Wednesday, March 23, 2011

The Importance of Regulation

Currently there is a major push by Congressman Darrell Issa to examine how government regulation affects economic activity.   There is no question that government regulation affects the cost of running a business.   However, those who believe that elimination of regulation is a good idea need look no further than the unregulated Japanese nuclear power industry, and poor regulation of oil drilling in the gulf, and the financial meltdown that caused the great recession.   In all three cases, the relaxation of regulation reflected the problem of dealing with rare but expensive risks.  

The importance of dealing with risk is recognized by many economists, most notably Richard Posner, a conservative economist and judge who recently wrote:

If the probability of loss is high, strenuous efforts will be made to avert it or mitigate its consequences. But if the probability is believed to be very low, the proper course to take will be difficult, both as a matter of sound policy and as a political matter (to which I return in the last paragraph of this comment), to determine and implement. The relevant cost is the catastrophic loss if it occurs discounted (multiplied) by the probability of its occurring. If that probability is believed to be very low, the expected cost may be reckoned to be low even if, should the loss occur, it would be catastrophic. And if the expected cost is low but the cost of prevention is high, then doing nothing to prevent the risk from materializing may be the optimal course of (in)action

The key here the "perception of risk."  The perception of risk is key as there are many factors that cause us to downplay or overplay the risk of an event.   For example, if preventing aheart attack requires a major change of diet that one does not want to make, no amount of prodding from a doctor or previous heart attacks, may cause the person to change.  Richard Posner goes on to explain the issue of risk perception for politicians

It would not be surprising, however, if as seems to be the case Japan failed to take cost-justified measures to minimize the damage from a 9.0 or greater earthquake. Politicians have limited time horizons. If the annual probability of some catastrophe is 1 percent, and a politician’s horizon is 5 years, he will be reluctant to support significant expenditures to reduce the likelihood or magnitude of the catastrophe, because to do so would involve supporting either higher taxes or a reallocation of government expenditures from services that provide immediate benefits to constituents. In principle, it is true, politicians would take a long view if their constituents did out of concern for their children and grandchildren. But considering how the elderly cling to their social benefits, paid for by the young including their own young, I doubt the strength of that factor, although I do not know enough about Japanese politics to venture a guess on whether politicians’ truncated policy horizons was indeed a factor in Japan’s surprising lack of preparations for responding promptly and effectively to the kind of disaster that has occurred.

The industries in the United States that face the greatest level of regulations, those in mining, construction, chemical, oil and gas, transportation of hazardous materials, and nuclear power, as well as the provision of health care, medical supplies, drugs and equipment. All are examples of industries that face the risk of rare but spectacular catastrophes.  

As the House Government Reform and Oversight Committee looks at government regulation, they need to look at the Japanese example of an unregulated market in an industry that has rare but catastrophic risks.  As Judge Richard Posner notes the U.S. and not Japan has an independent Nuclear Regulatory Industry.   Before condemming all regulations, it is worth looking at what happens when effective regulation does not exist. 

.  It is not enough to look at the cost to the firms involved of regulation but it is imporatant to determine if the regulations would argue impose costs that are less than the expenses associated with losses the regulations are designed to prevent.

No comments: