Marginal Returns of Regulation – Econlib

On this post by Kevin Corcoran, frequent commentator Steve writes:

One might be willing to dismiss Steve’s comment for falling prey to the Bandwagon Fallacy. Such a dismissal, however, would be inappropriate for two reasons:

First, just because an argument contains a logical fallacy does not imply the argument is incorrect. Indeed, such a dismissal would in and of itself be fallacious. It’s called the Fallacy Fallacy.

Second, Steve’s comment mirrors one frequently made by economists, namely that if there were a better way to do something, people would be doing it. It’s the oft-told “$20 bill on the sidewalk” joke. In this joke, two economists are walking down the street. One spots a $20 bill on the sidewalk. As he bends over to pick it up, his friend stops him. “There can’t really be a $20 bill on the sidewalk,” the friend says. “If there were, someone would have already picked it up.” The economist nods sagely, and the two continue along their way. 

This is, of course, a joke. It highlights the absurdity of taking models literally, but there is truth in it. If there are profit opportunities and they are obvious, then they will be snatched up quickly. A genuine profit opportunity is difficult to find. That’s one of the reasons why so many businesses fail. The argument is important but subtle (in a different post, Kevin does an excellent job discussing the subtleties of the argument), and it is a rule of thumb—it is not always and literally true. Profit opportunities do exist and some of them are quite large. Furthermore, failures do exist, preventing those mutually beneficial trades from being consummated (more on this point below). But it’s a useful starting point.

As I read Steve’s comment, he is making a similar argument. If heavy health care regulation were so bad, why do the wealthiest countries regulate so heavily? If governments want to improve health care, wouldn’t they choose the mix of regulations that is optimal? These are good questions. 

Whenever I think about things from an economic perspective, I start with the assumption that the present state of affairs is efficient (my null hypothesis, if you will). That is to say, I start with the assumption that all profit opportunities have been eaten up and, at least at the present time, there are no failures in the market. Then I consider how likely it is that such an assumption is an approximate representation of reality. That is where methodological individualism and the economic way of thinking come in. 

One of David Henderson’s 10 Pillars of Economic Wisdom is that incentives matter. Incentives are not mind control, of course, but they do shape people’s behavior. One of the key assumptions behind the $20 bill story is that the market provides the incentive for people to find those bills. In a market system, where the benefits are (largely) kept by those who create value, it incentivizes people to seek out those benefits. In other words, being allowed to keep profits incentivizes profit-seeking behavior.

Legislators and regulators do not face the same economic incentives. No matter how well-intentioned their actions are, they do not enjoy all (or even most) of the increased value produced by a well-regulated health care system. Cost-savings do not increase their bottom line. Efficiencies only help them insofar as their personal care improves. Even ignoring knowledge problems, there is no economic incentive for regulators to choose a mix of regulations that optimizes health care outcomes. Thus, it is not necessarily the case that the current mix of regulations is optimal, even if everyone is doing it. 

Indeed, there are often incentives for regulators and legislators to keep poor regulations in place, even if they acknowledge the regulation has failed in its goal. The regulations created jobs to fix the problem, which means that if a regulation has failed to solve a problem, there are benefits to responding with more regulation. Rarely do we get repeal-and-replace, but rather new regulation tacked on over the old, often creating contradictions (that are then fixed with more regulation). Eventually, the regulatory system lacks any sort of coherence. This is especially true of the health care industry in the United States, where there are so many rules and regulations that contradict each other. It’s less a body of regulation and more like a chimera.

There is another issue, which we might call diminishing marginal returns from regulation. The law of diminishing marginal returns is a scientific law in economics that states: all else held equal, each additional unit of input (or consumption) brings less output (or benefit) on the margin than the previous unit. 

The late, great Ronald Coase pointed out a similar pattern with regard to regulation. In a 1997 interview with Reason Magazine, Coase stated:

It’s probable we are past the point of diminishing marginal returns in health care regulations. The optimal level of regulation in health care is likely not 0, but it is also not likely to be the approximately 50,000 federal regulations we have (as of 2018). Initially, health care regulations likely had a significant positive effect on outcomes (that is, the benefits of the regulation outweighed costs). But, given the discussion of incentives above, one can reasonably argue that we (and indeed all major countries, since they also face the same incentives) are overregulated. Since the regulators do not face the costs of the regulations but enjoy benefits, they face the incentive to keep adding more, even if the net cost is negative. There are likely regulations we could remove that would improve health care outcomes.