Regulation has attracted more than a few posts as of late, and with good reason. The last few years have brought one of the greatest regulatory failures of the past century, Congress and the administration are in the process of producing the greatest regulatory expansion since the 1970s, and now the catastrophic situation in the Gulf of Mexico.
The standard take on regulation is simple: government regulates to address the various forms of market failure (e.g., informational asymmetries, the failure of firms to act as price-takers, negative externalities, transaction costs, public goods, etc.). However, as Charles Wolf and others remind us, the market and the state are imperfect alternatives. Every attempt to address market failure introduces the potential for government failure. Each has its costs and benefits, and a prudent person should carefully weigh them rather than assuming ex ante that government solutions are superior to imperfect markets.
I am a bit skeptical of the positive theory of market failure for reasons that are beyond this posting (in essence, I find the market-state dichotomy on which it is premised to be highly suspect given the role of law and public institutions in constituting the economy). Nonetheless, informational asymmetries, negative externalities, etc., do provide compelling justifications for regulation (the real challenge is finding the most appropriate regulatory instruments).
That being said, I would like to highlight an additional role for regulation: it can induce economic actors to exercise some “enlightened self-interest” and engage in higher levels of self-regulation.
Some regulatory analysts note that corporations work under a regulatory warrant (i.e., what is permitted by laws and regulations) and a social warrant (i.e., what is permitted by a broader set of stakeholders). If corporations violate the social warrant, they may find themselves subject to a stricter regulatory warrant. Highly salient crises can lead to an expansion of mandatory regulations. Many corporate managers understand this and, as a result, often go “beyond regulation,” seeking to nurture their reputations and protect their social warrants.
Consider the following example. Following the tragic Union Carbine chemical release in Bhopal India, the chemical industry began a concerted effort at self-regulation in the hope of forestalling more significant mandatory regulations. The result (Responsible Care) began relatively weak, but evolved rapidly into a global set of management standards. A similar story can be told in other industries (e.g., nuclear energy, wood and paper production).
For effective self-regulation to occur, it seems necessary that there be some association committed to managing the industry’s reputation as a collective good and willing to eject members for failure to comply. At the same time, regulation (or the threat of regulation) seems imperative to force industry to make the investment in self-regulation.
In the past decade or two, some scholars have concluded that market forces are sufficient to force higher levels of corporate responsibility. To the extent that pollution is a form of waste, for example, the elimination of waste streams can provide cost-based advantages. To the extent that consumers value environmentally friendly production, firms can claim differentiation-based advantages. This may be true for some firms, but I am skeptical that market forces are sufficient when taken by themselves.
Although many libertarians discount the need for regulations (after all, “didn’t Coase show…”), they may play a positive role in creating inducements for greater self-regulation, thereby forestalling a more direct form of regulation that could prove pernicious on a number of grounds.
One can only hope that, as the recent debacle in the Gulf of Mexico focuses attention on an expansion of regulations, the petroleum industry will respond by dramatically enhancing its self-regulatory capacity. I remain somewhat mystified that the American Petroleum Institute and the International Petroleum Institute have not developed a more coherent set of responses to every potential contingency and developed rapid response teams with easily deployable equipment to ensure that when accidents occur (as they inevitably will), they will not do undue damage to industry reputation. Hopefully, this recent disaster will help the industry better understand the concept of enlightened self-interest.