Consumer Prices and Federal Regulations

In April I'll be presenting a paper at the Association of Private Enterprise Education meetings on the relationship between EPA regulation and food prices. I'll talk more about that when I get a draft of the paper together, but I want to summarize a paper that caught my eye the other day.

Dustin Chambers (Salisbury University) and Courtney Collins (Rhodes College) recently published a working paper with the Mercatus Center on the relationship between consumer prices and federal regulations.

Here's the intro to the on-line summary:

When the federal government introduces new regulations for an industry, there are numerous potential consequences for both producers and consumers. Often, complying with regulations is costly for firms, and these higher costs may in turn drive up prices for consumers. Higher prices caused by regulatory growth are unlikely to affect all consumers equally. High-income and low-income households tend to have different spending patterns, and regulations may have a larger impact on one group than on another.

The authors use data from the Consumer Expenditure Survey and the Mercatus Center's RegData database, which is comprised of data on industry-level federal regulation, in a statistical model to determine the impact of federal regulations on a range of consumer prices from 2000 to 2012.

They summarize their key findings:

The stated purpose of regulations is often to help protect consumers from a variety of problems in the market. However, the benefit of any sort of protection must be weighed against the cost of higher prices. The data show evidence of a statistically significant relationship between regulation and increased prices.

There is a period of time between the publication of new regulatory restrictions and when they have a measurable impact on prices, so it is important to evaluate both variables over time. After the impacted production processes have been altered to comply with a new regulation, there is an associated jump in the price of the affected goods and services. Comparing the growth rate of prices over time against the growth rate of regulations over time, the data show that a 10 percent increase in total regulations leads to a 0.687 percent increase in consumer prices.

While this effect seems small, there are distributional issues at play. The authors conclude:

Regulators and policymakers often claim that regulations are intended to protect the poorest and most vulnerable consumers. However, the effects of regulations are most harmful to the poor because regulations drive up the cost of doing business, resulting in higher prices. Unfortunately, the goods and services to which the poor devote much of their limited budgets, such as energy and food, are also the most heavily regulated.

Another unintended effect of regulation is that the poor face a higher overall rate of inflation in the goods they tend to purchase. In addition to undergoing larger price hikes, these heavily regulated products also display greater volatility, meaning that low-income households face more uncertainty in their household budgets than do wealthier households. Policymakers must understand the unintended effects of higher, more volatile prices on the poor when considering new regulations.

More on Rural Health Care and Certificate of Need Laws

After my last post on certificate of need laws (CON laws) went up earlier this week a colleague rightly noted that the paper only addressed the quantity of facilities available in the rural areas of a state, not the quality of the care provided.

I think this recent post is at least a step in that direction. The authors examine the availability of imaging services in states with and without CON laws and find that:

These CON requirements effectively protect established hospitals from nonhospital competitors that provide medical imaging services, such as independently practicing physicians, group practices, and other ambulatory settings. In the process of protecting hospitals from these nonhospital providers, CON laws limit the imaging services available to patients.

The existence of a CON law decreases MRI scans by 34 percent, CT scans by 44 percent, and PET scans by 65 percent, all relative to states without CON laws.

As Hayek argued in the conclusion to his Nobel speech:

If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that in this, as in all other fields where essential complexity of an organized kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as the craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, in the manner in which the gardener does this for his plants.

CON laws have nothing to do with licensing of practicing physicians but with planning by state committees exactly how and in what manner new health care services will be established. The problem is that centrally planning (at the state level) this type of activity presumes that regulators possess knowledge they very well may not. It may very well be that hospital administrators and investors have a better grasp of the needs of their communities than state planning boards.

While CON laws may have important benefits, Stratmann and Baker find equally important drawbacks.

Masonomics and Externalities

During a conversation a couple of weeks ago on externalities and market failure, a colleague of mine noted that my perspective on these topics seems to be in line with that of the economists at George Mason University. This is slightly misleading since the origin of GMU Econ's perspective is quite diverse (and thus not uniquely their own), but GMU is certainly a hotbed of research and education in the path-breaking economic work of Alchian, Buchanan, Coase, Demsetz, Hayek, Mises, Ostrom, Williamson, and others.

