the subtle costs of regulation to business (esp. small business) and society

To have consumption, we must have production. We can produce our own stuff, but most of us aren’t good at a Robinson Crusoe approach to life. So, we usually produce a few things, in areas where we have a “comparative advantage,” and engage in trade with others who do likewise. When all of us work where we have skills, we win and society wins — tremendously.

But usually, we don’t work alone and then engage in trade. We work together in groups — often, large groups — to produce goods and services. Why do we do this? Did you ever think about why businesses exist at all? Economists point to three primary reasons.

First, different risk preferences will lead some people to value the (relative) security of employment. If 99 of 100 workers are risk-averse, they would happily work for the 100th and let him deal with the greater risks (and the potential big bucks) of ownership and entrepreneurship.

Second, bringing levels of production together often reduces “transaction costs” — the cost of making trades happen. If we’re all in the same building and trying to operate by the same mission, our costs of transportation and communication should be much lower.

Third, “economies of scale” can occur with larger production. For a variety of reasons, the average cost of production often decreases when you produce more. To note, it’s usually lower-cost to produce 70 units one — than to produce one unit 70 times.

To encourage business, there is a role for government. For example, the government enforces contracts and protects the property rights of business owners and employees. Without these functions, the incentives to engage in productive activity — inside or outside of a firm — are greatly reduced.

Government also provides a regulatory function in contexts where markets struggle. For example, because we don’t have enforceable private property rights for air and much of our water, firms have an incentive to throw their pollution onto these common resources. As such, government should protect common resources with effective regulation.

Unfortunately, the government also uses regulations to make it more difficult for businesses to participate in a market. The regulations are useful as restrictions, in an effort to enhance monopoly power for cronies who want higher profits and don’t want to compete as much. In The Triumph of Conservatism, Gabriel Kolko argued that the legislative agenda of the Progressive Era was quite useful for enhancing the monopoly power of those connected to political power.

But with both types of regulation, government necessarily creates additional costs for businesses — as they adhere to the regulations. Back to our point about “economies of scale”: Uniform regulations generally provide an advantage to larger firms, since they are in a stronger position to absorb these costs. As such, regulation typically encourages the formation of larger businesses and the reduction of small businesses.

A key exception: Lawmakers often seek to mitigate this problem by exempting smaller firms from certain regulations. For example, the Affordable Care Act only applies to businesses with 50 or more employees. But this is troubling for at least two reasons. First, the exemptions indicate that the regulation is not really all that important. (If it were so important, we’d mandate it for everybody.) Second, the cutoff is arbitrary. Even if this regulation is good policy, the chosen number is certainly not revealed from on high.

As with most public policies that expand the reach of government, the benefits of enhanced regulation are obvious while its costs are larger but far more subtle. We can see the benefits of mandated labeling on food, but its costs are absorbed into price and smaller firms will tend to be driven out of business. We can see the jobs saved by international trade restrictions, but the higher prices and the greater job losses are far more subtle. We can see the problems prevented by unlicensed hair braiders and peanut farmers, but the costs are more insidious.

Economists are fond of discussing the tradeoffs in personal choices, business decisions, and public policy. But in the case of regulation, it’s certainly troubling that the costs are so subtle. And it’s worrisome that regulation tends to cause so much more trouble for small business.

If Indiana wants to promote standards of living, then less regulation is generally preferable — to protect small business, to enhance business and to encourage competitive markets that will please workers and consumers.