Regulations are Good for Business

The gold standard argument for laissez faire advocates (besides arguments for an actual gold standard) has always been that regulations hurt businesses. By intruding on businesses and making them follow certain rules they say, government is actually hurting the economy in an unnecessary way and hurting profits, impeding investment and costing jobs.  Just let businesses use their own discretion they say, and the market’s self-regulatory power will sort things out, as consumers will ultimately decide to avoid those businesses which are negligent or causing more harm than good.  Economic data confirms this they say.  But is this really true?  Let’s analyze.

                Regulations Do In Fact Cause Inefficiency

The laissez faire advocates do make some good points in their anti-regulatory arguments. No one can deny that regulations often increase the costs of doing business.  By increasing the cost of doing business ultimately they can have the effect of reducing the marginal utility of capital, which in turn makes investment less profitable.  This can have the effect of reducing capital investment which ultimately translates to less jobs and higher unemployment.  It can also have the effect of impeding innovations by slowing down the time it takes for new products and services to enter the market. 

For example, in the pharmaceutical industry a potentially life-saving drug may delayed from entering the market for several years due to stringent regulations, and in the meantime people could die from illnesses which could have been prevented had those drugs been available.  It can also reduce incentives to even put money into developing such products in the first place.  Anyone familiar with the pharmaceutical industry knows that drug development is a crapshoot in many ways.  Pipelines send capital to highly expensive research facilities, which may or may not develop an effective drug.  Even if the research facility is successful in developing an effective drug, the company still needs to pass the stringent FDA guidelines to get it on the market.  This may necessitate thousands of hours and billions of dollars put into things like animal and petri dish testing, controlled trials, long term studies designed to look for latent side effects, and rigorous and painstaking procedures to look for things like potential contraindications and negative drug interactions. Companies can invest billions into a drug over many years, only to go bankrupt right before receiving FDA approval. 

The stakes are certainly high, and this often causes pharmaceutical companies to avoid making the investments in new and cutting edge drugs right from the start, in favor of safer alternatives.  For example, opiates have long been the workhorse of pain relief in medicine, however, they carry the notorious side effects of addiction. For decades companies have wanted to develop a holy grail of medicine: a painkiller which is just as effective as opiates, but does not carry with it the risk of addiction and abuse.  Such a drug would undoubtedly be revolutionary, and the person or company which discovers could make billions, possibly even trillions over the long run.  However, this is not so simple, in order to find such a drug one would have to look outside the opiate family and experiment with new and cutting edge formulas for which one is making the pharmacological equivalent of Christopher Columbus or the Apollo space program, boldly venturing into a great unknown, with risks and dangers and contingencies which are simply immeasurable.  Many companies have tried and failed to develop such a drug, as terrible side effects undoubtedly emerge.  And many a man has gone bankrupt searching for this holy-grail.  Because of the huge financial risks involved, many companies seeking to develop painkillers often opt to play it safe, and instead simply develop new kinds of opiates.  Humans have been using opiates for thousands of years, we have known about their terrible side effects for just as long.  Today we have hundreds of varieties of opiate drugs, each one possessing the power to turn you into a hopeless junky.  And while we have more varieties of opiates than we know what to do with, we still don’t have that magical holy grail of pain medicine that so many have sought and prayed for.

Free market advocates say that the regulatory burdens of the FDA only hurt things like the search for alternative painkillers, as the expensive and burdensome approval process only increases the costs of cutting edge research even more, and that this is why so many companies decide to only develop new forms of heroin rather than try to create opiate alternatives.  Milton Friedman famously called the FDA “frustrating drug advancement” because of its supposed burden on the process.  Let the market decide, say people like Friedman, allow companies to develop drugs and put them on the market without having to go through an approval process, and we will see faster innovation and put us on the fast track to finding panaceas like the elusive opiate free painkiller. 

