The case for market-based regulation.

• Author: O'Driscoll, Jr., Gerald P.

In this article, we reconsider the rationale for government regulation of markets. We begin by identifying markets as governed not only by prices but also by evolved institutions, rules, and standards. We then analyze how this complex order regulates human behavior, discuss the case for adding a layer of government regulation to the market's own regulatory system, and present a number of case studies to clarify the issues.

Our focus is not on the familiar public choice criticism of government regulation--namely, that regulation is more about the pursuit of economic rents than protecting the so-called public interest. While that criticism is correct and we make reference to it where appropriate, the thrust of our argument is that market self-regulation is often superior to government regulation, which frequently is a solution in search of a problem.

Two Types of Regulation: Market vs. Government

In a system of private property rights and competitive markets, prices regulate the behavior of consumers and producers so as to allocate resources to their highest-valued use. The price system works within a framework of institutions. A market economy evolves institutions, rules, and standards that further regulate the behavior of economic agents.

The reality of how markets operate contrasts sharply with textbook neoclassical theory in which anonymous buyers and sellers meet for an instant to exchange homogeneous goods at preordained equilibrium prices. The idea that prices alone allocate resources in a market economy is at best a limiting case and at worst a straw man.

Institutions and prices evolve through a similar process to jointly coordinate behavior. Part of that process involves the development of market-based regulation. There is no magic to the evolutionary process, any more than there is mystery in the rise of oil prices to reflect increased scarcity of that commodity.

The textbook justification for government intervention is the correction of an apparent market failure. It is now widely recognized that market failure, such as pollution, results from incompletely specified property rights. In the case of air pollution, for example, individuals do not have an enforceable and tradable right in air quality. (1) Merely postulating weak or absent property rights, however, begs the question. That procedure falls under Hayek's dictum that "before we can explain why people commit mistakes, we must first explain why they should ever be right" (Hayek [1937] 1948: 34). In O'Driscoll and Hoskins (2003), we analyzed the process by which property rights emerge. We briefly reprise that argument in the next section.

It is widely recognized that regulatory intervention attenuates private property rights. Governments can theoretically define property rights where they do not exist, but public choice theory would predict that the process would end up in rent seeking rather than law making. (2) In any case, rather then creating property rights in the face of apparent externalities, governments typically turn to regulating economic activity. That is the topic of this article.

Government regulation alters the allocation of resources and, indeed, is designed to accomplish just that reallocation. Along with attenuating property rights, government regulation can also undermine the complex system of market-based institutions, rules, and standards that enhance and strengthen property rights. That system, or institutional framework, is as an integral part of a market economy as is the price mechanism.

All economies have elements of both self-regulation and government regulation. Government regulation reinforces, supplants, or undermines market-based regulation. Accordingly, government intervention is efficacious, redundant, or counterproductive. We address classic textbook cases of public goods and externalities that suggest the case for "good" government regulation. We also present a number of cases in which bad government regulation suppresses the self-regulating mechanisms in a market economy.

Regulation is necessary for a well-functioning market economy, but that insight provides no necessary role for government intervention. Some additional factor must be adduced to justify government intervention because markets evolve self-regulatory mechanisms.

The Evolution of Institutions

Kenneth Arrow (1968: 376) identified the "most important intellectual contribution" of economics as "the notion that through the workings of an entire system effects may be very different from, and even opposed to, intentions." Arrow echoed Adam Smith's invisible-hand reasoning.

Economists, including Marx, have generally accepted invisible-hand reasoning for economic phenomena. They have not consistently extended the evolutionary mode of reasoning to fundamental institutions such as law. For contrast, compare Carl Menger's ([1883] 1963: 146) formulation of the scope of social science: "How can it be that institutions which serve the common welfare and are extremely significant for its development come into being without a common will directed toward establishing them?"

What kind of institutions did Menger have in mind? On the same page, he provided some examples: "Language, religion, law, even the state itself, and, to mention a few economic social phenomena, the phenomena of markets, of competition, of money, and numerous other social structures." Menger suggested that a broad array of social phenomena be subjected to invisible-hand reasoning. There were no institutional "givens" in Menger's analysis.

Friedrich Hayek was the most Mengerian of 20th century economists, and he often spoke of "the results of human action but not of human design" (Hayek [1967] 1969: 96-105). He advanced a research agenda that analyzed language, law, and money as evolved social structures and not products of conscious design. Specific legislative enactments were products of intentional human activity, but not the legal system or rule of law itself (Hayek 1973).

Even Hayek, however, viewed the regulation of economic activity as the product of legislation or human design. He observed that "a free system does not exclude on principle" regulation of economic activity, including regulation of production techniques and 'factory legislation'" (Hayek [1960] 1972: 224-25). He advocated a cost-benefit approach to evaluating government regulations. While he was dubious about all such activity, he did not believe that it could be excluded on principle.

Nor have many other economists adopted an invisible-hand approach to the emergence of regulation. Blundell and Robinson (2000) are a conspicuous counterexample, as is Armen Alchian (1950, 1977).

In his examination of economic success and uncertainty, Alchian shows how market-based rules evolve in an economic system based on profit-seeking behavior. The imitation of successful enterprises leads to rough and ready rules of behavior. "What would otherwise appear to be merely customary 'orthodox,' nonrational rules of behavior turns out to be codified imitations of observed success, e.g., 'conventional' markup, price 'followship,' 'orthodox' accounting and operating ratios 'proper' advertising policy, etc" (Alchian 1977: 29). These rules of behavior regulate economic behavior.

According to Alchian, people are motivated to copy or imitate a pattern of actions associated with past success because of uncertainty about the appropriate decisionmaking process as well as the variability of the environment in which they operate. In addition, people do not know if a trial and error process will lead to the desired outcome and they fear failure. These are some of the motivations for people to adopt imitative rules of behavior (Alchian 1977: 29-30).

In a seminal article, Bruce Benson (1989: 165) argued that "modern commercial law is, in fact, largely made by the merchant community despite government efforts to take over provision of such law" (Benson 1989: 165). He showed how historically lex mercatoria, "the Law Merchant," evolved within the merchant community. Based on Roman commercial law, medieval merchant law evolved as commercial practices evolved. It was customary law, that is, a set of rules reflecting business practice (Benson 1989: 168-70).

Benson (1989: 171) debunked the widespread belief that the state must be the monopoly source of law by demonstrating it to be historically untrue. "Such significant economies of standardization exist in commercial law that it took the voluntarily produced and adjudicated Law Merchant to overcome the limitations of political boundaries and localized protectionism."

According to Benson, "The Law Merchant 'governed' without the coercive power of a state." Merchants had their own courts, which functioned with speed and efficacy. The system was quick to adapt to changing business practice. To anticipate an important point of this article, the ultimate threat of that voluntary legal system was loss of reputation and business (Benson 1989: 172-75).

Historians of law have long recognized that law and property, more broadly, were evolved rather than consciously created. In Property and Freedom, historian Richard Pipes provides an overview of the evolution of the institutions of property from primitive times to the emergence of the state. He concluded that "in most countries property took the form of possession, claims to which rested not on documented legal title but on prolonged tenure, which custom acknowledged as proof of ownership" (Pipes 1999: 65). The critical issue for our discussion is that property and customary law preceded the state.

Hernando de Soto came to similar conclusions in his study of property and wealth in developing countries. Titling property is often extremely costly and time consuming in these countries. He concluded that "the only way to find the extralegal social contract on property in a particular area is by contacting those who live and work by it" (De Soto 2000: 182)...