Nth best, Posner-inspired

There are people out there who believe in this simple model:










This is a decision tree that says there are two choices: transactions with no problems -- no institutional failures, no externalities, a perfect market transaction -- and those that must be regulated. Of course, any regulation can be justified after the fact. If nothing else sticks, you can always invoke asymmetric or imperfect information, the last refuges of scoundrels.

But Posner makes an interesting point in Economic Analysis of Law that is rarely acknowledged by fans of regulation. He says,

Monopoly, pollution, fraud, mistake, mismanagement, and other unhappy by-products of the market are conventionally viewed as failures of the market's self-regulatory mechanisms and therefore as appropriate occasions for public regulation. This way of looking at the matter is misleading. The failure is ordinarily a failure of the market and of the rules of the market prescribed by the common law [emphasis added]. Pollution, for example, would not be considered a serious problem if the common law remedies, such as nuisance and trespass, were efficient methods of minimizing the costs of pollution. The choice is rarely between a free market and public regulation. It is between two methods of public control -- the common law system of privately enforced rights and the administrative system of direct public control -- and should depend upon a weighting of their strengths and weaknesses in particular contexts.

We can diagram this as:










But wait: it would be rare that a transaction would have a single institutional (market) failure, would it not? In fact, many if not most transactions are subject to multiple failures. The problem for the knee-jerk regulator is that they don't all work in the same direction. As I argued here, they may frequently cancel:

The state ownership of oil and the corresponding ease with which OPEC should be able to cartelize should raise the price, while externalities imply an artificially low price - which dominates? We know that the cost of our interventions in oil-producing regions is not accounted for in the price, but the risk premium brought about by the unstable regimes and regions that happen to possess the oil and our interventions in them is. Now add Hotelling into the calculus, and figure that the cartel members are going to cheat to drive prices downward, while federal taxes and regulations (not all of which are rational or efficient) raise the price.

So our decision tree now has four branches: no failure, self-canceling failures, common law, and regulation.









We can also add in the self-enforcing means open to private actors as suggested by Second Best Economist Dani Rodrik: repeated interaction, reputation, and collective punishment.













And since we're differentiating between types of self-enforcing agreements, why not differentiate between regulations? There are at least four; regulating inputs (as in the original Clean Air Act which mandated scrubbers), regulating outputs (as in mandating the use of MTBE in boutique fuels), taxation (alcohol) or user fees, and cap & trade (exemplified by sulfur dioxide markets created by the 1990 Clean Air Act).














This now looks like a rich spectrum of responses, many of which are open to private actors and therefore anarchists. I think it should be apparent now why I believe that regulations -- especially of the inputs or outputs -- are frequently a simplistic, unimaginative response to the particular class of institutional failures, real or perceived, known as market failures. True, not all are appropriate in a given situation, but it is rare to find a politician or state enthusiast who even recognizes that there are other options.