But would the suggestions of those like Friedman really be the answer?  Are things like the FDA really just unnecessary burdens on the market which slow down drug development and cost lives in the mean time?  Would the free market truly help society achieve important goals such the quest for ending medicine’s dependence on opiates to treat pain?

                The Laws of Physics and the Existence of Risk

First we must ask ourselves, why is it that certain industries are more heavily regulated than others?  Surely, pharmaceuticals, airlines, energy and finance appear to be regulated far more heavily than industries like lawn mowing, retail, information processing and tourism.  Why does Wall Street have more government officials meddling about than Silicon Valley? Does the government just have it out for certain people based on unjustified bias?  Is society simply prejudiced against these industries?  The answer of course, lies in economics.

Certain industries are more prone to risk just as certain activities carry inherent risks.  It is far more acceptable for me to go bowling while drunk than it is for me to drive a car while drunk. This is because driving, by virtue of the laws of physics, is an activity which poses a greater likelihood of serious bodily harm should something go wrong.  If I make a mistake while driving 72 mph on the highway, the consequences could be far more grave than if I make a mistake while bowling.  The former carries the risk of death to myself and others in the worst case scenario, the latter, perhaps a crushed foot, or simple property damage to the bowling alley should my ball roll in the wrong direction.

One does not need to have a background in economics to realize these simple truths.  Not all activities are created equally.  There are certainly ones which carry greater risks than others. And since all economic activity is simply human activity, this simple truth of the laws of physics applies to industry as well. 

It is easy to see how the laws of physics can make selling pharmaceuticals and operating a natural gas pipeline inherently risky.  A natural gas pipeline which is poorly maintained can lead to explosions, and indeed, such terrible events have occurred throughout history when such pipelines were not properly designed or maintained.  When you buy ibuprofen or Tylenol from the drug store, you are placing your very life in the hands of people you have never met.  Trusting that the chemical you are ingesting is safe, and unless you have a degree in chemistry and significant time on your hands, chances are most consumers never truly verify with certainty that the drug they are ingesting is actually Tylenol.  You are trusting that workers at a drug plant that you have probably never been to have properly made the drug, and that they have properly packaged it, and that it will be safe for you to ingest.  You truly are putting your life in the hands of someone you never met.  And should something go wrong, you could easily die, as was seen in the tragic case of the people who died from ingesting pills which they thought were Tylenol, but were in fact cyanide which someone maliciously put into the pill bottle solely to hurt people.  And while cases such as malicious poisoning of others could be said to be extreme rarities, it is still true that many people have gotten killed or injured from ingesting drugs which although made in good faith, still had some impurity, or latent side effect which escaped detection due to a mistake.  While most of us view taking Tylenol as among the most mundane of activities, it is, under the laws of physics, perhaps one of the riskiest things we ever do.

And while the laws of physics clearly reveal the risks in things like drugs and natural gas, it is not as clear with heavily regulated industries such as finance or law. However, these industries also carry inherent risks.  How does one know if their retirement manager is truly acting in their best interest?  How can you tell if someone who is saying they are a lawyer truly is one?  All one needs to do is to put on a suit, and put on a good act, and they could be able to fool even the brightest of us if they are talented in their deception.  People like Bernie Madoff destroyed the finances of hundreds of people, yet, for decades he seemed to be nothing more than a simple financial manager, and one who was highly respected by the community as well. The truth is, it is very difficult to discern between the fauxs and the for reals in such industries, and this is one reason why confidence artists are especially fond of posing as attorneys or financial advisors.  Simply put on a good act, and people will give you their money.  And when you give someone your entire life savings you are engaging in an act which requires just as much trust and confidence as when you buy the Tylenol from the drug store. 

Not to worry, say the laissez faire advocates, for consumers will be able to decide who to trust and who not to trust.  In fact, the free marketeers go as far as saying that those who support regulation must take all people for fools.  Surely consumers are not so stupid as to merely put themselves out as prey to the deceivers and the negligent individuals of the world. And perhaps the free market advocates are correct, people, though imperfect, are not stupid, and most rational adults are perfectly capable of assessing risk and protecting themselves and their families from these dangers.  But would consumers react in such a way which would help the markets?  What would truly be the economic effects of having a caveat emptor standard in the 21st century with all its complexities and risks?

