How to make Brexit Really Worthwhile – Example: Regulation dealing with Information Asymmetries

The Freeconomist

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In my last post I argued that Brexit in the sense of merely shifting powers from politicians and bureaucrats in Brussels to politicians and bureaucrats in London would unlikely lead to a significant improvement of the legal and regulatory framework governing British society because laws and regulations would still be the product of a centralized ordering authority rather than the result of a decentralized and market-responsive evolutionary process.

I therefore suggested that the production of laws and regulations in areas that up to now have been largely controlled by Brussels should – to a large extent – be turned over to the private market rather than merely to politicians and bureaucrats sitting in London.

In this post I want to apply the general argument for competitive production of laws and regulations provided in my last post to the specific case of regulations related to information asymmetries.

All specific types of market failure can be subsumed under one of two categories: externalities or information asymmetry.*

It is therefore not surprising that a big part of the vast amount of existing government regulation can ultimately be categorised as addressing the issue of information asymmetry.

Information asymmetry between buyers and sellers is a pervasive phenomenon. Ways of overcoming this problem include establishing a reputation or offering warranties. Another solution is third-party certification.

Third-party certification provides assurance to consumers that a product or a supplier of professional services meets certain quality standards.

Private suppliers of third-party certification include organisations such as Consumer Reports, the American Automobile Association (AAA), which rates motels, or A.M. Best, rating insurance companies. Examples of third-party certification provided by the government are product safety regulation, food standards regulation or occupational licensure.

Private suppliers of third-party certification can only exist because the product they offer is valued enough by market participants to justify the cost of providing it. And their profits are determined by their credibility.

The same cannot be said for third-party certification provided by the government. The government does not need to tailor its supply of third-party certification to consumer demand because it is financed by the taxpayer.

The result is overproduction of third-party certification by the state: even in areas where third-party certification is not needed (because there are alternative, more efficient ways of overcoming information asymmetry available), the government produces third-party certification in the form of laws and regulations on a massive scale.

The salaries of the bureaucrats producing unnecessary third-party certification constitute just the smaller part of the cost associated with those laws and regulations. The larger part arises from the fact that third-party certification in the form of government legislation/regulation is usually binding rather than non-binding.

Non-binding government regulation produced for the purpose of third-party certification would stand in competition with private third-party certification and other mechanisms for overcoming information asymmetry. That is, such regulation would simply not be applied in markets where there are other, more efficient alternatives available for overcoming information asymmetry.

But, being binding, third-party certification in the form of government regulation imposes additional cost on the economy: by generating unnecessary compliance cost and by preventing the development and application of more efficient solutions to the problem of information asymmetry.**

Consider a specific example of third-party certification produced by the state: product safety regulation. Product safety regulation in the UK has developed to a vast body of rules. Is this body of rules efficient? Maybe it is. The problem is that, as long as there is only one body of rules on product safety in Britain, which every producer and seller is legally bound to comply with, there is no way of telling whether the rules are efficient.

Only if consumers were free to choose between products manufactured in accordance with government product safety standards and products produced subject to private (or no) product safety standards, would it become apparent whether the current rules are efficient.

The purpose of product safety regulation is to benefit consumers by protecting them from potentially harmful products. Like any regulation, product safety regulation is associated with costs, i.e. higher prices. That does not mean that government product safety standards in the UK are inefficient.

Assume that, henceforth, the government allows producers to decide for themselves whether or not to manufacture their products in compliance with government regulations on product safety: if the government regulations on product safety are efficient in every case, nothing changes. All products continue to be produced in accordance with the government product safety standards because it is profitable for producers to do so.

If, on the other hand, the fact that a product has been manufactured subject to government product safety standards is worth less to consumers than it costs producers to implement these regulations, no product will be manufactured subject to the government regulations any longer.

If, as may well be the case, current government regulation on product safety is efficient in some cases but not in others, some products will continue to be manufactured subject to the government product safety standards, other products will be produced in accordance with private product safety standards and still others will be manufactured without any standards for product safety.

In short: under laissez-faire, third-party certification (such as in the form of product safety standards) is a market institution and as such is affected by market demand. Consumers are free to choose between strict and less-strict standards. Producers have an incentive to apply standards that satisfy consumer demand, so efficiency will increase.

My suggestion would therefore be this: after Brexit, turn all existing legislation and regulation produced for the purpose of third-party certification (product safety legislation and regulation, food standards legislation and regulation, occupational licensure, etc.) into non-binding rules and abolish the respective regulatory agencies such as the Food Standards Agency.

To the extent that third-party certification is useful, it will be supplied by the free market. To the extent that the government legislation and regulation in the field of third-party certification (that has been produced over the last decades) is efficient, it will continue to be applied by market participants.

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Footnotes:

* For example, public goods – the most commonly cited type of market failure – constitute in fact a specific case of the externalities category: producing a public good leads to positive external effects not captured by the producer, which is why public goods are underproduced.

** The most pernicious form of binding third-party certification produced by the government is certainly occupational licensure. Apart from being subject to all the problems of “ordinary” binding third-party certification produced by the state, occupational licensure is also subject to an additional problem: through occupational licensing schemes insiders may well attain control over entry into “their” industry.

The Freeconomist blogs at belowpotential.com

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