Professor Bainbridge...on law, politics, religion, culture & food

Behavioral Economics and Regulation

Dealbreaker.com:

… calls for additional regulation often depend on a double standard under which market process are characterized by imperfect information and dominated by self-interest while regulatory processes are somehow viewed as well-informed and public-minded. Why are people so attracted to regulatory solutions when despite the lack of evidence for concrete benefits?

David Hirshleifer has a delightful paper that sees through one prominent anti-market double standard and suggests an answer—several in fact—about why regulation is unduly attractive. His approach is simple. He points out that the findings of behavioral psychology—that people are often irrational, biased and ill-informed—apply to regulators as well as investors and consumers.

“The psychological attraction theory of regulation holds that regulation is the result of psychological biases on the part of political participants and regulators, and the evolution of regulatory ideologies that exploit these biases,” he writes.

The cumulative effect of these biases is overregulation. “[Since the universe of possible tempting regulations is unlimited, the theory predicts a general tendency for overregulation, and for rules to accrete over time like barnacles, impeding economic progress. The theory also predicts occasional drastic increases in regulation in response to market downturns or disruption.”

You can download the paper here. (Hat tip to Ribstein.)

Not to pat myself on the back or anything, but in Mandatory Disclosure: A Behavioral Analysis, 68 University of Cincinnati Law Review 1023 (2000), I wrote that:

Assume arguendo that capital markets fail to produce optimal disclosure through voluntary corporate action. The mere existence of such a market failure does not—standing alone—justify legal intervention. In addition to the standard prudential arguments in favor of limited government, which counsel caution in concluding that a purported market failure requires government correction, behavioral economics itself argues against presuming the desirability of intervention:

Proposals designed to address biases generally entail the intervention of judges, legislators, or bureaucrats who are [themselves] subject to various biases. The very power of the behavioralist critique—that even educated people exhibit certain biases—thus undercuts efforts to redress such biases. In addition, the decisions of government actors also may be adversely influenced by political concerns—specifically interest group politics. Thus interventions to “cure” bias-induced inefficiency may ultimately produce outcomes that are worse than the problem itself.

In other words, the claim that law can correct market failures caused by decisionmaking biases or cognitive errors treats regulators as exogenous to the system. Once the state is endogenized, however, regulators must be treated as actors with their own systematic decisionmaking biases. It thus becomes evident that behavioral economics loops back on itself as a justification for legal intervention.

Having said that, Hirshleifer indeed does a great job of making the point in a way that seems irrefutable.