Extreme Makeover: Regulation Edition

Lynne Kiesling

This week’s Economist has an article that points out what many US residents, and readers of this blog, know full well:

But red tape in America is no laughing matter. The problem is not the rules that are self-evidently absurd. It is the ones that sound reasonable on their own but impose a huge burden collectively. America is meant to be the home of laissez-faire. Unlike Europeans, whose lives have long been circumscribed by meddling governments and diktats from Brussels, Americans are supposed to be free to choose, for better or for worse. Yet for some time America has been straying from this ideal.

From federal financial regulation to local lemonade stand regulation, the regulatory systems in the US are a mess. I generally focus on energy and technology regulation (with the occasional foray into national security and surveillance), but that’s one piece of a large, complex, regulatory puzzle that has taken on a lumbering life of its own, beyond the intentions of the designers and well beyond any sincere interest they might have in reining it in. The growing weight of the regulatory state is both economically and socially corrosive.

I think the Economist has also hit on a home truth in its assessment of why we are in this messy, inefficient, costly regulatory thicket:

Two forces make American laws too complex. One is hubris. Many lawmakers seem to believe that they can lay down rules to govern every eventuality. Examples range from the merely annoying (eg, a proposed code for nurseries in Colorado that specifies how many crayons each box must contain) to the delusional (eg, the conceit of Dodd-Frank that you can anticipate and ban every nasty trick financiers will dream up in the future). Far from preventing abuses, complexity creates loopholes that the shrewd can abuse with impunity.

The other force that makes American laws complex is lobbying. The government’s drive to micromanage so many activities creates a huge incentive for interest groups to push for special favours. When a bill is hundreds of pages long, it is not hard for congressmen to slip in clauses that benefit their chums and campaign donors. The health-care bill included tons of favours for the pushy. Congress’s last, failed attempt to regulate greenhouse gases was even worse.

Yes. Hayek’s Pretence of Knowledge meets Smith’s “man of system”, Tullock’s rent seeking, and Olson’s concentrated benefits and diffuse costs. Regulatory complexity creates benefits for politically-powerful special interests, but it creates costs for everyone else, and this ongoing process feeds the egos of our elected representatives who believe they can engineer, design, and manipulate society to achieve their desired outcomes.

The Economist rightly recommends that regulatory proposals should have to pass a benefit-cost analysis by an independent group, and more importantly, that regulations should be simpler and more transparent. In this they invoke themes that resonate with Richard Epstein’s Simple Rules for a Complex World.

I would go farther. The underbrush of regulations that are passed and persist beyond their usefulness, the accretion of costly conflicting regulations, all of these have produced a stultifying regulatory thicket that makes attempting productive, entrepreneurial economic activity costly or impossible has to be evaluated and cleared out. I recommend that we make it popular with the American people by turning it into a reality TV show — Extreme Makeover: Regulation Edition. It’ll be like those makeover shows when you go into the house of the hoarder, clear out the stuff and put it all on the driveway, clean the place and modernize it, and then evaluate each piece individually and in its systemic entirety (to see whether or not the complexity is beneficial) before it goes back in the building. D’you think Ty Pennington could whip those legislators into shape and get them to see the folly of their ways?

Video — Regulating Monopolies

Lynne Kiesling

I am pleased to announce my first video in the Learn Liberty series — “Regulating Monopolies: A History of Electricity Regulation“.

It’s a brief overview of the economic history of the origins of the electricity industry and its regulation, and points towards the extent to which in the 21st century we are now having to confront the downsides of regulation, particularly with respect to environmental quality and the creation, adoption, and diffusion of digital technology. And I must give a big thank you to the production folks at the Institute for Humane Studies; I have never been comfortable in front of a camera, but they made it as easy as it could be, and the historical photos they found to illustrate some of the events I discuss are fantastic.

I hope you enjoy it, and share it with your friends!

Congressman Markey still worries about U.S. natural gas exports

Michael Giberson

A few weeks back Congressman Ed Markey asked the U.S. Department of Energy whether exports of natural gas might not be in the public interest (see prior note here, related note) as exports would tend to push U.S. gas prices higher.

The USDOE’s response apparently didn’t mitigate Markey’s concern; today the Congressman introduced two bills intended to impede the export of natural gas. (See here and here.) One bill would prevent the Federal Energy Regulatory Commission from approving any new LNG export terminals until 2025. Another bill would require natural gas produced from federal lands be sold only to American consumers. (Shall we require hotels on federal lands to only rent to American consumers as well? Those foreign tourists visiting the Grand Canyon are just driving up the cost for American tourists, right Congressman?)

