Tag Archives: Regulation

Lessons from Lance

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Lynne Kiesling

So now we at least know something direct from the horse’s mouth about Lance Armstrong’s use of performance-enhancing drugs before and during his long run of commanding Tour de France performances. In addition to the interview with Oprah Winfrey, this CBS 60 Minutes segment and this Cycling News interview with Armstrong provide fuller details. If you do not follow cycling or have not been following these events, Juliet Macur’s New York Times story from January 6 provides a good summary. (By the way, Juliet Macur, ESPN’s Bonnie Ford, and WSJ’s Jason Gay (here and here recently) are outstanding journalists and writers whose insights and knowledge have been essential reading on cycling for years, not just in dissecting l’affaire Armstrong).

Having followed cycling since the mid-1980s, my sense is that Armstrong is right that PED use is endemic in quite a few sports, including cycling. But it’s not universal. I also think that Armstrong is choosing his words carefully, and in a very calculated manner is trying to walk the fine line between saying enough to get some reputation capital back and be readmitted to professional racing (in triathlon this time, as in his early career) and saying so much that he re-triggers the federal lawsuit about his alleged conspiracy to distribute and use illegal substances, which would land him in jail.

What I find the most personally disturbing is his callous willingness to treat other people as means to an end, one end, his winning the Tour as many times as possible. The bullying and the backing of young, eager, naive athletes into Faustian corners is unforgivable. For that alone I’d deny him a USA Triathlon license. But I’m a very strong believer in private ordering through reputation and strong social norms, probably a stronger believer in them than the general population.

Some observers, including my good friends at Reason, argue that we should allow PED use in professional sports. I disagree, for two reasons, one physiological and one moral. In sports like cycling, the blood doping is intended to increase the oxygen content of the blood and to accelerate recovery from endurance activity. It does that, but it does that differently for each person, because each person has a different baseline blood oxygen content (hematocrit) and each person responds differently to augmentation. It’s not just a parallel shift that “raises all boats” equivalently. So if you are a rider with a low hematocrit who responds well to doping and you beat a rider with a higher hematocrit who responds less to doping, what have you achieved? Who’s the better cyclist on that day?

And that gets to the moral reason why I think we should continue to have sanctions against PED use in sports. Sports, whether professional or recreational, are meaningless unless they are grounded in the deeply human institutions of fair play. We have evolved a sense of fair play for a reason. Abandoning that institution with respect to PED use in professional sports would abandon fair play, would turn sports into nothing more than a “bread and circus” spectacle to entertain the masses in the manner of the Roman gladiators, and would feed back into youth sports with very perverse and negative incentives that would undermine the physical, psychological, and moral benefits we derive from participating in sports. If we relinquish fair play in sports we relegate sports to meaningless decadence. I can’t support that. Nor does the evolution of our institutions through human history match with that decision.

Which gets me to Roger Pielke Jr.’s very insightful post in which he argues that sports need stronger institutions. I really encourage you to read his post, because he does a very good job of summarizing the complicated institutional framework in which many sports operate. Cycling is an Olympic sport, and it also involves competitions (like the Tour de France and the Giro d’Italia) run by international organizations. It also has a governance organization, the UCI, which has come in for a lot of justifiable criticism regarding its transparency and its enforcement of its private rules against doping (in fact, I think it hasn’t come in for enough criticism and that lots of heads need to roll, but that’s for another post). Roger’s post also highlights the awkward nexus of the International Olympic Committee (and the USOC) and its private sanctions against doping, the non-governmental organization that is charged with monitoring and enforcing these sanctions (WADA, and in the US, USADA), and the treatment of PED use in sports by various international governments. In particular, in many other countries enforcement does involve governments and PED use violations are subject to criminal prosecution, while under US law they are treated as private matters as long as the substances are not themselves illegal. Of course, this line gets crossed all the time, as we see when Congress gets a burr under its saddle and hauls ex-baseball players up to testify about PED use.

