Quality-and-safety assurance: how voluntary social processes remedy their own shortcomings.

• Author: Klein, Daniel B.

In the United States, governments at every level impose many restrictions on voluntary interaction in the name of protecting consumers from poor-quality or unsafe products and services. Examples of government quality-and-safety agencies and restrictions include the Food and Drug Administration, the Consumer Product Safety Commission, the Occupational Safety and Health Administration, the Environmental Protection Agency, the Federal Trade Commission, the Securities and Exchange Commission, the National Highway Traffic Safety Administration, state and local occupational licensing laws, and local housing codes.

Many economists are critical of such restrictions. For instance, economists argue that FDA restrictions on drug production are politicized, tend toward rejection of new drugs, discourage the development of new drugs, delay the availability of drugs, and make drugs more expensive to the consumer (for overviews, see Temin 1980; Grabowski and Vernon 1983; Higgs 1995). On occupational licensing, economic researchers find that the restrictions increase practitioner fees and incomes, reduce the quantity supplied, stunt innovation, delay treatment, discourage preventative care, and induce consumers to turn to unlawful, do-it-yourself, and often unsafe remedies. Also, there is very little evidence that licensing achieves its primary goal of raising the quality of lawful practice (for overviews see Rottenberg 1980; Shimberg 1982; Carroll and Gaston 1983; Young 1987; Feldstein 1993, chap. 14; Svorny forthcoming).

The arguments in support of quality-and-safety restrictions are of two kinds: knowledge-externality arguments (e.g., lemons models) and paternalistic arguments. I attempt to place these issues within a larger vision, developed by Adam Smith and F. A. Hayek, of the economy as a division of knowledge. I argue that quality-and-safety restrictions on voluntary exchange cannot be justified by the knowledge-externality arguments, which leaves only paternalism as a possible justification. Paternalism, however, runs contrary to the broad liberalism typically favored by economists and to the cognate values of human dignity.

Distinguishing Quality-and-Safety Restrictions from Paternalism

By "quality-and-safety restrictions," I mean restrictions that purport either to protect consumers from getting less than they bargained for or to elicit higher-quality products or services. Quality-and-safety restrictions ostensibly serve as a safeguard against quacks, charlatans, and frauds and against degenerative "lemons" markets. Drug prohibition, in contrast, is not rationalized as helping drug users avoid being cheated by drug dealers (the effect of drug prohibition in this regard is, of course, to increase the likelihood of rip-offs). Prohibitionists do not seek to advance promise keeping or foster sound quality in the cocaine trade. Drug policy is rationalized on the grounds that the promises themselves are unworthy, that using cocaine, exactly as bargained for, should not be permitted. Drug prohibition is a form of paternalism. It may not be pure paternalism, insofar as the prohibitionist maintains that drug users impose on others external losses greater than the external losses of drug prohibition. In any event, a policy such as drug prohibition is distinct from quality-and-safety restrictions.

Complex Systems Rely on the Division of Knowledge

In the first chapter of his Wealth of Nations ([1776] 1936), called "Of the Division of Labour," Adam Smith marvels at the complex array of activities, some occurring at "the remotest corners of the world!" (11), involved in making a woolen coat. The description of the workmen and their activities occupies an entire page of text. By virtue of the proper coordination of activities within a complex system, Smith argues, England is much richer than less complex economies. (The term "coordination" is used here in the Hayekian sense, not the Schelling sense; on the distinction, see Klein 1997d.)

Complex systems require a division of knowledge. Smith notes that no single mind could have the knowledge utilized in the economy (423, 651). The principle of the division of knowledge applies also to other complex systems. Marvin Minsky, MIT computer scientist and author of The Society of Mind (1986), applies the principle inward, writing of the division of knowledge within the human mind:

Achieving a goal by exploiting the abilities of other agencies might seem a

shabby substitute for knowing how to do the work oneself. Yet this is the

the very source of power of societies. No higher-level agency could ever

achieve a complex goal if it had to be concerned with every small detail

of what each nerve and muscle does. Unless most of its work were done by

other agencies, no part of society could do anything significant. (169)

Within the human mind, Minsky explains, the activities of subagents with divided knowledge are coordinated chiefly by organizational structures. In the economy, the activities of those with divided knowledge are coordinated, as Ronald Coase (1937) has explained, sometimes by relations within organizations and sometimes by market exchange. The division of knowledge is limited by the extent of voluntary interaction.

