The Extent of the Market is Limited By the Imagination of the Regulators

Adam Smith begins Book I, Chapter I of An Inquiry into the Nature and Causes of the Wealth of Nations by pointing out that “(t)he greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is any where directed, or applied, seem to have been the effects of the division of labour.” He begins Book I, Chapter II by pointing out that “(t)his division of labour, from which so many advantages are derived, is not originally the effect of any human wisdom, which foresees and intends that general opulence to which it gives occasion.” Finally, Book I, Chapter III is titled “That the Division of Labour is Limited By the Extent of the Market.”

More extensive markets mean a finer division of labor and, in turn, general opulence. The extent of the market, unfortunately, is limited by the imagination of the regulators. When entrepreneurs have to ask people for permission to innovate, they are limited to what the regulators can understand or at least imagine. Government regulation doesn’t exactly lend itself to real novelty, nor does it lend itself to seemingly strange cultural transplants. I have spoken with several entrepreneurs who have had rocky experiences trying to get health officials to sign off on products that don’t fit easily into categories the regulators understand. Efforts to require natural hair braiders to get cosmetology licenses are famous examples. Crackdowns on or sluggish approval of innovative foodstuffs are another.

There is a cruel irony in all this. It turns one of the usual and most plausible arguments for government regulation on its head. According to this view, asymmetric information means governments should step in and protect consumers from unscrupulous producers. Sellers have more information than buyers, and this asymmetry means a lot of potentially beneficial trades might not be made. Marc T. Law explains the economic history in this article for the EH.net Encyclopedia of Economic History. 

The argument for regulation gets considerably weaker when the regulators themselves don’t actually know what the product is. Regulatory roadblocks on fermented foods are a product with which I have a bit of personal experience. Incidentally, it speaks volumes about business and the legal/regulatory environment that one of the tracks at the 2021 International Fermentation Conference is “Business, Legal, and Regulatory,” where participants can “Learn how to launch and grow a fermentation business, and navigate the industry’s legal and regulatory hurdles.” As John W. Dawson and John J. Seater explain in a 2013 article in the Journal of Economic Growth, regulation has slowed economic growth considerably.

The regulatory state substitutes the knowledge and beliefs of regulators for the knowledge and beliefs of entrepreneurs and innovators. This means entrepreneurs and innovators have to divide their time between actually developing their product and convincing regulators to say “yes.” Regulators are understandably overcautious because of their incentives. Approving an unsafe product is a mistake, but so is failing to approve a safe product. The first mistake is a lot more vivid and visual. As for the second mistake, a lot of people might not know what they are missing and likely will not miss what they never had to begin with. I doubt that many people would have noticed had ridesharing been strangled in the crib. A lot of people would notice if it were to disappear tomorrow. The incentives of the regulators are also not well-aligned with the incentives of the regulated in that they are unlikely to have the same sense of urgency. Entrepreneurs lose money for every day they are delayed. Regulators basically lose nothing for every delay they create. The cost is compounded by the all-too-human tendency to procrastinate. The temptation to delegate a big decision to one’s future self, perhaps with the pretext that one needs to gather more information, can be overwhelming.

Regulators are also limited in that they process ideas by passing them through a variety of cultural filters. This isn’t because of any deep-seated fault of their own; rather, it is because they are human beings, and all human beings pass ideas through their cultural filters. Unavoidably, regulation unavoidably embodies and codifies cultural assumptions. Virginia Postrel discussed this in her underrated 1998 book The Future and Its Enemies. Vidal Sassoon, she noted, ran into a lot of trouble with the regulators by doing a lot of things that simply weren’t in the book or that weren’t recognized by the regulations. If I’m a regulator, then what is permissible is unavoidably affected by my idea of what is normal.

Even that is based on the rather heroic assumption that I actually understand what I’m permitting or prohibiting. If you want to see a real comedy of errors–or, more accurately, a tragedy of errors–go to YouTube and look up any government hearing in which a tech executive has been called to testify. Facebook CEO Mark Zuckerberg’s Senate testimony is a famous example. Google CEO Sundar Pichai’s appearances before the House and Senate are less notable, but the hearings make it painfully clear that the representatives running the show don’t actually understand what they think they can design and are really just grandstanding. If there was anything substantive, it was an accidental byproduct of what I suspect the representatives really wanted: a press release and a donor letter about how the courageous Senator or Congressional Representative is standing up to Big Tech.

In The Fatal Conceit: The Errors of Socialism, F.A. Hayek wrote, “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” That is true of simple products like pencils. It is even more true of complex systems like markets for food, transportation, and communication technology. If the regulators lack the imagination to successfully design a pencil, it is hardly clear that they have the imagination to successfully design an effective and efficient regulatory framework.

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