And that’s where I think l’affaire Armstrong and the US government’s pursuit of him and how USADA plays into that should make us all pause and consider the implications of this government power more broadly. Last week in Wired, Brian Alexander wrote that the Armstrong case and USADA’s role in it should make you, and me, and each of us worry:

So here’s the thing you need to know: The USADA takedown of Armstrong matters, and it could effect everybody. Because it will enhance the power and reach of a private, non-profit business that has managed to harness the power of the federal government in what’s quickly becoming a brand new war on drugs … with all the same pitfalls brought to you by the first war on drugs.

The USADA is a private outfit. Yet it gets taxpayer money. And it has existed in this weird legal nether world since its creation in 1999 at the instigation of the International Olympic Committee, United States Olympic Committee, and President Clinton’s White House Office of National Drug Control Policy. The USADA is designated by the U.S. Congress as the company that handles anti-doping for this country, because the World Anti-Doping Treaty — a UNESCO-promulgated document that the U.S. signed with almost no discussion – obligates the U.S. to do a number of things, which includes conforming our laws to the international anti-doping code. …

The USADA has wanted Armstrong for years. To it, and to the World Anti-Doping Agency (WADA), Armstrong was Moby Dick: If they could kill the whale – and do it without a raft of positive tests to show Armstrong doped – a new model of anti-doping would be enshrined into practice. And that’s just what happened.

Piggy-backing on a federal investigation, the USADA was able to pressure Armstrong teammates to confess to doping and implicate Armstrong … with no positive test results. It was an FBI-style investigation spanning multiple countries, but there was no “smoking syringe” found stuck in Armstrong’s arm. …

So while you might wish athletes didn’t dope — I do, too — and want action taken to combat doping, you might also want to be careful about what you’re wishing for. Especially since sports is taking on a broader definition that includes amateurs, low-level marathon runners, and even your kid’s high school football team.

I’ve excerpted Alexander’s argument, but I do encourage you to read it fully for a better understanding of exactly how sobering the implications are.

That’s what I think there are a lot of disturbing lessons from Lance, and from the USADA’s pursuit of him. Both his craven conduct and lack of character and the sinister implications of his prosecution bode ill in ways that will diminish sports that we love, as spectators and as participants. And they increase the authority of the state in ways that we’ve already seen are destructive.

What is regulatory capture?

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Lynne Kiesling

Regulatory capture is one of the defining phenomena in the political economy of regulation. What is regulatory capture, exactly? In a Tech Liberation post from 2010, Adam Thierer offers this definition:

“Regulatory capture” occurs when special interests co-opt policymakers or political bodies — regulatory agencies, in particular — to further their own ends.  Capture theory is closely related to the “rent-seeking” and “political failure” theories developed by the public choice school of economics.  Another term for regulatory capture is “client politics,” which according to James Q. Wilson, “occurs when most or all of the benefits of a program go to some single, reasonably small interest (and industry, profession, or locality) but most or all of the costs will be borne by a large number of people (for example, all taxpayers).”  (James Q. Wilson, Bureaucracy, 1989, at 76).

This short video from Susan Dudley at George Washington University provides a concise introduction to the concept:

As she points out, one of the consistent outcomes arising from regulatory capture is that the regulated industry can use regulation in ways to increase its benefits at the expense of consumers.

In the post quoted above, Adam does a great service by generating a compendium of quotes from economists and other analysts about regulatory capture and he’s added to this list since the original post. His chronological list gives you a good sense of how pervasive the phenomenon is of politically-connected interests to shape regulation to their own advantage.

Regulatory capture: putting the “crony” in crony capitalism for as long as regulations and politics have existed.

Regulation’s effects on innovation in energy technologies: the experimentation connection

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Lynne Kiesling

Remember the first time you bought a mobile phone (which in my case was 1995). You may have been happy with your land line phone, but this new mobile phone thing looks like it would be really handy in an emergency, so you-in-1995 said sure, I’ll get a cell phone, but not really use it that much. Then, the technology improved, and more of your friends and family got phones, so you used it more. Then you saw others with cool flip phones, in colors, and you did some searching to see if other phones had features you might like. Then came text messaging, and you experimented with learning a new shorthand language (or, if you’re like me, you stayed a pedant about spelling even in text messages that you had to tap out on number pad keys). You adopted text messaging, or not. Then came the touch screen, largely via the disruptive iPhone, and the cluster of smartphone innovation was upon us.  Maybe you have a smartphone, maybe you don’t; maybe your smartphone is an iPhone, maybe it isn’t. But since 1995, your choice of communication technology, and the set from which you can choose, has changed dramatically.