                How Consumers Respond to Risk

Consumers are not stupid, humans are naturally risk averse.  We will not expose ourselves to danger unless there is a good reason behind it. Consumers, as economic actors, engage in the cost benefit analysis that all economic actors do.  I could, in theory, strap myself to a rocket and shoot myself in the air in order to transport myself to work each day.  However, strapping myself to a rocket would be an extraordinarily risky endeavor, by virtue of the laws of physics.  And while it may actually transport me to work faster than simply taking the metro or diving my car, my chances of dying or incurring seriously injury en route, are much higher.  Thus, most rational people will easily conclude that taking the metro or driving a car to work is the more favorable form of their commute to work.  This cost/benefit analysis is deeply rooted in our psychology and our evolutionarily endowed survival mechanisms.  The fact that my mere mentioning of taking a rocket to work seems ridiculously absurd to most of my readers is evidence of just how automatic and ingrained this sense is in our minds.  The ability to engage in such calculations need not be taught, it is something which we all learn, something which is second nature to all sane people.

And while deciding on whether to buy a product may not be as obvious as my example of taking a rocket to work (which is admittedly and purposely designed to be an absurd comparison), this same, automatic risk aversion occurs in economic transactions all the time. If a consumer is wary of a certain product to the degree that its costs outweigh the benefits, they will forgo that choice in favor of a more sensible alternative. These automatic calculations are made with the information and signals we receive.  Some information may be all but self-evident, such as the dangers of strapping yourself to a rocket, one does not need to be told that it is dangerous to know that it is dangerous, as anyone with enough life experience can immediately see the risks (and thus potential costs) involved.  This is risk assessment which comes purely from first-hand knowledge, wisdom and intuition.  However, in other instances we rely on information obtained from what we see and hear of what happens to others who engage in said activity. This kind of information is essentially second hand information, what we hear from others. And this second hand information in many circumstances can be so powerful that it can trump our primal intuitions of the risks of an activity.

Think for a second why buying pills at the drug store is seen as so mundane by most people despite the incredible risks. When you buy a bottle of pills, the powder or liquid contained in said pills could be anything, it could be something deadly, it could easily kill you, and you have essentially no way of knowing until you consume them.  Why then do we do it?  Shouldn’t our survival mechanisms make us more fearful?  This can be answered by simply asking yourself: “why do I trust the pills I buy at the drug store?”  Most likely, this is because most of us have never known anyone who has died from taking pills which were negligently made.  Most of us have taken thousands of pills in our lifetimes, each one with those same risks, yet, chances are, nothing bad has happened (outside of the usual risks of a drug like Tylenol which can kill one if it is misused or taken in high doses or in combination with things like alcohol).  Most of us have seen friends and family members take pills on a regular basis, without dying.  The overall attitude and consensus we get from our culture, our media, our interpersonal communications, is that pills from the drug store are safe to use, and as long as you follow the directions on the bottle and don’t take too much, you will be absolutely fine.  It is possible that someone pulled out of a deep rainforest, or who has lived in a bomb shelter under-ground her entire life, may immediately see the risks in taking pills, and be fearful of it.  However, those who are exposed to our culture, and to the attitudes of others think nothing of it at all.

The information we receive from what others tell us and from what we see others doing is the most important factor in consumer risk assessment. We trust our senses, we trust what we see happening, and we act on information from such trustworthy sources.  However, this trust can be shaken, or it can be impeded when we see great risk or a great unknown. And when we are confronted with such risk, we tend to avoid it.