The economy can be seen as a complex system of chains of promises. Any single exchange is but one link in long chains of promises that finally result in things such as woolen coats. An entire chain is sustained ultimately by consumers willing to pay for woolen coats, who thereby create opportunities for entrepreneurs to profit by providing what is demanded. At each link in a chain, transactors pay heed to current prices and other conditions to discern profit opportunities in dealing with adjoining links. Knowledge of these local opportunities resides locally: "in their local situation [the people] must generally be able to judge better of [their own interest] than the legislator can do" (Smith [1776] 1936, 497; see also 651). This condition I call the canon of local knowledge. When what is beneficial for the chain as a whole is advantageous at each individual link, the canon of local knowledge points directly to a conclusion of freedom. As Smith puts it, "the law ought always to trust people with care of their own interest" (497).

In some cases, as Smith recognized (651), what is beneficial for the chain as a whole is not advantageous to the individual link. In these cases the necessary basis for exchange (namely, private property rights) is weak or absent, so the activities of those with divided knowledge do not come into beneficial coordination. But these cases do not present violations of the canon of local knowledge: individuals are still presumed to know best where their own interest lies.

Divided Knowledge Implies an Expanded Role of Trust

Since Smith's time, economists have explained how the price system guides people to make the promises that bring about a beneficial coordination of activities. Economists have devoted much less attention, however, to a problem that would seem to grow as an economy becomes more complex. As Hayek (1960) pointed out, "The more civilized we become, the more relatively ignorant must each individual be of the facts on which the working of his civilization depends. The very division of knowledge increases the necessary ignorance of the individual" (26; see also Benson 1997, 171). Ignorance makes one vulnerable to deception and cheating. In a complex economy, we stand, as Smith ([1776] 1936) put it, "at all times in need of the co-operation and assistance of great multitudes" whom we cannot know (14). Increases in the division of knowledge imply an expansion of our dependence on things unknown to us and an expansion of the role of trust in economic affairs.

Economists have explained how people come to make the correct promises, but they have not studied very much why people keep their promises. In other words, economists have explained the coordination of promises but have done much less to explain the integrity of promises. For the most part, economists take for granted that people will keep their promises, perhaps assuming implicitly the existence of efficacious tort remedy. If we consider seriously why people keep their promises, we can better understand how quality and safety are governed by the canon of local knowledge. In the fight of this understanding, we shall be more inclined to support the liberal prescription.

Promises Made to Assure that Other Promises Will Be Kept

In telling blackboard stories of markets, economists usually assume away transaction costs. With positive transaction costs, however, the market may not establish a single price. Transaction costs also lie at the heart of other stories of "market failure," such as those involving externalities, public goods, and even natural monopoly. If the market is imperfect, perhaps government can improve the situation.

Consider consumers who want to shop downtown where parking is scarce. By virtue of their demand for the goods in the stores, consumers have an associated demand for parking, which creates profit opportunities for entrepreneurs. When a shopper pays $5 for parking, that $5 may be viewed as part of the transaction costs of shopping downtown. But with reference to the parking-space transaction, it is not a transaction cost; it is the price paid for the thing purchased--parking space. The transaction costs of one market may become payments for services rendered in other markets.

Is the cost a transaction cost? The question has no definitive answer; it is a matter of interpretation. Consider another illustration, again involving parking. One way to deal with parking is for the stores to provide parking space at no additional charge to customers. Their costs of providing parking space may be viewed as part of their overall costs. Alternatively, the costs of providing parking space may be separated from other costs and viewed as costs incurred by the...