This change didn’t happen overnight, and for most people was not a discrete move from old choice to new choice, A to B, without any other choices along the way. Similarly for technological change and the production of goods and services. For both consumers and producers, our choices in markets are the consequence of a process of experimentation, trial and error, and learning. Indeed, whether your perspective on dynamic competition is based on Schumpeter or Hayek or Kirzner (or all of the above), the fundamental essence of competition in market processes is that it’s a process of experimentation, trial and error, and learning, on the part of both producers and consumers. That’s how we get new products and services, that’s how we signal to producers whether their innovations are valuable to us as consumers, that’s how innovation creates economic growth and vibrancy, through the application of our creativity and our taste for creating and experiencing novelty.

This kind of dynamism is common in our world, and is increasingly an aspect of our lives that creates value for us; mobile telephony is the most obvious example, but even in products as mundane as milk, the fundamental aspect of the market process is this experimentation, trial and error, and learning. How else would Organic Valley have started coming out with a line of milk that is entirely from pasture-raised cows? (I am happily consuming this milk; pasture-raised cows make milk with more essential fatty acids and conjugated linoleic acid, very important for health)

But this kind of dynamism, while common, is not pervasive. Institutions matter, and in particular, various forms of government regulation can influence the extent to which such technological dynamism occurs in a market. The example I have in mind as a counterpoint, the example I want to explain and understand, is consumer-facing electricity technologies, like thermostats and home energy management systems. For the past several years there has been considerable innovation in this space, due to the application and extension of digital communication technology innovations. But despite the frequent claims over the past few years that this year will be the year of the consumer energy technology, it keeps not happening.

Tomorrow in New Orleans, at the Southern Economic Association meetings, I’ll be presenting a paper that grapples with this question. My argument is that traditional economic regulation of the electricity industry slows or stifles innovation because regulation undercuts the experimentation, trial and error, and learning of both producers and consumers. As I state in the abstract:

Persistent regulation in potentially competitive markets can undermine consumer benefits when technological change both makes those markets competitive and creates new opportunities for market experimentation. This paper applies the Bell Doctrine precedent of “quarantine the monopoly” to the electricity industry, and extends the Bell Doctrine by analyzing the role of market experimentation in generating the benefits of competition. The general failure to quarantine the monopoly wires segment and its regulated monopolist from the potentially competitive downstream retail market contributes to the slow pace and lackluster performance of retail electricity markets for residential customers. The form of this failure to quarantine the monopoly is the persistence of an incumbent default service contract that was intended to be a transition mechanism to full retail competition, coupled with the regulatory definition of product characteristics and market boundaries that is necessary to define the default product and evaluate the regulated monopolist’s performance in providing it. The consequence of the incumbent’s incomplete exit from the retail market suggests that as regulated monopolists and regulators evaluate customer-facing smart grid investments, regulators and other policymakers should consider the potential anti-competitive effects of the failure to quarantine the monopoly with respect to the default service contract and in-home energy management technology.

In August 2011 I wrote about the Bell Doctrine, Baxter’s precedent from the U.S. v. AT&T divestiture case, and how we have failed to quarantine the monopoly in electricity. This paper is an extension of that argument, and I welcome comments!

If you’ll be at the SEA meetings, I hope to see you there; I am headed to NOLA tonight, and look forward to a fun weekend full of good economic brain candy.

Enron and crony corporatism

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Lynne Kiesling

Rob Bradley has an Econlib essay on Enron, and it’s a good one. He focuses on Enron’s particular form of crony corporatism, its ability to take advantage of regulatory complexity, and the lessons that we should carry forward from the experience:

Enron was essentially a political company, not a free-market one. Ken Lay’s creation would be unknown to history were it not for the distorted incentives from the government side of the mixed economy.

For classical liberals, Enron is a case study in support of the separation of government and business. There is egregious rent-seeking, whereby the company worked to shape political intervention for economic advantage. There is bootleggers and Baptist politicking, whereby Enron teamed with nonprofit groups to win support for what was in the company’s narrow self-interest.

