Element 2.3: Sensible and Limited Regulation

“If you make 10,000 regulations, you destroy all support for the law.”

Government regulation looks like an easy way to achieve various goals, such as lower unemployment, higher wages for low-skilled workers, or removal of low-quality products from a market. When we think about what can be achieved with regulation, however, it is important to keep three points in mind.

First, competition is a great regulator. Open, competitive markets provide individuals and businesses with a strong incentive to supply others with goods and services they value because this is the source of higher income levels. Under these conditions, it is usually unlikely that regulation will improve the situation.

Second, regulation generates secondary effects that are often wasteful and at odds with intended objectives. In many cases, the secondary effects are directly opposite of the objectives stated by proponents.

For example, in the mid-1980s customs officials in Guatemala were permitted to waive tariffs if they thought that doing so was in the “national interest.” Such legislation is an open invitation for government officials to solicit bribes. It creates regulatory uncertainty and makes business activity costlier and less attractive, particularly for honest people.

Third, regulation reflects the political process, which generally favors business and other interest groups that are much better organized than consumers, taxpayers, and the general public. While proponents of regulation often argue they are seeking to achieve some noble objective, the truth is they are almost always seeking to use the political process to gain at the expense of others.

All of these observations are subject to one major caveat. In general, we have been discussing economic transactions as if they took place between a buyer and a seller, each of whom reflects their own best interests. What if what I buy from you impacts someone else who does not even know that we are discussing this transaction? These effects are called “externalities”. An externality can be either positive or negative. As an example of a positive externality, if my coworker gets a Covid vaccine, I am less likely to get sick. A negative externality will occur if my neighbor’s dog barks all night and I am unable to sleep.

Externalities create a complex issue for societies. Economist Ronald Coase established that in many cases nothing needs to be done. This is a somewhat complex argument but it is a good example of the power of economic logic. Consider the barking dog. Two people are involved, my neghbor who loves her dog and me, who loves my sleep. As long as the market is free, we can resolve the conflict between ourselves. If she values the barking more than I value my sleep, she can pay me money to put up with it or maybe go out and buy earplugs. If I value my sleep more than he values her dog’s barking, the reverse is true. I can pay her to stop the barking (maybe with a muzzle).

This Coase theorem only works, however, in limited situations. More complex ones do create a role for limited government regulations, usually when there are so many people affected on each side that the difficulties of getting to work together prove impossible. Consider the citizens of a country who would be willing, in the aggregate, to pay a sufficient amount to get a factory to reduce the pollution is spills into the air. The problem is: “how do you organize all of them to do this and reign in the cheaters who say “well, if everyone else is contributing, my little bit won’t matter!’”

In such cases there may be a case for collective (i.e. government) action. In an ideal world, governments collectively representing citizens would accurately evaluate costs and benefits to deal with large-scale problems such as pollution. Even in these situations, however, most economists favor pricing each unit of pollution (called a “negative externality") rather than passing rules. The reasoning is obvious. Once a price is set, say € a ton, factories can decide for themselves whether it is cheaper to clean up their emissions or pay the price. If the price set does not achieve the desired outcome, it is easy to raise or lower it. Profit maximization does most of the work.

Now consider an alternative. Perhaps a regulator decides how much pollution each factory can emit. How could it possibly know which factories would find it easiest to clean up their production? Without the massive information hidden in the market, inefficiencies must necessarily result.

Most regulations we are familiar with create more problems than they solve. Consider the impact of regulations that restrict entry into markets. Many countries impose regulations that make it difficult to enter and compete in various businesses and occupations. In those countries, if you want to start a business or provide a service, you must acquire a license, fill out forms, get permission from different bureaus, show that you are qualified, indicate that you have sufficient financing, and meet various other regulatory tests. Some officials may refuse your application unless you are willing to provide them with political contributions or pay them a bribe. Often, well-established and politically influential businesses that you would be competing against can successfully oppose your application.

Hernando de Soto, in his revealing book The Mystery of Capital, reports that in in the early 2000s in Lima, Peru, it took 289 days for a team of people working 6 hours a day to meet the regulations required to legally open a small business to produce garments. In an earlier book, The Other Path, he revealed that along the way, ten bribes were solicited, and it was necessary to pay two of the requested bribes to get permission to operate legally.⁽³⁴⁾