Given GMU Econ's unique perspective, it's no surprise that a term like "Masonomics" was coined. In an article back in 2007, economist Arnold Kling laid out several characteristics that make Masonomics unique. Below I reproduce the section of Kling's essay on the "cure for market failure."

At the University of Chicago, economists lean to the right of the economics profession. They are known for saying, in effect, "Markets work well. Use the market."

At MIT and other bastions of mainstream economics, most economists are to the left of center but to the right of the academic community as a whole. These economists are known for saying, in effect, "Markets fail. Use government."
Masonomics says, "Markets fail. Use markets." 

Somewhere along the way, mainstream economics became hung up on the concept of a perfect market and an optimal allocation of resources. The conditions necessary for a perfect market are absurdly demanding. Everything in the economy must be transparent. Managers must have perfect information about worker productivity and consumers must have perfect information about product quality. There can be nothing that gives an advantage to a firm with a large market share. There cannot be any benefits or costs of any market activity that spill over beyond that market.

The argument between Chicago and MIT seems to be over whether perfect markets are a "good approximation" or a "bad approximation" to reality. Masonomics goes along with the MIT view that perfect markets are a bad approximation to reality. But we do not look to government as a "solution" to imperfect markets.

Masonomics sees market failure as a motivation for entrepreneurship. As an example of market failure, let us use a classic case described by a Nobel Laureate, which is that the seller of a used car knows more about the condition of the car than the buyer. Masonomics predicts that entrepreneurs will try to address this problem. In fact, there are a number of entrepreneurial solutions. Buyers can obtain vehicle history reports. Sellers can offer warranties. Firms such as Carmax undertake professional inspections and stake their reputation on the quality of the cars that they sell.

Masonomics worries much more about government failure than market failure. Governments do not face competitive pressure. They are immune from the "creative destruction" of entrepreneurial innovation. In the market, ineffective firms go out of business. In government, ineffective programs develop powerful constituent groups with a stake in their perpetuation.

This is a (well-written) summary of my own view on the topic. Thanks to my exposure to this perspective in graduate school I continue to develop interests and to work in the political economy of agriculture. What do you think? What problems can you identify with the Masonomics view of externalities?

Russ Roberts also has a nice blog post giving his take on Masonomics here. Several Farmer Hayek posts have addressed externalities and market failure over the past year and can be read here, here, here, here, here, and here.

Regulation and Rural Hospitals

A new working paper at the Mercatus Center looks at the effect of Certificate of Need (CON) laws on rural health care provision. CON laws require providers to get permission from state governments. This permission is ostensibly determined by the need for new facilities in an area. Currently, CON laws are on the books in 26 states primarily in the southeast, northeast, and northwest.
According to the authors, the primary concern that CON laws address in rural areas is that ambulatory surgical centers (ASCs) will engage in "cream skimming" which is the practice of refusing to treat poorer, more risky, or less well insured clients and only treating the easy cases. This would result in closures of rural hospitals reducing the quantity and quality of care in rural areas.

However, CON laws are literally a barrier to entry in the health care market, so it remains an open question whether this barrier to entry reduces the quantity of hospitals or, through some unintended consequence, increases the quantity of hospitals by preventing "cream skimming."

Pigou's Persistence

I recently ran across an interesting working paper by James McClure and Tyler Watts on some lesser-known or lesser-applied critiques of the standard Pigouvian perspective on externalities. The authors note that Pigou's perspective is still the standard in today's undergraduate texts, teaching students that externalities cause all manner of market failures which governments can fix with the appropriate political will.

The author's quote Pigou's 1920 book "The Economics of Welfare"

No "invisible hand" can be relied on to produce a good arrangement of the whole from a combination of separate treatments of the parts. It is therefore necessary that an authority of wider reach should intervene to tackle the collective problems of beauty, of air, and light, as those other collective problems of gas and water have been tackled.