There is the peril of half-slave, half-free. Partially deregulated markets (such as with electricity in California) created a devil’s sand box for profit-making that otherwise would have been absent in a free-market order.

Economic Freedom of the World: We’re #18!

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Lynne Kiesling

This year’s Economic Freedom of the World report is released today, and the US has dropped to #18, its lowest ranking ever. From the press release:

The United States, long considered a champion of economic freedom among large industrial nations, dropped to its lowest position ever in to the Fraser Institute’s annual Economic Freedom of the World report. This year, the U.S. plunged to 18th, a sharp decline from the second overall position it held in 2000. Much of this decline is a result of high spending on the part of the U.S. government.

Hong Kong again topped the rankings, followed by Singapore, New Zealand, and
Switzerland. Australia and Canada tied for fifth overall among the144 countries and
territories in the Economic Freedom of the World: 2012 Annual Report. “The United States, like many nations, embraced heavy-handed regulation and extensive over-spending in response to the global recession and debt crises. Consequently, its level of economic freedom has dropped,” said Fred McMahon, Fraser Institute vice-president of international policy research.

The report’s authors, James Gwartney, Robert Lawson, and Joshua Hall, have a column in today’s Philadelphia Enquirer summarizing the results of their research, and why economic freedom is such an essential input for prosperity:

Economic freedom means people are free to choose, trade, compete, invest, and have the fruits of their labor protected against aggressors within a legal framework of equal treatment and minimal interference from government. The link between economic freedom and long-term prosperity is overwhelming: freer economies invest more, grow more rapidly, and achieve higher income levels than those that are less free.

The United States, long considered a bastion of economic freedom, has become less free during the past decade. This decline is across the board. Increases in government spending, record deficits, violation of property rights, more onerous regulation of business, and wars on terrorism and drugs have all contributed to the erosion of economic freedom in America.

Sobering, right? But where’s their data?

During the past decade, the U.S. rating fell nearly a full point on our 0-to-10 point scale, from 8.65 in 2000 to 7.70 in 2010. While it is difficult to pinpoint all the reasons for this decline, the increased use of eminent domain, the ramifications of the wars on terrorism and drugs, and the violation of the property rights of bondholders in the bailout of automobile companies have all clearly weakened private property and the rule of law tradition of the United States.

Our empirical work indicates that a one-point change in a country’s EFW rating is associated with a 1.0 to 1.5 percentage point change in the long-term annual growth rate, all else equal. It is worth noting that U.S. growth averaged 2.3 percent in the 1980s and 2.2 percent during the 1990s, but it fell to an annual rate of only 0.7 percent during 2000-2010. Without a reversal of undermining economic freedom, the future economic growth of the United States will be weak for many years to come.

Which suggests that in an election year, our political candidates will focus on the connection between economic freedom and the conditions for prosperity? OK, maybe not.

During this election season, the two major political parties will attempt to convince voters that their policies are dramatically different. But the EFW data indicate that the U.S. decline in economic freedom began during the presidency of George W. Bush and has continued under President Obama. Subsidies, grants, and other forms of political favoritism directed toward well-organized interests providing large political contributions have become the primary business of both parties, undermining economic freedom and retarding economic growth.

Unless American voters and the politicians they elect reverse course, our future will be one of stagnation, dependency, broken promises, and increased political corruption.

Financial regulations add burden to wind power projects

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Michael Giberson

Lawrence Berkeley National Lab’s recently published 2011 Wind Technologies Market Report (pdf) provides a fairly focused look at wind power industry developments. Among the insights:

At the same time [as the European debt crisis began creating trouble for some lenders], new banking regulations took hold, driving considerably shorter bank loan tenors (institutional lenders, meanwhile, continued to offer significantly longer products). In contrast to the weakened debt market, the market for tax equity improved somewhat in 2011 … As the number of grandfathered Section 1603 grant deals begins to taper off in 2012, however, attrition in tax equity investors is possible, as some have indicated no interest in PTC deals.

I’m sure banking regulators didn’t intend to lead banks to offer shorter loan terms to wind power developers, but the rain falls on the just and the unjust and similarly the consequences of bank regulations are no respecter of conflicting government policies. (I’m wondering how banking regulators would score the net costs and benefits of slightly discouraging subsidized energy projects?)