I’m neither for or against the prospect of exporting LNG, but I’m entirely for letting companies finding the best offer for their products. If the product is natural gas and the best offers come from customers outside the United States, then by all means I’d want them to export.

I continue to wonder why the Congressman from Massachusetts is singling out natural gas exports as an object of concern, since any big growth in such exports is a few years from reality and the United States remains a net importer of natural gas. At the same time, Massachusetts producers are exporting billions of dollars worth of goods and services each year – over $26 billion worth of goods and services in 2010 – which by the Congressman’s crabbed logic is contributing to higher prices for U.S. consumers and therefore harmful to the public interest.

Congressman, why are these Massachusetts exports okay, but natural gas exports are not?

Alex Tabarrok on innovation, barriers to it, and the warfare-welfare state

Lynne Kiesling

I was glad Mike mentioned Alex Tabarrok’s recent Launching the Innovation Renaissance in his recent post on the Honeywell-Next patent lawsuit, because reading Alex’s new TED book was on my to-do list for this past weekend. Alex’s focus in this book is U.S. innovation policy and ways that we could improve the institutional environment to better enable innovation to create opportunities for people to thrive, and consequently to create growth. He analyzes the patent system, education, and how the federal warfare-welfare state has a high opportunity cost in terms of resources that could be dedicated to R&D (through both public and private funding) but aren’t because of the heavy burden of defense and entitlement spending.

An important variable on which Alex focuses is the ratio of development costs to imitation costs, and he argues that laws such as patents are more likely to be positive-sum and pro-growth in industries with high development costs and low imitation costs. He discusses pharmaceuticals as the canonical industry in this category, where the absence of patents would be likely to reduce the amount of new drug development. But patents in other industries with lower development costs and lower imitation costs can hinder innovation, because they discourage the use of ideas in novel, unexpected ways by people other than the patent-holder. Moreover, notice the dynamic incentives that the current patent system presents to engage mostly in defensive patenting, which is wasteful and reduces the extent to which patents are positive-sum. The high-profile activities of patent trolls in technology-related industries in the past decade indicates just how wasteful this perverse incentive is.

One of Alex’s recommendations to reform the patent systems is variable patent duration in accordance with these differences in development costs and imitation costs. For example, from the book, one-click shopping and a pharmaceutical that cost millions of dollars to develop both receive 20-year patents. Uniform patent length means that the patent system ignores the importance of both development costs and imitation costs in determining whether the monopoly granted by the patent will be positive-sum or not. Granting different monopoly lengths depending on the interplay of development costs and imitation costs in that industry when the invention is created would enable developers to recoup costs while reducing the lost beneficial applications of imitation. Note in particular that a lot of these beneficial applications are not direct imitation, but are rather creative uses of the idea as an input into some other idea. Patents that are either too long or too broad (or both) deter such beneficial activity.

For brevity I’ll skip over his thought-provoking discussion of education (but I do recommend it to your attention), and connect the patent discussion to the implications of federal warfare-welfare spending for whether or not we have an institutional environment that is conducive to unleashing innovation. Alex presents some sobering data on federal government spending on research, entitlements, and defense, data that he elaborates on in a post at Marginal Revolution today in which he puts a NY Times article on the welfare state in the context of his argument.

And that doesn’t even take into account the important, but trickier to estimate, effect of government spending on private R&D funding (the crowding out question). Crowding out can take two forms — government spending on R&D reducing private R&D spending, or government spending on other goods and services reducing the resources available for private R&D spending.

Alex boldly makes what I think is the crucial material point:

The point is not simply that the U.S. should spend more money but that a state with these kinds of budget priorities does not have innovation at the center of its vision. If innovation is not central to the vision, then it is inevitably given short shrift.

Given the incontrovertible evidence that low barriers to innovation are the biggest ultimate institutional cause of the unprecedented growth in well-being and living standards over the past 250 years, the absence of this innovation vision is backward-looking and short-sighted.

Alex also highlights the extent to which regulatory thickets generate wasteful spending, particularly in health care and energy. Money we could spend on medical research and basic energy research gets spent instead on regulation-induced bureaucracy and wasteful projects like Solyndra and others that have failed. Reducing these regulatory thickets and focusing more vision on innovation and basic research than on bureaucratically-weighted and centrally planned projects would be an important incremental move in the right direction. To the extent we’re going to have a state, we should move from a warfare-welfare state to an innovation state.

Sadly, I think Alex is right about the political economy of innovation when he notes that “… few people lobby for innovation because almost by definition, innovation creates present losers and future winners and the present losers are by far the more politically powerful. Innovation has few champions.”

The book closes with seven institutional/policy recommendations touching on patent reform, education, regulation, and open trade in goods, services, and ideas. These recommendations also have implications for issues like immigration and health care.

One of the most valuable features of this book is how well written it is. While being a short, easy, compelling read, it’s a book dense with good and thought-provoking ideas presented clearly for non-specialists (and backed up by extensive references at the end for further analysis). I don’t remember where I saw it, but I think someone commented that we should send a copy of Alex’s book to every member of Congress and their staffers. That would be a valuable education process.

See also a short essay drawn from the book, and listen to Alex’s EconTalk podcast with Russ Roberts discussing the book.

One nation, under guard

Lynne Kiesling

This TechDirt article pulls together a lot of the various strands that are worrying about the growth of the U.S. police state — extralegal detention, the militarization of local police at the hands of the DHS, surveillance, increased imprisonment despite an all-time low crime rate, punitive immigration policy, the war on x where x is a member of the set {drugs, terror, …}. The only dots they don’t connect here are the invasive, expensive, ineffective policies and practices of the TSA and the indiscriminate use of drone strikes. But even without connecting those dots in, their assessment is

Bad news about the impending police state here in America: it’s already here. From the indefinite detention (without trial) of terrorism suspects both foreign and American to the escalating militarization of our nation’s police forces, there’s little to indicate that any level of government is willing to “walk back” the overreach of law enforcement, much of which stems from the Patriot Act’s anti-terrorism aims.

The persistence of these policies defies both logic and common sense. For how long are we going to put up with these rights-eviscerating, socially corrosive uses of our tax money? After following the Patriot Act, DHS, TSA, digital surveillance, the NDAA, and so on over the past decade, I fail to see either the moral or economic justification for these policies that fall under the Patriot Act umbrella, particularly since the terrorist threat has ebbed. And what’s more disturbing is that support for such authoritarian policy is high and crosses the tribal Team Red-Team Blue political boundaries.

It’s enough to make a dispassionate economist weep for her country’s lost principles.

Honeywell vs. Nest, continued

Michael Giberson

Slate‘s technology columnist Farhad Manjoo examines Honeywell vs. Nest from a tech consumer’s point of view.

The Honeywell v. Nest lawsuit is being justifiably criticized as another black mark on our broken patent system. If Honeywell invented all these cool features, why didn’t it make something of them? …

Honeywell seems to have patented a bunch of great ideas in order to just sit on them. The sad thing is that if it tried, Honeywell seems capable of building a thermostat that’s every bit as wonderful as the Nest. From my testing, I found that Honeywell really does make great home heating and cooling equipment. If it competed in the marketplace rather than in the courts, I suspect it could really turn up the heat on Nest. (Sorry, couldn’t resist.)

When I compared the Nest and the Prestige, I found that feature for feature, Honeywell’s thermostat is more capable. …

On the other hand, you don’t need a one-page dossier, two installers, and an hour-and-a-half briefing to describe and install the Nest. That’s Honeywell’s greatest problem….

Manjoo concludes Honeywell has the technology, but not the consumer design nor the business model to get consumers clamoring for their product.

But Nest isn’t unstoppable. Honeywell has been in the thermostat business forever, and it’s got a lot of engineering and distribution advantages. It also, clearly, has a lot of innovative ideas. From what I’ve seen of its gear, Honeywell seems quite capable of creating a consumer-friendly version of the Prestige, one that works as easily and stylishly as the Nest. Now that Nest has paved the way, Honeywell would likely earn a lot of press coverage, too.

If I can summarize that last paragraph, he’s suggesting that rather than suing Nest for copying Honeywell technology, Honeywell ought to be copying some of Nest’s consumer-oriented design and marketing attitudes. (Fortunately for Honeywell, you can’t patent attitudes.)

A secret to Chipotle’s good-food-fast innovations

Michael Giberson

At Slate, Matthew Yglesias tells the story of a business that is booming: Chipotle’s Mexican Grill, “a company that shows there’s clearly room for growth and innovation in even the most basic sectors of the economy.”