In 2020 the World Bank released a report on “Doing Business” in various countries around the world⁽³⁵⁾ that reported that the global average time to open a business has fallen from 52 days in 2003 to 20 days in 2019. This time required improved dramatically among countries at every income level and in every region of the world except North America, where it declined from already low 3.5 days in 2003 to 2.85 days in 2019. Last place in the league table is held, not surprisingly, by Venezuela, where legally opening a business would take 230 days. Top ranked were New Zealand and Georgia, where the process could be completed in half a day. Among post-communist countries the longest time to open a business was in Bosnia and Herzegovina, where 80 days were required. Post-communist countries have actually made great strides in ease of opening businesses, which takes around 14 days on average across the region as compared to 23 days in East Asia & the Pacific and 28 days in Latin America & Caribbean in 2019.⁽³⁶⁾

Moreover, when governments impose regulations that restrict market entry, existing businesses will push for additional regulations that will make it more difficult for potential rivals to enter the market. In turn, this reduction in competition will lead to higher prices and larger profits for the favored firms. It will also reduce productivity as businesses spend more time and money seeking government favors (for example, lobbying political decision-makers) and less time producing goods and services that people value. As a result, consumers are harmed and total output falls below its potential.

Regulations that interfere with voluntary exchange generally reduce the gains from trade, entrepreneurial discovery, and social cooperation. Price controls, mandated activities, and tariffs are examples. Consider how price controls affect the gains from trade. When the price of a good or service is set above the normal market level, buyers will purchase fewer units than they otherwise would. This reduces the volume of mutually advantageous exchanges, reducing trade. Alternatively, when prices are set below the market level, sellers will cut back on the quantity they are willing to supply, also causing the number of exchanges and the gains from trade to decline. Regardless of whether set above or below the market level, price controls will reduce the volume of trade and the gains from production and exchange.

Minimum wage rates are perhaps the most imposed price control throughout the world. A minimum wage rate establishes a price floor that pushes the hourly wage of some workers (and jobs) above the market level. Minimum wages are a hot issue in many European countries. Minimum wage practices in European countries vary significantly, reflecting the diverse economic conditions, labor market structures, and social policies across the continent. As of January 2024, minimum monthly wages across EU Member States varied widely, starting at €477 in Bulgaria and reaching up to €2,571 in Luxembourg.⁽³⁷⁾ In non-EU post-communist countries they are generally lower even in 2024, equaling €376 a month for a person Albania and €173 in Kazakhstan, still high, however, in relation to levels of productivity of the least skilled workers.

Mandating higher wages looks like an easy way to help low-skilled workers, but there are secondary effects. As the basic postulate of economics indicates, a higher minimum wage will mean less employment for low-skilled workers. There is some controversy about the size of the employment reduction, but the weight of the empirical evidence indicates that each 10 percent increase in the minimum wage will reduce the employment of affected workers by between 1 and 3 percent.⁽³⁸⁾ There will also be other unintended secondary effects.

Employers will take steps to control or compensate for their higher wage costs. These will include fewer training opportunities for low-skilled workers, less convenient work schedules, and smaller fringe benefits. Moreover, the higher minimum wage will increase the earnings of some workers to levels where they lose their eligibility to food, health care, and other transfer benefits, which means their incomes after taxes and transfers will increase less, and sometimes substantially less, than the increase in the minimum wage.⁽³⁹⁾

In essence, a minimum wage prohibits the employment of persons whose productivity is less than the minimum—that is, whose output does not justify the payment of the minimum wage. Is this a sound idea? Do we really want to deny persons with productivity less than the minimum wage the opportunity to work at all? This is precisely what minimum wages do.

To clearly see the harmful impacts of minimum wages, it helps to realize that these effects are not really captured by the number of workers are unemployed. Unlike what many people assume, official statistics in most countries require that a person not be working but actively be looking for work. Someone who is not working because the minimum wage required that they be paid more than their productivity is not called “unemployed.” They are, rather, a discouraged worker. Supporters of a higher minimum wage often argue that it will reduce the poverty rate by increasing the income of poor workers. At first glance, this appears to be true, but examination of the data indicates it is highly questionable. There are three major reasons why this is the case.

First, the vast majority of minimum wage earners are not in poverty. In the US about 80 percent of minimum wage employees are members of households with incomes above the poverty level; one-third live in households with above-average incomes. Half of the minimum wage workers are between the ages of sixteen and twenty-four years and most of them work part-time. Only one out of every seven minimum wage workers (about 15 percent) is the primary earner for a family with one or more children. Thus, the typical minimum wage worker is a single, youthful, part-time secondary worker in a household with an income above the poverty level.

Second, many of the minimum wage workers are also consumers of products impacted by the higher minimum wage. A minimum wage will likely raise the price of goods such as groceries and fast-food meals. These higher prices will, at least partially, offset workers’ gains from the higher minimum wage.

Third, many poor families do not have anyone in the labor force, and therefore a higher minimum wage will not help them unless the increase is great enough, after adjusting down for the welfare benefits they would lose if they got a job, to induce them to enter the labor force.

Consistent findings were reported by different scholars for European countries. For example, a paper about Germany concludes that introducing a minimum wage could lead to fewer job opportunities for low-skilled workers.⁽⁴⁰⁾ The study "The Economic Impact of Minimum Wages in Europe" analyzed the effects of minimum wages in seventeen European countries. The research found the evidence that minimum wages reduce employment of young workers.⁽⁴¹⁾ Post-communist Russia provides an interesting laboratory to study the effects of minimum wages. In 2007, the country more than doubled the federal minimum wage (and increased it even more in some regions). Results suggest that this caused a decrease in employment of young people, some of whom took jobs in the informal (underground) economy while others simply dropped out of the labor force.⁽⁴²⁾

When we think about the effects of the minimum wage on youthful low-skilled workers, it is important to consider the impact in both the short and long runs. Work experience provides youths with opportunities to develop self-confidence, good work habits, valuable skills, and positive attitudes, making them more valuable to future employers. Unless young people can prove their value to employers and develop on-the-job skills, it is unlikely that they will be able to move up the job ladder and realize higher earnings in the future.

Even when a worker receives a pay increase because of a higher minimum wage, they may not actually be better off. Employers need the value added by a worker to be at least what they pay their workers. If forced to raise wages, they can cut back on other, non-regulated parts of the worker’s job. Breaks could become shorter, the assembly line could be sped up a bit, contributions to a retirement plan be reduced. Perhaps the most damaging impact of all is that employers will not invest in increasing workers’ skills. If the employer provides costly training that increases productivity in other firms, they can only recover their costs by paying workers less than their productivity while they are being trained. This means that the worker’s compensation (their wage plus the value of the training they are getting which will enable them to earn more in the future) will be equal to their current productivity.⁽⁴³⁾ This inability to provide the training that would enable workers to get promoted and earn more over time condemns some workers to a “dead end job”.

The value of work experience and skill development is widely recognized in the case of college students. Members of Congress provide college students with low-wage employment and even unpaid internships, recognizing this experience helps them develop skills and generate higher future earnings. Ironically, however, these same politicians support minimum wage levels that reduce the on-the-job training opportunities available to less-educated youths. The adverse impact of minimum wages on apprenticeships and other training opportunities for youths with less education is almost always ignored by minimum wage proponents, including the members of legislatures who institute them. Nonetheless, this is an important adverse secondary effect of minimum wages.

Many countries also impose other labor market regulations that undermine economic growth. Dismissal regulations are an example. In a number of European countries, employers who want to reduce the size of their workforce must (1) obtain permission from political authorities; (2) notify the employees to be dismissed months in advance; and (3) continue paying the dismissed employees for several months after they leave. Employment restrictions on migrant workers, particularly in some Asian countries, are notable examples. An International Labor Organization 2019 report⁽⁴⁴⁾ highlights that these restrictions, by increasing recruitment costs, often result in labor shortages in sectors like construction and agriculture. This, in turn, hampers productivity and economic growth.

Such regulations may appear to be in the interests of workers, but the secondary effects must be considered. Regulations that make it costly to dismiss workers also make it costly to hire them. Employers will be reluctant to take on new workers because of the high cost if they turn out to be unsatisfactory or unnecessary. As a result, jobseekers, especially entry-level workers, will find it difficult to find jobs, and the overall growth of employment will be slowed. In European countries, where restrictive labor market regulations are more pronounced than in the United States, the unemployment rates of Western European countries such as Italy, Spain, and France have been, on average, 4 or 5 percentage points higher than in the United States during the past couple of decades.⁽⁴⁵⁾ Research by Steve Hanke at Johns Hopkins University has found that between 2010 and 2015 unemployment rates in EU countries with mandated minimum wages were up to 50 percent higher than in those EU countries without mandated minimum wages.

Although hiring and dismissal regulations are generally less restrictive in the United States than in Europe, occupational licensing is a major labor market restriction in the United States. Most of the occupational licensing occurs at the state level. To obtain licenses, people pay fees ranging from modest to exorbitant, complete training courses of six to twelve months, and pass examinations.