Gayer & Viscusi: Energy efficiency regulations, the environment, and consumer sovereignty

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Lynne Kiesling

Ted Gayer of the Brookings Institution and Kip Viscusi of Vanderbilt University have a new Mercatus working paper that is a careful and thoughtful critique of the rationale, the methodology, and the outcomes of federal energy efficiency regulations. Using standard Pigouvian externality theory, most environmental regulations are based on the “market failure” rationale that individual actions create unaccounted-for and uncompensated costs. Gayer and Viscusi begin their argument with the claim that such a rationale for regulation is indeed valid, to the extent that such costs exist. It also matters whether or not those costs are relevant at the margin — would imposing a tax for a cost or a subsidy for a benefit change the individual’s actions in ways that would account for the externality? If not, then it’s an irrelevant externality.

In the case of a relevant externality, we use benefit-cost analysis (BCA) to evaluate policy proposals that are intended to move from the existing outcome toward a more efficient outcome by changing individual incentives and choices. Gayer and Viscusi provide a clear, succinct summary of BCA’s analytical framework. Much of their subsequent argument hinges on something important that they point out early in the paper: while it’s possible that individuals don’t fully take into account the effects of their actions on others, we still assume that the individual is in the best position to evaluate the likely net benefits they will obtain across a range of alternatives. I’ve phrased this statement of rationality quite generally — it doesn’t require full information, nor does it require perfect foresight. All of the rationality that is required to support the consumer sovereignty at the core of BCA is that the individual is better positioned than any other person or set of persons to perform that evaluation.

Here’s where the Gayer and Viscusi analysis is very useful, because from here they open up a critique of how regulatory agencies use the consumer irrationality interpretations of behavioral economics as a further rationale for regulation. This is common practice, and one that I find analytically unacceptable. Moreover, I think it’s common practice in energy policy analysis to conflate the “market failure” argument and the “consumer irrationality” argument; for example, several years ago I attended a talk in which the author took the empirical finding that consumers have high discount rates for vehicle fuel savings (typically they value three years worth but not beyond), and he labeled that fact as a “market failure”! To this day I wish I had challenged him on that false conflation.

This sovereignty/irrationality point is a crucial core of the normative arguments and justifications for legitimate policies and regulations, and it’s an argument that isn’t well-made often enough. Gayer’s and Viscusi’s contribution here is important. They note that

If BCA abandoned the presumption of consumer sovereignty and replaced it with another  assumption about the systematic behavior of consumers, it would lead to the normative implication that the analyst or policymaker decides what is best for each consumer. Given the informational and analytical challenges of finding behavioral failings among heterogeneous individuals, this is a tall order for any analyst or policymaker, especially given that they are also prone to information and behavioral failings. A principal theme of Viscusi’s book, Rational Risk Policy, is that government regulators often institutionalize individual irrationality because policymakers are human and because the pressures exerted by their constituencies push policies in directions away from rational norms. (pp. 7-8)

Here Gayer and Viscusi argue in the spirit of robust political economy — humans have cognitive limitations both in their individual decision-making and in the institutions they design and the political/policymaking roles they perform. Their analysis in this paper presents an argument, and provides supporting evidence, that individual sovereignty should remain our analytical standard in the BCA methodology that regulatory agencies implement to evaluate policies. As they state, this standard implies that

A shift away from the principle of consumer sovereignty will also lead to regulations focused more on correcting self harm than on internalizing environmental harm. For example, it would place greater weight on regulations that ban energy-inefficient products than on regulations that raise the price of pollution. … Therefore, the burden of proof for any BCA conducted as part of a review of regulatory proposals should be placed heavily on justifying any presumption of a deviation from consumer sovereignty. The agency preparing the BCA needs to demonstrate a systematic deviation from consumer rationality rather than just presuming that the regulator is better equipped to make decisions that protect individuals from themselves. (pp. 8-9)

They then evaluate four specific applications of energy efficiency policies designed to close the “energy efficiency gap” — the high discount rate implicit in the tradeoff facing consumers between near-term capital costs of energy-efficient devices and longer-term energy savings (as in the example I alluded to earlier). In evaluating energy efficiency regulations for vehicles (CAFE standards), room air conditioners, clothes dryers, and incandescent light bulbs, they examine both the academic literature and agency analyses to see whether the regulations internalize environmental harm or correct self-harm, to use their language.