Critiques of this perspective can be found all over the economic literature, but much of it is ignored in today's policy discussions. The authors identify 5 critiques and extensions of externality theory missing in current treatments of the subject: 1) the distinction between pecuniary and technological externalities, 2) the "invisible hand" as a generator of positive externalities, 3) the over-emphasis on negative externalities, 4) ignoring Coase's critique of Pigovian taxes as a solution to negative externalities, and 5) ignoring the potential for negative consequences of policy solutions to negative externalities. I'll discuss 2, 4, and 5 here and leave 1 and 3 to the interested reader.

Adam Smith's concept of the "invisible hand" is well known, if perhaps not well understood by most economists. (Pete Boettke recently wrote a great post on this subject.) McClure and Watts provide some helpful discussion on the subject:

The idea that "the market" generates positive external effects has been clearly articulated among a long line of economists, even though the term "externality" is often absent in their discussions. Since Adam Smith, economists have maintained that the use of scarce resources in ways that foster prosperity throughout society generally is the natural, but unintended, byproduct of economic interactions between individuals each pursuing his or her own self-interest.

I agree with the authors that Smith's concept of the invisible hand can be thought of as a positive externality. Boettke's post above also notes that Smith's concept is fundamentally about institutions, not about perfect information and other elements of individual rationality.

McClure and Watts provide some interesting discussion on Coase's critique of Pigou, focusing on Coase's concept of "reciprocal harm:"

To expose the weaknesses in Pigou's approach, Coase considered the reciprocal harm inherent in two conceptual experiments; in each the production of one economic good interferes with the production of other goods. 

Since both production processes in question produce economic goods, there is a trade off associated with taxing or subsidizing either process. In a previous post I discussed a column by Dierdre McCloskey in which she discusses a more important insight from Coase regarding externalities. In her characteristic style, McCloskey puts it this way:

Coase is forever saying that this or that proposal for a public policy entails knowing things that no economist can in fact know. He claims, with considerable empirical evidence, that in many cases laissez faire will be in practice better than what we will get from actual governments - though neither is perfect (we live in a second-best world, that is, a world of transaction costs). The methodological point is that Coase does not claim to have proven laissez faire on a blackboard. He says in effect, "If you look at the FCC or the lighthouses or the law of liability you see that governmental attempts to guide things minute-by-minute - as you say, Tom, 'getting the prices right'- don't work very well. Maybe it's better to just deal the cards and play. But in this veil of tears there are no guarantees. It may not work like some curves you have drawn. Life is hard. Knowledge is scarce. Grow up and admit that you can't extract policy from a couple of lines on a blackboard.

Finally, McClure and Watts discuss inframarginal or "irrelevant" externalities that can be relevant to policy decisions. The idea is that a policy designed to correct some problem with market allocations or prices may, on net, harm people if there is some positive externality "hidden" in a negative one.

For instance, when prices of basic necessities skyrocket during a natural disaster, policymakers might feel the need to outlaw "price gouging." However, such a prohibition on higher prices would reduce the incentive to bring in more of the necessities from areas unaffected by the disaster. Aid might come much slower than it otherwise would have.

The authors state the issue more generally:

Any policy that attempts correction of a negative externality while ignoring positive externalities in the form of inframarginal benefits, risks the possibility that corrective policy may impose welfare losses that could, if of sufficient magnitude, end up making matters worse than had the negative externality been ignored. 

The article is an interesting read so, as usual, I recommend reading the whole thing. There are of course many applications of these theoretical insights in agriculture. As the (vocal subset of the) public continues to emphasize the negative externalities associated with production agriculture, it will become more important to bring the insights of Coase, Demsetz, Buchanan, and others to bear.

Cooperation Between Environmentalists, Oil, and Agriculture

A recent Twitter conversation with the folks at the Property and Environment Research Center (PERC) pointed me to some interesting examples of cooperation between environmentalists and oil interests, farmers, and ranchers. Some of them involve artificial markets for conservation credits while others are simply payments to land owners to help preserve environmental amenities. I don't specialize in environmental economics but I think it's important to bring up theses issues from time to time on the Farmer Hayek blog. On a related note, I want to be clear that I don't take a position on these issues personally since I haven't studied them carefully.

One example concerns the decline of monarch butterfly habitat. A blog post last week at the Environmental Defense Fund gives the details: