It is common for politicians and media writers to speak of a dichotomy between free markets and government regulation. Proponents of free markets argue that they create economic opportunities and generate efficiency in the overall economy. Those favoring government regulation believe it creates economic fairness, worker rights, or environmental protection. The reality is that the ideal of free markets is misleading and there is no simple dichotomy between markets and government regulation.
Markets and the economic outcomes they create are always shaped by the rules set by society and the way those rules are enforced. Economics is much like sport. If you want to explain outcomes of games or the economy you need to know what the rules are and how those are going to be enforced. Say your team’s quarterback likes to throw footballs with lower air pressure and your rival’s quarterback prefers throwing footballs with higher air pressure. The rules about what the football air pressure should be and how those rules are enforced will give advantage to one team or another. The same applies to markets.
If small businesses get an income tax break for the purchase of new vehicles, then the sales of pick-up trucks and vans will increase – benefit to the auto companies who specialize in these vehicle types. If labor laws make it hard to organize unions or allow workers to opt out of paying dues when there is a union — benefit to the companies with large numbers of workers. If you have an import business with ties to Brazilian sugarcane producers, you are disadvantaged by import duties on ethanol designed to favor American corn-based ethanol. This is the reality of the American market economy. Statutes, rules implementing these statutes, and their enforcement all matter for the outcome of markets. There never have been free markets.
The obvious effect of this reality is to encourage firms and individuals to find ways to affect the laws and regulations that are most important to their personal circumstances. Economists call this rent seeking behavior. The idea of rent is that when you are successful in getting the market rules to favor your circumstance you will earn more money, a rent, then you would have otherwise. The rent is the premium caused by rules in your favor. In the extreme this results in what The Economist magazine calls Crony Capitalism. When rents are generated through manipulation of regulatory processes, economists sometimes call this regulatory capture. In the early 1980s I worked on milk price regulation in Maine and I was witness to the ongoing process where milk producers, processors, and retailers all worked to shape regulations to favor their individual business positions. They tried to capture the regulatory process to generate rents for themselves or to preserve rents created in earlier regulatory processes.
Rent seeking is not always obvious. Effective rent seeking behavior is often couched in terms of the public interest. It is not very compelling in either legislative or regulatory processes to argue for rules of the game because they help my firm or industry prosper. Rather, the goal is to argue that rules generate public benefits. For example, in the 1970s makers of catalytic converters for automobiles were strong proponents of stricter, technology-based auto emissions standards. This sold more catalytic converters. Renewable energy companies used the promise of reduced greenhouse gas emissions to promote market rules to generate rents for them, even when the positive environmental effects are minimal at best. And hedge funds and supposed investors got Maine to establish its New Markets Capital Investment program with the promise of job creation. The results, large rent payments to the firms behind the legislation yet no new jobs for Mainers.
The rules of the game matter and the outcomes of markets are defined by those rules. When we hear that a proposed new law or regulation will create jobs, protect the environment, generate new and better energy supplies, or otherwise promote the public interest, we should be wary. The first question to ask is, how does the proposal change the rules? The second question is, who are the winners and losers? Then we can make better judgements about the policy.