Their analysis of agency (and, by implication, national lab) studies shows a recurring pattern of emphasis on engineering analyses that compress the treatment of consumer benefits into energy-efficiency-focused dimensions and ignore other aspects of consumer preferences. For example, in performing vehicle analyses, regulatory studies will incorporate data on the transportation function of the vehicle, fuel costs, and the energy efficiency of the vehicle. Omitted from the analyses are variables like comfort, number of seats, volume of cargo capacity, mortality statistics and safety ratings, maintenance ratings and costs, and performance variables such as acceleration. Omitting these variables from the analysis implies that the agency’s policymakers do not believe that such variables should factor in to consumer technology choices, and that energy efficiency is the most important variable. Gayer and Viscusi argue that agencies should make that argument based on evidence of external costs and market failure, and not based on arguments that policymakers know better than individuals what choices are most in their self interest.

My summary does not do their argument justice; the entire paper is well worth your time. Mercatus has also generated some policy briefs to accompany this longer paper: this four-page policy brief that summarizes the analysis, and this graphic that illustrates their estimate of the effects of energy efficiency regulations. If the purported objective of energy efficiency regulations is reducing environmental harm, this analysis suggests failure.

 

I would add another arrow to their analytical quiver. Taking as given the cognitive limitations of humans and the evidence we see from behavioral economics, which institutional framework is more likely to lead to more efficient error correction? If their analysis is correct and most of the outcomes of energy efficiency regulation are “protection from self-harm” and not reduction in environmental harm, what’s the most effective means of enabling individuals to correct those errors? Imposition of choice-restricting regulations is less likely to do so than either market processes or, in the cases where the “self-harm” results from incomplete information, regulations that focus instead on providing clear information and comparisons of the effects of different alternatives.

 

Should ice-making be a regulated utility?

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Michael Giberson

Lynne’s post on early commerce in ice reminded me that ice making has made other appearances in economic history. For example, some U.S. states once required a state license to make and sell ice.

The question of the reasonableness of such licensing requirements reached the Supreme Court in 1932 in New State Ice Co. v. Liebmann. The New State Ice Co. had secured a license from the Oklahoma Corporate Commission to operate an ice-making plant in Oklahoma City. Subsequently Liebmann built his own ice-making plant in the city and began to operate without a state license. New State Ice sued to enjoin Liebmann from operating without a license.

At the time Oklahoma state law said: “the manufacture, sale and distribution of ice is a public business; that no one shall be permitted to manufacture, sell or distribute ice within the state without first having secured a license for that purpose from the commission; that whoever shall engage in such business without obtaining the license shall be guilty of a misdemeanor, punishable by fine not to exceed $25, each day’s violation constituting a separate offense, and that by general order of the commission, a fine not to exceed $500 may be imposed for each violation.”

The court said:

Stated succinctly, a private corporation here seeks to prevent a competitor from entering the business of making and selling ice. It claims to be endowed with state authority to achieve this exclusion. There is no question now before us of any regulation by the state to protect the consuming public either with respect to conditions of manufacture and distribution or to insure purity of product or to prevent extortion. The control here asserted does not protect against monopoly, but tends to foster it. The aim is not to encourage competition, but to prevent it; not to regulate the business, but to preclude persons from engaging in it….

The court affirmed a lower court ruling against the state law:

The principle is imbedded in our constitutional system that there are certain essentials of liberty with which the state is not entitled to dispense … This principle has been applied by this court in many cases. [Citations omitted.] In the case last cited the theory of experimentation in censorship was not permitted to interfere with the fundamental doctrine of the freedom of the press. The opportunity to apply one’s labor and skill in an ordinary occupation with proper regard for all reasonable regulations is no less entitled to protection.

Justice Brandies dissented from the majority, saying “It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of the country,” and “Denial of the right to experiment may be fraught with serious consequences to the Nation.”