Take Bitcoin for example, as an asset which can be purchased, it is perhaps no more risky than other investments and assets available to us on the market.  But Bitcoin is new and different, a supposed currency which is nothing more than a mere programming script.  We have no idea how impervious it is to hackers, and the volatile market of Bitcoin has shown that we have no idea how much it will be worth in future, or if it will be worth anything at all.  As a result, the vast majority of the population has shied away from putting their wealth in Bitcoin.  However, is Bitcoin any more risky than an online bank account?  Surely they can be hacked, surely you are taking a risk when you put your finances into the dangerous world of the internet. However, while the first-hand information of these things may indicate that Bitcoins and bank accounts have similar risks, the second hand information presents vast differences between the two.  The fact is that people trust online banks more, our culture trusts them more, we have more information about what they are and what could possible happen, while Bitcoin is surrounded by great unknowns.  And even if the risks are the same, we feel much safer with online banking than we do with Bitcoin.  Information is a powerful force.

So what happens when an industry releases a product which does cause harm? Well, we act on our information, and consumers will choose what they perceive as the safest path based on that information. Sales of Tylenol sharply dropped when the news got out that a family had been poisoned because the pills were maliciously filled with cyanide.  This was in spite of the fact that only a few people died.  This was in spite of the fact that the overwhelming majority of Tylenol bottles on the shelves across America were perfectly safe to consume.  This was in spite of the fact that your chances of buying a cyanide filled bottle were virtually nil. The fact of the matter is that consumers acted on this powerful and terrifying information, and in their minds the cost/benefit analysis indicated that it was better to play it safe.

When consumer’s trust is shaken in a product they will avoid it, even if the first-hand information indicates that such risk aversion is excessive and perhaps even irrational. Consumers can be so rational that in fact it can almost appear to be irrational. We have all met people who are terrified of flying despite the overwhelming evidence that it is safer to do even than driving. Those people perhaps have never gotten over the feeling in their gut about what could happen should they go on a plane.  We were all terrified of flying after 9/11.  We were all terrified of investing after the 2008 crisis.  We are all irrationally rational when it comes to such things, and when our trust is shaken in a product or an industry, we will avoid that industry, even if such fears are irrational in light of the data.

                Why Regulations are Good for Business

The truth is that those industries which carry more risks often benefit from regulations, despite the fact that regulations may impede on capital and innovation. The laissez faire advocates display a fundamental misunderstanding of human economic behavior when they assume that getting rid of agencies such as the FDA would only benefit industries. The fact of the matter is that regulatory safeguards convey information to consumers, information that this product or service is under supervision, trustworthy supervision. Information which tells us that when we buy a bottle of pills, or invest money with a finance manager, we are not merely relying on their word, we have a 3rd party which has our back and is working to ensure that these things are safe.

When people do not have these safeguards, consumers have less information, and they are subject to more unknowns.  And when they are subject to more unknowns, they will act in the rationally irrational behavior of avoidance in far higher levels than if those safeguards existed.  And when people do this, it translates into decreased sales for the companies involved in those industries.  And the decreased sales translate into decreased profits, and decreased profits tell us that one should question whether the inefficiencies of regulation are truly hurting businesses in the way we are told by the free market fundamentalists.  Perhaps the pharmaceutical industry would not be benefitted should the Milton Friedmans of the world have their way.  For if we repeal the regulatory safeguards, we are removing the level of trust a 3rd party overseer creates, which will undoubtedly generate greater uncertainty among consumers.  And furthermore, by removing such safeguards, we greatly increase the risk of negligence occurring, and of more people dying.  Even free market advocates acknowledge that such tragedies will occur in greater instances should regulations be repealed.  And these events will undoubtedly generate even more uncertainty among consumers, and create even lower sales and lower profits for these businesses.

