The Republican Retreat From Market-Based Regulation

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August 14, 2017

During the debate over the repeal of Obamacare, Republicans made frequent reference to their desire for a “free market” for health care. This is consistent with the GOP’s long-standing support of deregulation and free market principles.

But all well-functioning markets are regulated to one degree or another. Consider, for example, an important set of regulations we mostly take for granted, weights and measures. When we, for example, fill up our cars or buy fruits and vegetables using a scale at the grocery store we have assurances we will get what we are promised.

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 Without these regulations, the market would regulate itself to some degree. Presumably “cheats” would be driven out of the market as information about their business practices spread. But there would be some transactions where consumers would have no choice but to trust someone they are unfamiliar with and perhaps be cheated, or be forced to take the time and trouble to verify that they are getting what they pay for. In many cases, the risk of being cheated and costly verification will stand in the way of the transaction happening at all.

All of these costs – transactions that could happen but don’t, the time it takes to ensure you aren’t being cheated, and people being forced to carry around scales and other equipment to verify weights and measures – make these markets less efficient. Imagine the cost involved, to take just one example, if farmers had to find a way to double check truck scale weights each time they bring their crops to processors.

The point is that government regulation does not always hinder market performance. There are times when regulation improves market efficiency. Contract law, truth in labeling, enforcement of property rights, information disclosure requirements, antitrust, and other ways markets are regulated help to overcome market failures that waste valuable resources.

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Thus, though it is often posed in this way, the choice is not between free or regulated markets. Some degree of regulation is needed even if in many cases it does not go beyond the standard legal and institutional structure that all markets need to function effectively. The question is how much regulation a particular market needs and what type of regulation will work the best.

Many types of regulation can be separated into two categories. The first, command and control, is when the government issues broad-based edicts requiring, say, every firm to hit a particular pollution target. But the costs of reducing pollution differ across firms. Instead of having each firm reduce pollution by an equal amount a more efficient way to achieve a particular level of pollution reduction is for firms with the lowest cost of abatement to reduce pollution more than those with higher costs.

It would be difficult for the government to identify which firms have the lowest abatement costs, how much extra pollution these firms should be burdened with, and how much they should be compensated for their efforts via transfers from firms with high abatement costs. This is the problem the second type of regulation, market-based regulation, attempts to solve.

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With this type of regulation, the government sets a desired goal, such as an amount of pollution reduction, and then uses instruments such tradable pollution permits to exploit the ability of markets to minimize costs. In a tradable permit system, for example, the firms with the lowest pollution abatement costs can reduce their pollution by more than required, and then sell their leftover pollution permits at a profit to firms with higher costs. The overall reduction in costs enhances efficiency.

This principle of setting a goal, and then using market mechanisms to achieve it was originally a Republican innovation. It’s an approach that was first implemented during the Reagan years when a cap-and-trade system was used to reduce and then eliminate leaded gas. Later, George G.W. Bush used a cap-and-trade system to reduce acid rain levels by approximately 50 percent.

This was a time when Republicans recognized the need to regulate some markets, and the introduction of market-based mechanisms was a way to influence the form that regulation would take. At first, Democrats were skeptical of the free market approach, but over time both the theoretical superiority of market-based regulation and the successful real world outcomes led most Democrats to endorse this type of regulation. The market-based approach is, for example, the foundation for the regulations surrounding Obamacare. Unfortunately, as Democrats moved towards this type of regulation Republicans moved away, and today, many in the GOP are reluctant to admit that regulation is needed at all.

The correct amount of regulation is difficult to determine. A difference of opinion across party lines about how much regulation a particular market needs is to be expected. However, both Republicans and Democrats ought to be able to agree that many markets, health care and financial markets for example, suffer from important and obvious market failures. They ought to be able to agree that some regulation is necessary and desirable. But so long as Republicans pretend that free markets are always best, there’s little hope of that happening.

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