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Rationality and regulation

September 3, 2009

Often, people will try to assume away human motivation. Simply because someone does something (you perceive as) unethical, does not mean they are acting irrational. The incentive structure that makes it possible could be called “irrational,” (each case would require some analysis) but not  necessarily the act itself.

Rationality (from an economist’s perspective) is pursuing one’s goals in a manner congruous with what one knows (or thinks one knows) about the world. Naturally this requires balancing a lot of different goals, so people will act along the margin (though imperfectly).

Regulators and politicians are human beings (I think that’s a safe assumption). As such they have cognitive limitations, as well as hopes and dreams independent of the hopes and dreams of voters (though there is some natural overlap). They also have inherent biases (such as a belief that they have more power to affect outcomes than they really have).

This line of thought is important. We can’t count on perfect regulation, just as we can’t count on perfect competition.

And our government has a great deal of power (I’m going to play around with some numbers in a less than scientific way, my results will not be very accurate, but the point will be demonstrated). The Forbes 400 list of the 400 richest Americans is worth a combined $1.57T, with a net worth of $1.3B to get onto the bottom of the list. If we assume the next 135 are worth $1.3B, we get $1.75T in the hands of as many people as congress. Keep in mind, this is their net worth, not their spending money. Congress, on the other hand, spent about $3T in 2008. Congress is also able to pass laws that can instantly alter the property rights (and hence net worth and economic power) of American citizens. The total control that congress has is enormous! Although their ability to use that power is constrained by laws and political consideration, the fact remains, this is a group we should be far more afraid of than plutocrats.

Many people expect and count on perfect regulation, but that is naive, to say the least.

Unintended consequences can be a big problem.A classic example is the rise of SUVs with the CAFE standards. Suddenly station wagons couldn’t meet government standards without giving up features that consumers wanted (like enough power to get up a hill with a car full of kids) and so manufacturers had to substitute toward SUVs resulting in more emissions than before. Better regulation might have solved that problem, but it didn’t. We can’t count on perfect regulation, just as we can’t count on perfect competition.

Regulation has costs (for government and the market… which has to pay for the government). It also has risks (such as corruption, or bad regulation). If the real costs exceed the real benefits, we should not want it. I don’t believe that it is usually the case that the benefits outweigh the costs.

The closest I think we have to a “perfect regulation” is “Don’t steal!” I think that’s a pretty good rule.

They also have inherent biases (such as a belief that what they do is more valuable than it really is).
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