Federalism and Regulation: What Sorts of Regulation Are Best Handled on the Federal Level?

By Hahn, Robert W.; Layne-Farrar, Anne et al. | Regulation, Winter 2003 | Go to article overview

Federalism and Regulation: What Sorts of Regulation Are Best Handled on the Federal Level?


Hahn, Robert W., Layne-Farrar, Anne, Passell, Peter, Regulation


ECONOMISTS GENERALLY AGREE ABOUT the role of regulation in modern market economies: If there is no significant "market failure," then government should not intervene. If the failure is substantial, and there is good reason to believe that regulation would improve outcomes, government should intervene.

By contrast, the issue of which level of government in a federal system should do the regulating (if regulation is indeed appropriate) often divides free market economists who otherwise have little difficulty finding common ground. On the one hand, the efficiency of applying one set of rules to national markets is embodied in the Commerce Clause of the U.S. Constitution. On the other, decentralization within a federal system is prized, both for its capacity to reflect diverse values and for the opportunities it creates to use states and localities as laboratories for innovation in regulation.

On balance, we do not believe there is a simple way to decide, from an economic efficiency standpoint, what jurisdiction is best suited to regulating. In some cases, the specific history of regulation in an industry and the institutions created to do the regulating matter a lot. The most that theory can offer here is a disciplined way of thinking about the issue.

WHY REGULATE AT ALL?

To justify regulation as a means of increasing economic efficiency, there must be evidence that markets are distorting resource allocation. However, evidence of that distortion does not prove that the intervention will increase welfare. As public choice economics suggests, regulation can do more harm than good for reasons ranging from the high cost of obtaining information to interest-group capture. Thus, making the case for regulation is a two-stage process: Is there good evidence that the unfettered market has failed, and if so, is regulation likely to improve matters?

The significance of this second hurdle is all too apparent in light of the problematic experiences with regulation even where it is easy to demonstrate market failure--cases ranging from efforts to internalize the costs of air pollution to the assessment of the safety and efficacy of prescription drugs. As discussed below, the imperfect nature of regulation is also relevant in the context of federalism: In some instances, the decisive factor favoring regulation at one level of government rather than another is the quality of the regulatory institutions.

REASONS TO CENTRALIZE REGULATION

If the potential welfare gains from intervention in private transactions do outweigh the losses, one is still left to choose the appropriate level of government to intervene. The case for centralizing regulation in a federal system is based on a variety of arguments.

Externalities The actions of regulators in one locality will often affect producers and consumers in another. And, other matters equal, regulators in one jurisdiction will have incentives to give greater weight to the interests of their constituents than others affected. The classic examples are siting disputes. In some cases, like the creation of national storage facilities for high-level radioactive waste from nuclear power plants, the potential consequences for those directly affected have the potential to be very serious. In most, the tensions have the same source, but the stakes are not as high.

Commercial airports, for example, may generate substantial net benefits for a large region. However, the minority of people who live closest to the site, and are thus most affected by the noise and congestion, may have disproportionate influence over decisions. For example, local activists have been able to block the conversion of the El Toro military air base in Orange County, Calif.--one of the few remaining sites for creating a commercial airport in a region much in need of airport capacity.

Conversely, local regulators may choose to ignore the costs generated in their jurisdiction that damage another. …

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