As recently as 1970, fewer than 15 percent of Americans worked in jobs that required a license. Today, the figure is nearly 30 percent, and it is continuing to grow. In the mid-1980s, 800 occupations were licensed in at least one state. By 2023, according to the Council on Licensure, Enforcement and Regulation, more than 1100 occupations are regulated in at least one state. A national study of burdens from occupational licensing identified 2700 licenses across 50 states and the District of Columbia in 2022.⁽⁴⁶⁾ Recent studies find that approximately 22 percent of workers in the European Union are subject to occupational licensing requirements, although the number and impact of such requirements varies greatly across member countries, with Germany leading the pack at 33 percent. It has been estimated that licensing reduced employment in related industries in the EU by approximately 700,000 jobs in 2015. The same study also found that the above-market wages associated with restrictive licensing contributes to income inequality within the EU.⁽⁴⁷⁾

The supporters of licensing argue that it is necessary to protect consumers from shoddy and potentially unsafe and unhealthy products. But licenses are required in numerous occupations that have little to do with public safety or protection of the consumer.⁽⁴⁸⁾ For example, one or more US states require licenses to work in the following occupations: interior designer, makeup artist, florist, barber, hair braider, shampoo specialist, athletic trainer, tour guide, auctioneer, potato dealer, casket seller, ferret breeder, and palm reader. The pressure for licensing seldom originates from consumer groups. Instead, it nearly always arises from those business owners already in the occupation who are trying to protect themselves from competition.

In many of these licensed occupations, individuals could acquire the skills necessary for high-level performance through on-the-job experience and working with others skilled in the trade. The licensing requirements prohibit persons from developing their skills via these methods and pursuing their desired career. Licensing, particularly when it mandates lengthy formal training and levies expensive fees, reduces supply and drives up the price of the goods and services provided by the licensed practitioners. Those currently in the occupation gain at the expense of consumers and unlicensed potential producers. Some research has even found that convicts who have completed their sentences are more likely to reoffend in states that have greater licensing requirements, presumably because they find it hard to get jobs.

An alternative to licensing is certification. With certification, the government can require suppliers to provide information about their education, training, and other qualifications to consumers without prohibiting anyone from working in his or her chosen field. In essence, certification makes information about the suppliers’ qualifications readily available to consumers but does not restrict their choices. Furthermore, it allows practitioners to develop and demonstrate their competence, while still providing information consumers can use to make informed choices.

Regulation is a breeding ground for cronyism, political favoritism, and even corruption. Proponents of regulations restricting competition often use health and safety protection to obfuscate their real motivations. For example, thirty-five states and Washington, DC, have Certificate of Need regulations. These rules require those who want to start new hospitals, clinics, and other healthcare facilities to convince state boards or commissions that current providers cannot supply the quantity of health services demanded. Existing firms are permitted to argue that this is not the case. Similarly, regulations prohibit American consumers from purchasing prescription drugs from Canadian sellers even if the same drug is priced lower in Canada. Regulations of this type undermine both market competition and the confidence of citizens in the political process.

For example, The European Medical Device Regulation (EU MDR), a new set of regulations that govern the production and distribution of medical devices in Europe, was subject to concern within the medical device industry. Although the new regulation of medical device law at European level probably brings more safety for patients, it also leads to longer waiting periods for new drugs innovative products.⁽⁴⁹⁾ Critics argue that these regulations impose burdensome requirements that could slow down innovation, limit the availability of medical devices in the EU market.

The process for approving new pharmaceuticals and introducing them to both the EU and the US has faced criticism for being overly lengthy and complex. While it is often claimed that drug approval is slower in the United States compared to the EU, some research suggests that medications actually become available to the public faster in the U.S. than in EU.⁽⁵⁰⁾ In either case, seriously ill patients who would willingly undertake any risks involved are denied care they want and need. One study by researchers at the University of Ottawa who studied 21 cancer drugs approved between 2001 and 2015 found that worldwide 1 life was lost for every 12 seconds of delay.⁽⁵¹⁾

To the uninformed, regulation often looks like an easy way to solve problems. Want higher wages? Increase the minimum wage. Want a lower unemployment rate? Pass laws making it harder to fire workers. Want higher earnings in an occupation? Restrict the entry of those job seekers willing to work for lower wages. But these simplistic policies do not enhance society’s total production and they ignore the secondary effects. As we have pointed out, mutually advantageous trade and competitive markets encourage low-cost production and discovery of better ways of doing things. They encourage us to obtain more value from our resources. Thus, regulatory policies that impose roadblocks against trade and entry into markets will almost always be counterproductive. If a country is going to grow and prosper, it should minimize regulations of this type.

The discussion so far has presented the choice between market and government mechanisms for dealing with externalities as a stark contrast between two alternatives. Actually, there is often a middle road. When the groups affected by externalities are relatively small they can negotiate agreements to reduce or eliminate externalities among their local community without government action. Indeed, in 2009 Elinor Ostrom became the first woman to win the Nobel Prize in economics for documenting such understandings in many different situations across the globe.