The chain has been expanding rapidly, Chipotle’s stock has risen 500 percent over 5 years, and yet:

… the food service industry can’t seem to get any respect. Politicians don’t name-drop burrito innovators as examples of the kind of entrepreneurs they want to encourage, and despite food’s ubiquity in our lives, culinary progress is slighted as a source of human progress.

Chipotle’s growth since its 2006 IPO should be seen as a great American success story. There’s nothing new about fast food, of course. But it’s not as if Steve Jobs invented the cellphone.

Yglesias follows with, “In many ways, the Chipotle burrito is very similar to the iPhone.” Maybe that analogy is a little strained, but it doesn’t matter, we get a peak at some of Chipotle’s key innovations. The article usefully reminds us that not all innovations are high tech or high science.

(The article gives a brief shout out to burger chain Five Guys, also a family favorite.)

MORE: Another story of entrepreneurial insight in action: Risk and stealth paid off in Eagle Ford shale.

Dynamic pricing and technology in different markets

Lynne Kiesling

Dynamic pricing has long been a topic of great interest here, in large part because digital technology is increasingly making it feasible to implement dynamic pricing in retail electricity markets in ways that can be acceptable to consumers. But dynamic pricing is fraught with challenges, and not just in retail electricity markets. Dynamic pricing is a form of price discrimination, and as such can improve efficiency; prices also are knowledge surrogates, communicating diffuse private knowledge about the relative scarcity of that good in that place at that time. Dynamic pricing is also most applicable in markets in which demand varies over time, and if you are going to implement dynamic pricing without annoying and aggravating consumers, consumers have to have access to the prices in advance.

These general principles showed up recently in a kerfuffle over dynamic pricing of taxi services by a new firm called Uber:

On New Year’s Eve, Uber, a start-up in the city, adopted a feature it called “surge pricing,” which increases the price of rides as more people request them.

Although New Year’s Eve was very profitable for Uber, customers were not happy. Many felt the pricing was exorbitant and they took to Twitter and the Web to complain. Some people said that at certain times in the evening, rides had spiked to as high as seven times the usual price, and they called it highway robbery. Uber’s goal is to make the experience as simple as possible, so customers are not shown their fare until the end of the ride, when it is automatically charged to their credit card. While the app does not show the total fare in dollars when customers book a ride, Uber did show a “surge pricing” multiple to customers booking rides for New Year’s Eve.

So what’s the underlying economics here? Jodi Beggs comments on the kerfuffle starting from first principles, pointing out that when demand increases, consumers are not likely to be able to get the quantity they want at the price to which they may have gotten habituated as “the price”. She also points out that the dynamic pricing is what keeps shortages from occurring — think about it: would you rather pay 7 times the base fare to have an immediate ride home after your New Year’s Eve party, or would you rather wait in line for the next available car? Either way, you pay; opportunity cost matters. In other words, as my colleague Jeff Ely observes, variable pricing means that prices go up and down, and generally will be higher when more people want the good (due both to higher and more inelastic demand at that time and to higher relative scarcity). Note that these observations also apply to retail electricity pricing — market demand varies over time, and prices can signal relative scarcity, if regulators allow them to.

The relative scarcity is another aspect of the economics here, because in the immediate run the firm can’t go out and scare up more cars and drivers; in other words, supply is not going to increase. Here we see the analogue to other industries that use dynamic pricing, such as airlines and hotels and car rentals — they have a pretty fixed supply, so as demand rises and falls the price to the consumer will rise and fall accordingly, because the supply response at the time is so limited. Over time profit signals will indicate to them whether or not to invest in more cars, planes, hotels, but if you’re trying to get home on that New Year’s Eve that’s not going to kick in that quickly. Thus prices adjust to communicate relative scarcity.

But notice another aspect of the story of Uber’s pricing: although they told the customer what the “surge multiple” was when they called the car, the customer doesn’t know the fare until after the transaction has occurred. Here I concur entirely with the NY Times blog post, Jodi, and Jeff, that not informing customers ex ante about at least an estimate of the fare is a bad way to implement dynamic pricing! Especially for flesh-and-blood humans who are more than calculating machines, and are likely to be royally ticked off when they are charged 7 times base fare for such a short ride. The NY Times blog post quotes Yale economist Dirk Bergemann, saying that consumers prefer price predictability, which is true as a very broad claim … but if I draw an analogy from regulated retail pricing in electricity (and using a rhetorical trope of Jeff’s), consider the equilibrium. If instead they kept their fares constant, it’s entirely possible that the average fare could be higher in the single fare market design than in the dynamic pricing market design. That’s one of the anxious concerns that regulated electricity firms have about dynamic pricing — what if our revenue falls because a large enough share of demand ends up happening in low price periods (i.e., more demand is more elastic)? In any case, not giving customers at least an estimated fare before they commit to the order is bad business, and it should be easy to communicate that estimate, because customers are all using smart phones to order the cars.

