be to subsidize all other ways of
generating electricity and all conservation activities. Such
attempts quickly become unwieldy in practice.


Addressing Externalities Through Command-and-Control Regulation


The government can also attempt to limit negative externalities
with command-and-control regulations that mandate certain behavior.
For example, the government requires automobile producers to meet
overall fuel-efficiency standards. There have also been proposals
to mandate that a certain percentage of electricity be generated by
renewable fuels such as wind and solar power.

Command-and-control regulations can sometimes be the only way to
deal with an externality. In general, however, they should be
avoided because they discourage flexible and innovative responses
to externalities and can result in higher costs than alternative
policies. For example, mandating use of a particular technology
to lower emissions could lessen firms' incentives to develop more
effective techniques to reduce pollution. Furthermore, people
adapt to command-and-control regulations in unintended ways that
can limit their effectiveness over time. For example, one
unintended consequence of the automobile fuel-efficiency standards
was to increase the demand for light trucks and sport utility
vehicles (SUVs), which were not as stringently regulated.


Regulation and Market Power


Market power, which arises in the presence of impediments to
competition, is another potential source of inefficiency in a
free-market system. Firms that have market power typically have
the ability to charge prices above the competitive price level
and maintain those high prices profitably over a considerable
period. In some cases, the impediment is a law that makes it
difficult for competitors to enter a market, but market power
can also arise from the nature of the industry itself. For
example, the high cost of wiring residential neighborhoods
for electricity makes it unlikely that multiple firms would be
willing to compete to distribute retail electricity. In these
cases, regulation can be useful to prevent firms with market
power from charging consumers prices that substantially exceed
the cost of providing the good.

Policy makers need to recognize, however, that regulations
themselves affect firms' and consumers' behavior and incentives.
Regulations that do not take these effects into account can result
in excessive consumption, misaligned incentives, stunted innovation
and investment, and needless waste. Even regulations that do account
for these effects may be rendered obsolete or counterproductive by
changes in the industry that occur over time. For this reason, it
is important to periodically reevaluate regulatory policies. Chapter
8, Regulating Energy Markets, discusses opportunities for
reevaluation in further detail.


Regulation in the Absence of a Market Failure


Some government regulations attempt to reverse what would otherwise
be efficient market outcomes due to beliefs that a particular
market-based allocation of resources is undesirable. For example,
regulations to prevent "price gouging" might be seen as fair, but
the economic consequences of these regulations must be recognized
(Box 7-1). Attempts to circumvent the market in this way must
confront a basic reality--resources are scarce, so that if market
prices are not used to ration commodities, some other mechanism has
to be used instead. For example, resources could be allocated to
consumers using ration coupons, a lottery, or first-come,
first-served. Resources could also be allocated based on cronyism
or other discriminatory means. These nonprice methods cannot
guarantee that the scarce resources go to the consumers who value
them the most. Furthermore, they reduce suppliers' incentives to
increase production. For example, if prices are capped, suppliers
may not work overtime to increase supplies or pay extra
transportation costs to bring in supplies from distant areas. As a
result, resources are not put to their best uses.

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Box 7-1: Market Responses to Unexpected Shortages

When there are large, unexpected increases in demand or decreases
in supply for a good, a normal market response is for prices to
increase by enough to restore balance between supply and demand.
Consumers might accuse sellers of "price gouging" when such price
increases occur in response to a natural disaster or a failure of
supply infrastructure. A number of states have laws that make price
gouging illegal. Even without such laws, some businesses might
choose not to increase prices during an emergency for fear of a
consumer backlash. If prices do not increase, however, consumers
do not receive a signal to cut their consumption and suppliers might
not have the proper incentives to increase supply adequately.

By not allowing market forces to restore the balance between supply
and demand after the shock, nonprice rationing must be implemented
instead. For example, after a pipeline break reduced the supply of
gasoline into the Phoenix, Arizona, area in August 2003, press
reports indicated that some stations ran out of gasoline, consumers
waited in line for hours, and some drivers started following
gasoline tankers as they made their deliveries.

Changes in demand can induce shortages as well. For example, in the
days leading up to the arrival of Hurricane Isabel in the
Mid-Atlantic states in September 2003, press reports indicated
that many retailers sold out of flashlights and D batteries. The
flashlights and batteries went to the first people to show up at
the store, rather than to those who valued them the most. It also
meant that people who were able to buy the goods might have bought
more than they would have at the higher price, leaving fewer for
others. Without price increases, there was no mechanism to allocate
the available goods to their highest-valued uses. For example, if
prices were higher, early customers may have decided not to buy
new batteries for their fifth flashlight and later customers would
not have been forced to sit in the dark.

While allowing prices to increase in the face of a natural disaster
or a supply disruption may seem unfair, the alternative would be to
restrict the allocation of scarce supplies and to possibly keep
supplies from those who need them most. Artificially low prices
remove incentives for consumers to conserve and for suppliers to
meet unfilled demand, potentially prolonging the shortage. Society
must decide whether the perceived fairness resulting from
regulations to hold down prices is more important than allowing the
market to provide incentives for resolving the shortage as quickly
as possible, while making sure that scarce resources are available
for those who value them the most.

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Conclusion


In general, market systems allocate resources toward their most
highly valued uses. Importantly, no one directs society to this
result. Rather, it is the outcome of a process in which each
consumer and each producer observe prices and privately make the
decisions that maximize their well-being. The coordination of
economic activity is done by prices, which provide signals of the
costs to society of providing various goods. However, in the
presence of market power, externalities, and other types of
market failure, market-generated prices may not incorporate all of
the relevant information about costs. Under these conditions,
there are opportunities for government to intervene and improve
the allocation of resources.

The fact that the market-generated allocation of resources is
imperfect does not mean that the government necessarily can do
better. For example, in certain cases the costs of setting up a
government agency to deal with an externality could exceed the
cost of the externality itself. Therefore, proposed remedies for
market failure must be evaluated on a case-by-case basis.

Energy and the environment are two areas in which government
intervention may play a role in correcting market failures. Such
interventions are likely to be more successful when they harness
market forces to the extent possible. The next two chapters
illustrate the challenges in properly designing regulations in
these areas. An important implication of the analysis of both
chapters is that in order to make society better off, regulatory
policy must be based on a solid economic foundation.