Markets can be regulated by the figurative force of competition or by the literal force of government. Which better protects buyers and sellers? Contrary to popular belief, regulation by competition usually renders regulation by government either unnecessary or counterproductive.
Regulations are usually presented to the public as a matter of guarding the public interest and protecting safety; however, one of the curious facts about regulation is that participants in the a particular industry are usually the ones calling for government regulation, not disinterested parties looking out for the social interest. Marc T. Law and Sukkoo Kim have argued that while they lend themselves to capture by special interests, these regulations might have helped solve information problems and actually create markets for some goods and services in the early years of the Progressive Era; however, Morris Kleiner shows that particularly today licensing and regulation restrict competition actually make consumers worse off in his 2006 book Licensing Occupations: Ensuring Quality or Restricting Competition?
Markets are plagued by information problems: sellers usually know more about what they are selling than buyers do, which means that markets can unravel (tracing the implications of this asymmetry helped win economist George Akerlof the Nobel Prize). Regulation by markets or by governments can solve the information problem and ensure that a market exists in the first place.
You have probably heard people claim that consumer ignorance means that governments should regulate in order to ensure safety. Someone getting off a plane at the airport in Birmingham, for example, may not have a lot of experience with local taxi drivers and, therefore, may not know which drivers are and aren’t trustworthy. In the interests of protecting the prospective taxi customer, government regulation might be warranted.
We shouldn’t be too quick to kick the problem to government. Competition creates incentives for businesses to deal honestly. Brand names are powerful indicators of quality and trustworthiness. I know what I’m getting when I buy a Toyota or a Honda. Volvo has earned a reputation for reliability, trustworthiness, and toughness. When I eat at McDonald’s, get on a Delta flight, or stay at an Embassy Suites, I have a pretty good idea of what to expect.
These companies have valuable brand names to protect, and the competitive pressure is even fiercer in a twenty-first century world of blogs, ratings sites like Yelp and UrbanSpoon, and social media. Every Yelp review, Facebook post, or tweet about a company affects the value of the company’s brand name, so these companies have a very powerful incentive to make sure people have good experiences with their products. In the case of rides-for-hire at airports, national brands like Yellow Cab (or global ride-sharing companies like Uber and Lyft) can solve the information problem. In an unregulated market for rides-for-hire, a traveler in an unfamiliar city can rely on a national brand like Yellow Cab, Uber, or Lyft just like a traveler in an unfamiliar city can rely on a familiar brand like McDonald’s or Embassy Suites for food and lodging.
Have you ever wondered why (especially in old movies) banks are so fancy and ornate? Have you ever wondered why companies pay millions of dollars for celebrity endorsements? One theory is that these are fundamentally competitive measures. A bank is signaling that it’s going to be around for a while by building an ornate building. Similarly, companies probably hope that you’ll want to buy their product so you will Be Like Mike (or like LeBron), but they’re really sending a signal about quality: they’re so confident in their product that they can afford to “waste” a few million dollars on a celebrity endorsement—preferably a celebrity with discriminating (and good) tastes in clothes, cars, and gear.
This isn’t to say competition is perfect or that you won’t ever have a bad night’s sleep at the Embassy Suites or eat a bad burger at McDonald’s. I’m sure just a few minutes’ reflection will call to mind bad experiences with this brand or that. Given that McDonald’s advertises “billions and billions served,” I’m sure you will be able to find no shortage of horror stories. As a fraction of the total number of transactions that take place at McDonald’s, however, these are likely to be extremely small. The Bible is right that a good name is to be chosen over great riches, but in a competitive commercial environment a good name can lead to great riches.
Another important reason we shouldn’t be too quick to entrust regulation to the government is that government officials also respond to incentives. As economists beginning with William Niskanen have argued, bureaucracies will tend toward bloat and waste as bureaucrats seek to expand control over resources. This means larger staffs and bigger budgets. This does not require that the bureaucrats be corrupt, incompetent, or evil. They are simply responding to the incentives inherent in bureaucracy: in this case, to do more of the thing they are commissioned to do. Regulators and bureaucrats can also be “captured” by the industries they regulate and then pass regulations that restrict competition in exchange for campaign contributions, possible future employment, consulting contracts, or other favors.
Regulation also lags innovation, and government regulators almost by definition cannot be nimble enough to adapt to changing technology without causing delay and wasting resources. One version of the discussion is taking place in cities around the country as they think about how to deal with ride-sharing firms like Uber and Lyft. These cities are missing an opportunity to ask fundamental questions about whether these regulations actually serve the public interest.
Market-chosen rules and norms can change in real time with major conflicts that arise being settled through private arbitration or in courts. Meanwhile, changing regulations to adapt to new technology requires lawyers, meetings, votes, and probably a few rounds of revision before an “appropriate”—and I use the word loosely—regulatory environment can be devised. In recent municipal debates about ride-sharing apps like Uber and Lyft and room-sharing services like Airbnb, I fear that regulators and city councils and other government actors have been missing the point. I don’t doubt that they mean well, but they’re asking “how should we regulate this new thing that competes with incumbent taxis and hotels” when what is happening with the sharing economy (and eventually the introduction of driverless cars) is a set of changes that will ultimately change how we live, work, and play. The problem isn’t that the regulations never envisioned services like Uber, Lyft, and Airbnb. The problem is that government regulation in these sectors is obsolete, redundant, and restrictive.
The downstream consequences are considerable. In their 2009 book Violence and Social Orders, Douglass C. North, John J. Wallis, and Barry R. Weingast emphasize the importance of an open access order in which innovators earn profits by producing more and better goods and services. They contrast this to a limited access order in which people earn profits by restricting access to the market, which allows them to restrict output, raise prices, and innovate more slowly, if at all. As we are seeing with intense lobbying over regulation of licensed professions, rides-for-hire, and other barriers to entry into the marketplace, there are still a lot of vestiges of a limited-access order even in a well-functioning market economy like the United States. The problem of institutional design, then, is to try to devise “rules about rules” making it so that it is prohibitively costly to try to limit access to the economic order.
Free markets don’t produce magic dust that creates utopia or that prevents (literally) every problem. Adam Smith was right when he wrote “there is much ruin in a nation.” It’s a non sequitur to jump from “there is much ruin in a nation” to “we can fix it with government.” Liberty, not force, is our best weapon against the darker angels of our nature.