WHEN, HOW, AND WHY DO WE REGULATE*
Otto Doering, Purdue University
Mature free market economies tend to have increasing amounts of regulation. This
indicates that some things of concern to the public fall between the cracks in a free
market economy.
The Enron scandal reflects the intent of the Glass-Stiegal Act which was passed during
the depression to prevent banks from having a close relationship with firms they loaned
to. Glass Stiegal was repealed a few years ago and some believe that had it been in place
the damage from Enron’s collapse would have been less. Enron also petitioned to have
some of its activities exempted from the Public Utilities Holding Act (again passed at the
time of the Great Depression). Enron was allowed to set up some of its partnerships
outside the purview of this act. Had the act been applied, what Enron was allowed to do
would have been much more restricted. (There is a current effort to repeal the Public
Utilities Holding Act so that holding companies will have more freedom to operate.)
These recent examples and the anti-trust laws that were passed over a hundred years ago
represent regulation of the market itself to prevent monopoly and the abuse of economic
power that might hurt consumers.
We also regulate health, safety, and the environment. The reasons for many of these
regulations usually involve what are called ‘externalities’. We say an externality exists
when the welfare of a firm or individual depends directly not only on his or her activities
but also on activities under the control of some other firm or individual. Thus, SO2 from
the coal fired electric utility smokestacks of the Midwest are an externality that affects
those living downwind of those smokestacks. In addition, externalities usually involve a
market failure. There is no market linkage between the coal fired utility and those
downwind of the smokestacks that ensure that the market will make the utility pay for
any damage occurring downwind. Thus, we tend to regulate when damage is sufficient to
gain attention and the society is wealthy enough to suffer a loss of efficiency or transfer
of resources to ameliorate the damage.
One of the early Federal regulations for pollution control was the 1899 Refuse Act,
primarily aimed at maintaining navigation. Other early regulatory acts include the Pure
Food and Drug Act, Mine Safety Acts, various railroad safety acts, local, state, and
federal public health laws, and the Soil Conservation Acts of the Great Depression. For
clean air, we operate under the 1990 Amendments to the Clean Air Act that also added
some new wrinkles to the regulatory process.
Traditionally, environmental regulation, especially that involving a pollutant, has been by
command and control. Thou shall not emit, or thou shall not emit more than a certain
*Presented at the ADS Discover Conference on Nitrogen Losses, April 29th, 2002
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amount of a given pollutant. Our initial focus was on point pollution sources, the end of a
discharge pipe or smokestack. Command and control sets a standard to be met, assuming
that we know what standard is appropriate for health, safety or ecological maintenance.
Command and control economies, such as today’s Chinese economy and the economy of
the former Soviet Union, have the opportunity to regulate within the economy as a matter
of course. More often than not, the primary goal has been high levels of production. Thus
we end up with situations like the Ariel Sea that has been sacrificed for, among other
things, cotton production. A command and control economy does not recognize property
rights widely, so they are usually not an issue in regulation or resource use decisions.
Criteria we wish to apply to environmental or health regulation in market economies are:
1. there is good science involved in the regulation and 2. the regulation makes some
economic sense – or at least not nonsense. What in fact actually drives regulation in an
open and democratic country is public perception of the need to regulate.
Once good science is brought to the table, how does one deal with the issue of economic
sense in regulation? There is guidance from negligence law that reflects the thinking of
economists. Justice Learned Hand formulated a test suggesting that negligence exists if
the loss caused by the negligence times the probability of contamination exceeds the cost
of preventing the loss. The level of liability damages also reflects the cost of prevention.
What this speaks to is the economists’ notion of how much should be spent to prevent
damage or pollution. The attached figure on the efficient allocation of a fund pollutant
illustrates the concept. Note the quantity of the pollution increases from left to right, and
values increase from baseline upwards. Start at the right hand side of the graph. A high
quantity of pollution is being emitted, causing a high marginal damage cost, and there is
no control cost. As one moves from right to left, increasing amounts are spent on
pollution controls and the marginal cost of damage begins to decrease. This goes on until
at point Q* the amount spent on pollution control just equals the marginal damage.
Continuing to spend more on pollution control clearly doesn’t make sense because the
additional expenditure is more than the damage of the pollution. Q* is clearly the place
one wants to be. Why then does society often end up elsewhere?
The 1990 Amendments to the Clean Air Act provides a superb example of the public
perception driving the decision rather than economic analysis of the sort assumed in the
figure. The Reagan Administration commissioned a national deposition study to forestall
‘hasty’ action by congress. Congress, pushed by the public, passed the amendments to the
clean air act a year before the scientific studies were finished. Supposedly, the studies
would allow us to identify point Q* and we would be able to regulate the level of air
pollution at an economically efficient level. However, the public acted precipitously.
When the dust settled, the study results indicated the public had set a level of air quality
regulation to the left of Q*. I.e., the public wanted a higher degree of pollution control
than would be economically efficient when comparing the cost of damage and the cost of
control. The public perceived the costs of damage to be higher relative to the costs of
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control than the economists did. Was this a bad thing, or was it just the public expressing
its desire for more clean air?
The innovation of the 1990 Amendments was the introduction of tradable permits. While
these increase economic efficiency of pollution control, they have regional impacts that
have been a source of friction between the Midwest and the East Coast. The tradable
permits allow the regulator to first set a limit on the total amount of pollutants. Firms are
then given discharge permits allowing them to discharge a proportion of their historical
discharge. However, firms are then allowed to trade these permits. This means that firms
for whom internal control of discharge is inexpensive, can sell the permits at a profit to
firms whose costs of discharge reduction is high. This results in the firms having the least
cost of controlling discharge doing most of the control. However, geographically, East
Coast permits moved to the Midwest allowing Midwest utilities and industries to pollute
“more” than they would have if everyone had a fixed proportional reduction requirement.
Where does this leave us?
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
Public perception drives, whatever economists and scientists might think to the
contrary.
There still is a critical role for scientists, economists, and other ‘experts’
1.Science and technology create the options and gauge their effectiveness.
Transparency, a reliable metric, establishment of a baseline, and
monitoring become critically important components of the process.
2. Economists indicate the cost effectiveness of the different approaches.
In a sense we have to solve a three way optimization where public perceptions of
damages, costs of control, fairness, and irreversibility interact with alternative technical
approaches and alternative public and private costs. All three are seldom fully realized at
any one moment in time. Central planning of command and control economies would
seem to be so much more effective and efficient – but history tells us otherwise.
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