I’d like to suggest a couple of alternatives that my colleagues did not. The first alternative is inspired by time-of-use pricing as used in electricity, or by the types of dynamic pricing contracts used in car rentals. If I know well enough in advance that I want a car at 2AM on New Year’s Eve, why not offer me a contract in which I can make a reservation at a firm price, albeit one that is higher than the base price? Then Uber could, say, take reservations for 50% of their fleet, and leave the other 50% open for spot-market transactions. With that model, those customers who are risk averse and want to make sure to have a car at a particular time at a reasonable price will have an option. But if they can’t commit to a time for a pickup, then they suck it up and deal with the spot market.

The second alternative is less relevant to the Uber example, but in lots of markets that could have dynamic pricing, we can use technology to automate our responses to the price. I’ve gone on ad nauseam about the potential for transactive technology in retail electricity markets, and it’s applicable in other markets too — automated reservation bots for making a flight reservation if the price on your preferred itinerary on your dates goes below a trigger price that you set, or a device in your car or an app on your phone that receives the current toll level and tells you whether or not to take the toll road, wait to go home, etc. Transactive technolgies reduce the cognitive barriers associated with price uncertainty, as well as reducing the transaction costs of using dynamic pricing in the first place.

New paper: Knowledge Problem

Lynne Kiesling

I have a new paper that may be of interest to KP readers, since the subject of the paper is the same as the name of this site: Knowledge Problem. I am honored to have been invited to contribute this paper to the forthcoming Oxford Encyclopedia of Austrian Economics (Peter Boettke and Chris Coyne, eds.). Here’s the abstract:

Hayek’s (1945) elaboration of the difficulty of aggregating diffuse private knowledge is the best-known articulation of the knowledge problem, and is an example of the difficulty of coordinating individual plans and choices in the ubiquitous and unavoidable presence of dispersed, private, subjective knowledge; prices communicate some of this private knowledge and thus serve as knowledge surrogates. The knowledge problem has a deep provenance in economics and epistemology. Subsequent scholars have also developed the knowledge problem in various directions, and have applied it to areas such as robust political economy. In fact, the knowledge problem is a deep epistemological challenge, one with which several scholars in the Austrian tradition have grappled. This essay analyzes the development of the knowledge problem in its two main categories: the complexity knowledge problem (coordination in the face of diffuse private knowledge) and the contextual knowledge problem (some knowledge relevant to such coordination does not exist outside of the market context). It also provides an overview of the development of the knowledge problem as a concept that has both complexity and epistemic dimensions, the knowledge problemʼs relation to and differences from modern game theory and mechanism design, and its implications for institutional design and robust political economy.

In this paper I analyze the development of the two categories of the knowledge problem — the complexity knowledge problem and the contextual knowledge problem — and explore both the history of the development of these concepts and their application in robust political economy and new institutional economics. As is the hallmark of a good research project, I think on balance I learned more than I created in the process of writing this paper.

One other thing I made sure to include was a discussion of how the knowledge problem and its development relates to game theory and mechanism design, through the work of Oskar Morgenstern (and then through some of the work of Herb Simon and Vernon Smith, among others).

Tying together economics, institutional design, history of thought, and epistemology, I hope you find this paper informative and useful! I’ll also make sure to update when the full volume is available.

Online privacy is like portfolio diversification

Lynne Kiesling

You know the down-home advice on investing — don’t put all of your eggs in one basket? That advice also holds for maintaining your online privacy in the face of Google’s impending “service integration” to use all of the information you provide in all of their services. This Wired article on how to hide from Google is the best I’ve seen thus far, and the advice is pretty straightforward — don’t put all of your activity in the Google basket. Use different search engines, use different browsers, spread it around.

For example, I’m now using Chrome to manage my Gmail accounts, calendar, and Google+ account. I have signed out of all Google accounts in Firefox and Safari, and I do all of my searching and other activities in one or the other of those browsers, depending on the application.

Sure, I’m giving up the ability to +1 articles, but that’s a small price to pay … and as we learn from portfolio theory, diversification comes at a cost but provides a net benefit.