10 Journal of Regulatory Compliance Vol. I
III. DIAGNOSING THE PROBLEM
How are we to know whether persistent inefficiencies in the market are
the result of market failures or government failures? 13 We may never know
for certain, but we can cast an analytical eye to determine whether the
industry is prone to any known market failures. We can also ascertain the
incentives presented by prior government regulation of the industry.
Regulation, by its nature, is an interference with market processes. If applied
appropriately, regulation will be used only when necessary to counteract or
mitigate the distortions caused by—or unable to be remedied by—voluntary
transactions in an imperfect market. 14 However, regulation also has costs and,
as regulation increases, those costs will escalate, likely at an increasing rate. 15
At some point, therefore, even regulations necessary to mitigate existing
market failures will cross the line into government failures.
The first step, then, in identifying a government failure is to ascertain
whether natural market failures exist in the relevant industry. If not, any
regulation is likely to cause costly distortions, so any current market
imperfections are likely external. If the industry is prone to market failures,
step two is to determine whether existing or proposed regulations are well-suited to correct the specific market failures in that industry. 16 If not, then
existing regulations are a likely source of market distortions, above and
beyond those caused by natural imperfections in the market. If the regulations
are very poorly designed, the size of the government failure could dwarf the
size of the market failure. Even if the regulations seem well-designed to
correct market failures, the final step is to ask whether or not the regulations
are “narrowly tailored,” to borrow a phrase from constitutional law, to meet
that goal. If the regulations are broader than absolutely necessary, they will
13. The phrase “government failure” has been criticized as being nothing more than an
ambiguous rhetorical tool, designed to achieve ideological goals. Barak Orbach, What is
Government Failure?, 30 YALE J. ON REG. ONLINE 44 (2013). But see W. Kip Viscusi, Review:
Government Failure Versus Market Failure, 45 J. ECON. LIT. 1070, 1071 (2007) (defining
“government failure” to describe “public policies that also underperform on efficiency
grounds”). In order to avoid Orbach’s critique, it is important to be perfectly clear exactly how
the term is to be used herein. If not already obvious from the foregoing discussion, a
government failure is a previous government action that can be identified as the cause of
current market dysfunction.
14. Wolf, supra note 3, at 112.
15. This standard economic assumption is known as the law of increasing marginal costs.
16. Wolf, supra note 3, at 107 (“Policy formulation properly requires that the realized
inadequacies of market outcomes be compared with the potential inadequacies of nonmarket
efforts to ameliorate them.”). Id. at 112 (“Where the market’s ‘hidden hand’ does not turn
‘private vices into public virtues,’ it may be hard to construct visible hands that effectively
turn nonmarket vices into public virtues.”). Public choice theory informs us of the likelihood
that government efforts to regulate may be motivated by the rent-seeking efforts of powerful
special interest groups. See, e.g., Bruce Yandle, Bootleggers and Baptists—The Education of
a Regulatory Economist, REG.: CATO REV. BUS. & GOV’T, Fall 1999, at 5.