This is not mere conjecture, but in fact is evidenced by real world economic data.  There was a time when drugs were not regulated by the FDA, and consumers knew that drugs contained risks.  And in fact throughout the first half of the 20th century, there were tragedies of poorly tested drugs causing deaths among consumers.  It was the Elixir Sulfanilamide tragedy of 1937, in which over 100 people died from taking an under-tested drug, which finally prompted Congress to pass the Food, Drug and Cosmetic Act.  The law gave the federal government incredible authority over the marketing of new drugs, and was the birth of our modern FDA system.  It certainly raised costs for businesses, and made it longer and harder for companies to develop and release new drugs.  However, rather than retracting and stagnating, the pharmaceutical industry blossomed into the incredible powerhouse that it is today in the years and decades which followed.  By the 1950s hundreds of new drugs had been developed and were flourishing on the markets.  By the 1970s this number had become thousands.  In the years that followed the pharmaceutical industry absolutely exploded, creating a revolution of new drugs which changed our society, saved millions of lives, and improved the lives of billions.  And ofcourse, the pharmaceutical industry reaped billions in profits.

So why did this happen?  If regulations hurt the pharmaceutical industry, why has almost all of the major progress in pharmaceuticals happened after 1938?  Why has the pharmaceutical industry emerged from a small industry of dubious trustworthiness to one of the most powerful and profitable industries in the world economy?  For those of us who understand economics, the answer is quite simple: consumers had greater reason to trust the industry, and bought more drugs, and this increase in profits was reinvested into making new drugs, and society as a whole was benefitted.  The miracle of the 20th century pharmaceutical industry is one of the great achievements of mankind, and is a classic example of how business, profits and capitalism can truly benefit society.  And this miracle of capitalism is largely because of the Food, Drug and Cosmetics Act and the greater trust and certainty it gave to consumers. If this law had not been passed, this miracle may not have occurred.

Now there are those who claim that our tort law system can pick up the slack and make up for a lack of regulation.  And it is true that litigation, when combined with liability insurance, does act as a regulatory measure.  However, the economic data clearly shows that court systems are not enough, they only deal with tragedies after they happen, and they do nothing to act as a prophylactic for potential harm. The mere fact that a company has liability insurance which dictates certain procedures does not carry as much weight in consumer’s minds as does the existence of a 3rd party, financially disinterested overseer does.  Furthermore, many of the people who call for an end to regulation also call for damage caps on tort claims, meaning that liability insurers will have even less incentive to incentivize safe behaviors. In essence, the reduction of damage caps merely makes negligence cheaper, and when combined with a lack of regulatory oversight, causes even more harm, and increased the chances of accidents occurring.  And consumers will, as they did in the days before regulations, respond to this increased risk by avoiding certain industries.  Not to mention the inherent unfairness of such damage caps in that they allow companies to get away with negligent activities without having to pay for them. 

                Conclusion

Laissez faire advocates forgo economic science in favor of ideology when they claim that regulations are wholly bad for businesses. The free market fundamentalists expect consumers to behave in a way in which our psychology simply does not allow.  They are asking consumers to incur greater risk, while at the same time continuing to purchase these products and services at the same degree.  Laissez faire advocates should revisit the old adage ‘there’s no such thing as a free lunch”, because when one looks at the situations from an economic lens, it becomes abundantly clear that is what people like Friedman are promising us. To take such a position reflects poorly on their own understanding of human nature and of economic behavior.  However, the much more likely answer is that they are simply ignoring relevant data in favor of ideological and rhetorical goals.

The truth is that certain industries, by nature of the laws of physics will carry more risks than other industries.  And consumers are smart enough to realize those risks and adjust their decisions accordingly.  When we remove the safeguards we are not merely removing approval processes and increasing the likelihoods of accidents and tragedies, we are removing an important source of information which consumers rely on.  And it is the lack of information is perhaps even more damaging than the chance of accidents, as I have mentioned earlier, consumers will be rationally irrational and avert risk when they are faced with unknowns, even if statistically their chances of incurring harm are not great.  It is the existence of information which makes markets possible, and when information is decreased, it will reflect in people avoiding certain activities.  By increasing information through regulation, many of these industries have seen a substantial rise in sales and profits. And by increasing profits while simultaneously increasing innovation and development of new products and services, we are creating a better situation for all parties involved, businessman and consumer alike.  Regulations are good for business.

