Why are the economies of affluent, market-based economies so heavily regulated? Or, turn that around: how can heavily regulated economies operate efficiently enough to create high living standards? The questions don’t have much traction for non-economists; regulation, after all, is widely viewed as what prevents the powerful from taking advantage of the rest of us. But that answer isn’t good enough for those – among them, Andrei Shleifer of Harvard — who take economic theory very seriously.
Yes, left unregulated, “externalities ” (like the cost of pollution emitted by a cement factory), may undermine efficiency. Yes “asymmetric information” (is that drug you’re taking for asthma dangerous?) may invite abuse in unregulated markets. But powerful countervailing forces are at work here, too, driving markets toward efficient solutions. Competition rewards clever solutions to both the externalities and asymmetric-information problems. Meanwhile, the courts can force efficiency where competition can’t through the resolution of contract and tort disputes.
But in an as-yet-unpublished paper [Download Here], Shleifer argues that the justice system is the weak link in the chain. So weak, in practice, that government regulation, for all its warts, sometimes increases efficiency. For example, it may be more efficient to require drug companies to prove to the FDA that medicines are safe than to leave the question of harm (and who caused it) to the wisdom and impartiality of judges and juries.
Is Shleifer right? It might more sense to try to reform the judicial system than to depend on inevitably-problematic regulation. But whether Shleifer is right or wrong, the paper is well worth reading for its jargon-free analysis of why high levels of regulation are apparently compatible with high levels of economic efficiency.