Prof. Bryan Caplan
I. Recap: Problems with Markets
A. In the first 10 weeks, we identified a number of problems with free markets:
1. AC pricing instead of MC pricing prevails in many (most?) real-world cases. (A)
2. Most efficient firm can price just below MC of second most efficient firm. (I)
3. Externalities lead to too little of some activities and too much of others. (I)
4. Intellectual property rights and other incentives for innovation don't work perfectly (still some free riding), and are inconsistent with MC pricing. (I)
5. Markets may be unable to solve coordination problems. (A, K)
B. Are these problems of ability, knowledge, or incentives?
C. One natural way to try to improve upon free markets is through regulation. Retain private ownership, but use "stick and carrot" to correct the problems of markets.
D. Examples of regulation:
3. Price controls
4. Quality controls
II. Ideal Regulatory Solutions to the Problems of Markets
A. Recall that ideal regulation assumes away any problem of incentives. Politicians and bureaucrats are simply assumed to have the sole desire to increase efficiency.
B. Could ideal regulation correct any of the problems of markets? Maybe.
C. Ability Problem #1: Many kinds of regulations necessarily increase inefficiency.
1. Price controls in a competitive market. (Reduces gains to trade; also, lobbying turns transfers into costs).
2. Mandated benefits/quality/safety (If consumers were willing to pay the extra costs, the market would already provide it).
D. Ability Problem #2: Even ideal regulation always costs something (often a lot): direct cost of maintaining agencies, paying regulators; indirect costs of reduced productive efficiency and higher fixed costs.
1. Question: What is the impact of higher fixed costs on the number of firms in an industry?
E. Ignoring these costs, there are ideal regulatory solutions to the 5 problems of free markets listed above.
1. Subsidize firms to permit MC pricing.
2. Offer to subsidize inefficient firms. This can actually be a free lunch: as long as the MC of the second-best firm minus its subsidy is still more than the MC of the first-best firm, prices fall but no subsidy actually has to be paid!
3. Optimally subsidize activities with positive externalities and optimally tax activities with negative externalities.
4. Get rid of intellectual property; replace with government prizes for innovation equal to the full social value of innovation.
5. Have government issue order (with penalties for non-compliance) to switch to efficient technology.
6. Have government issue licenses to eliminate excess variety, and pay subsidies to correct for insufficient variety.
F. Some problems with these ideal regulations:
1. Subsidies, prizes, etc. have to be raised by taxation, which also creates allocative inefficiency. (A)
2. Hard to know what MC of firms is. (K)
3. Very hard to know what the optimal subsidy or tax is.
4. Very hard to know the "full social value" of an innovation. (K)
5. Hard to identify efficient technology. (K)
G. General conclusion: Often even ideal regulation can't improve upon laissez-faire.
III. Real Regulation and Politicians' Incentives
A. Real regulation faces all of the problems of ideal regulation, plus the incentive problem.
B. What do politicians and bureaucrats have the incentive to do? In particular, why would politicians and bureaucrats use their powers to solve the problems of markets, when they could instead use their problems to gain political support and wealth for themselves?
C. But: if politicians are democratically elected, won't it be in the self-interest of politicians to only do things that benefit most people?
IV. Why Politicians Have Bad Incentives, I: Public Choice Theory
A. Public Choice Theory claims that democracies mainly give politicians incentives to benefit special interests, not the majority of voters.
B. The case of the sugar subsidy: it pays the sugar interests to be informed, but not the general public.
1. If you are the special interest, what is the marginal benefit of extra lobbying for e.g. a sugar subsidy? Possibly huge; your effort may make a big difference to you.
2. If you are a random citizen, what is the marginal benefit of extra lobbying against the sugar subsidy? Effectively zero: your effort won't make a difference.
C. "Rational ignorance": in any election with a reasonably large number of voters, the probability that you will cast the decisive vote is so low that it isn't worth gathering information.
D. The general pattern: Concentrated benefits, dispersed costs yield strong incentives for politicians to do the wrong thing.
E. Ex: Regulatory capture. Regulatory bureaus often work in the interests of regulated industries, with a "revolving door" between public and private employment.
F. Moreover, once regulators have "prizes" to give out, people lobby to get the prizes. As seen in Part I of the class, the end result of competitive lobbying can be to waste resources equal to the prize being awarded.
1. Ex: Litigation.
V. Why Politicians Have Bad Incentives, II: Rational Irrationality
A. People often don't like thinking rationally about problems. They often find it more comfortable to believe whatever they feel like believing.
B. The demand for irrationality slopes down: the cheaper it is to be irrational, the more people "buy."
C. The marginal cost of voting irrationally is zero, so people buy a lot of irrationality in politics. The same thing happens either way, so why not feel good about it?
D. Ex: Protectionism.
E. This makes politicians' incentives even worse, since they can do well by satisfying the demand for willful irrationality.
VI. Interest Groups or Voter Irrationality?
A. Politicians' incentives are shaped by both lobbying of special interests that take advantage of rational ignorance, AND rational irrationality. ("Bootleggers and Baptists")
B. Real regulation bears little resemblance to ideal regulation, because real regulators have totally different aims than ideal regulators. They often have incentives to make the market less, not more efficient.
C. "The tyranny of the status quo." Once a regulation is established, classes of beneficiaries arise that resist reform and constantly push for expansion: lawyers for both sides, regulators, liasons, expediters, etc.
D. Rational ignorance or rational irrationality?
1. Price controls.
2. Monopoly privileges for inefficient producers and political allies.
3. Banning or restricting risk-adjusted insurance premiums.
4. Prohibiting drugs until proven "safe and effective."
5. Banning low qualities.