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6 responses to “Regulations are Good for Business”

  1. Miguel Santana says :

    Are you seriously inferring from the pharmaceutical industry the conclusion that regulations are good for all business? Besides, I believe you are forgetting that although courts can only treat crimes after they have happened, the law sets a standard in the first place – those who break it are far less than those who abide by it; the FDA is, in fact, much more liable to fail than the law: the former is human, the latter is abstract.

    • thehobbesian says :

      You obviously did not read this article very well if that’s what you are inferring. I am not saying that the pharmaceutical industry proves that all industries should be regulated, but rather that regulations in and of themselves are not bad and can be good for business. Certainly some industries do not need to be regulated (as I pointed out in the essay), while others do, it is not a uniform standard that can be blanketly applied to business in general. Also, I think you have some confusions about the common law, I was talking about judicially set precedent as a form of law, in which case precedents can only be set after a wrong has occurred. So no standard has been set until a precedential case has occurred. It is true that legislating law sets a standard to begin with, and that is exactly what regulations do. I don’t see how you think that the rules of the FDA are more liable to fail than the law, because regulations are laws. Like I said, you seem to have some confusion about how legal systems operate.

  2. Phil says :

    Good points well made. The way I see it, yes, pure capitalism would be amazing, but only under a crap load of assumptions, including perfect information. Where those assumptions fail, the state is your friend…

  3. EH says :

    Potentially, the problem with this view would be the idea that, if regulations were in alignment with the pecuniary interests of businesses, they would have adequate incentive to do it themselves. To justify, say FDA, you would have to assume that there is some particular reason why companies would not hire independent testing agencies, or in effect hire their own FDA. For example it is common at the market place that companies buy “seals of approval” to indicate environmental friendlessness, security or whatever. That is, in effect, what ‘ecological’ milk is to environmental friendliness, and what VISA and Master Card is to payment security. So is there a particular reason to believe that this couldn’t spontaneously be extrapolated to pharmaceuticals?

    Here are some reasons that may keep businesses from doing this privately: the authority and monopoly of government does in fact instill a sense of trust amongst people, despite the fact that a monopolistic agency with no particular incentive to keep customer satisfaction in mind, logically ought to instill suspicion. But it doesn’t, so there. Another reason would be a coordination problem. Would it be too much of a hurdle for some companies to take the initiative to make the investment, only to see their unregulated competition take all of their business in the meantime? I don’t like the second argument as much as the first, but both may potentially hold some truth.

    But if all these problems could be overcome, then we would be in a much better position with regards to the heavy-handedness of poor FDA regulation if the FDA was dismantled or privatized. And assessing the benefits and the costs of each approach seems like something that could be done, although not by me personally.

  4. Larry Butler says :

    According to the OMB, the economic benefits of regulation in the US greatly exceed the cost of regulation for EVERY regulatory body except the Department of Agriculture. It’s all here: http://www.amazon.com/Money-Myth-Minefield-Saving-American-Capitalism-ebook/dp/B00U6D82E2/ref=sr_1_1?ie=UTF8&qid=1426186385&sr=8-1&keywords=money-myth+minefield

  5. David says :

    Again, very well argued. The only piece I can comment on from experience is the Pharma sector. It is right as you say that this is regulated industry. However in recent times it seems to be that the regulators have almost forgotten the profit motive that drives these companies. Examples being the almost hysterical reaction to the price of the first drug ever to cure Hep C (Sovaldi from Gilead) or the emotional brow beating the industry gets for not investing in new and more powerful anti-biotics (the don’t because there is no profit in it unless the governments will cut them a deal). And I’ve seen many if not most Pharma companies trash scores of millions of profit by arranging licensed production of their patent drugs to local suppliers in the third world. Perhaps am a bit biased as I work with Pharma companies quite a bit, but nevertheless they are getting an overly harsh bad rep today (save of course for that class-A idiot who bought Turing and thankfully got his just desserts.

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