While I’m a big supporter of the idea of social and economic experimentation, notice here that Oklahoma’s “experiment” with regulating the ice industry was itself a “denial of the right to experiment” by private businesses. Such denials, too, may be fraught with serious consequences.

Economic experimentation, economic growth, and regulation

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Lynne Kiesling

For much of the past year I’ve been thinking about experimentation and the role that experimentation plays in economic activity and value creation; my post on Jim Manzi’s book earlier this week is in keeping with my interest in this topic. When I reflect on the processes of value creation and economic change that we observe in the real world, I see experimentation everywhere — firms experiment with new business models, new products and services, new modes of organization; consumers experiment by exploring, trying out new products and services, to learn whether or not things they haven’t tried before would give them more enjoyment, better enable them to thrive, or not be worth purchasing or consuming again. In this way, both producers and consumers are entrepreneurs, and when firms profit from having created new combinations that consumers try and like and purchase and recommend to their friends, that’s an example of the role that experimentation plays in value creation. And particularly in the forms of technological change and ensuing commercial innovation (and subsequent technological change, lather-rinse-repeat) that we’ve experienced over the past two decades, the role of experimentation in value creation is even more obvious.

There’s actually an academic literature on this topic in management and organizational theory, including contributions from my colleague Shane Greenstein, who is the world’s foremost expert on the economic history of the Internet and its development and organizational structure. Shane also writes at a wonderful blog, Virulent Word of Mouse. Shane’s work draws largely on Nate Rosenberg’s important work on the economic history of technological change. Rosenberg’s article Economic Experiments, in the inaugural volume of Industrial and Corporate Change, defines economic experiments as encompassing market experiments leading to new products and new technologies as well as “experimentation with new forms of economic organization”. Rosenberg then goes on to argue that the freedom to engage in economic experiments is one of the causal factors in the unprecedented economic growth and industrialization in countries like Britain and the United States.

One of the insights from Shane’s analyses of the market for Internet access (and, in an as-yet unpublished paper, wireless Internet access) is that economic experiments enable firms to benefit from experiential learning — economic experimentation enables them to learn things that they cannot learn in any other way, because they put products and services out for consumers to experiment with and choose, or not. Absent this process of market experimentation, firms have limited access to the private, subjective knowledge of individual consumers because otherwise they only have indications about consumer preferences and perceptions from focus groups or controlled laboratory experiments. Why is the knowledge created and captured in this market experimentation so valuable? For one thing, it communicates that subjective, diffuse private knowledge of consumers to firms, signals that they see in data on adoption rates, revenues, and profits/losses. For another, market experimentation is a process through which consumers themselves create knowledge as they learn their preferences, tradeoffs, willingness to pay for some features of products and services. Those consumers do not, and cannot, know those preferences before they actually confront those options in a real situation in which they can make a choice among the various alternatives presented to them. Only by market experimentation with the actual technologies, products, and services as they are available in the market can both firms and consumers learn what value consumers attach to them and what ways they will create and what applications they will find of them that the producers did not envision at the outset.

You probably recognize the argument I just made as an Austrian knowledge-based argument for market experimentation. In an article in Organization Science (2000), Scott Shane draws on Austrian economics to make a related point, that when technological change occurs, market experimentation allows entrepreneurs to discover how best to exploit the new technology. He grounds his argument in Hayekian diffuse private knowledge that is only accessible to others via market signals such and prices and profits/losses. The profits earned or losses incurred indicate the value consumers can generate with the technology, product, or service, as well as whether the firm has an organizational structure enabling it to control the costs of bringing this new value proposition to market.

In all industries and markets, regulatory policy affects the extent to which such economic experimentation can occur. Some regulations restrict the nature of new technologies, products, or services that can be offered to consumers (think, for example, of all of the debate over the past three years about retail financial services and the new CFPB). Some regulations either directly or indirectly affect the scale and scope of the organizational structure that firms can have. Some regulations restrict entry into the provision of specific technologies, products, or services (one example here is occupational licensing, which erects entry barriers). And some regulations do all three of these things, stifling economic experimentation in multiple dimensions.

Traditional electricity regulation restricts product and service characteristics and restricts entry, thereby reinforcing the old vertically-integrated monopoly utility organizational structure (three for three in my above taxonomy). Not surprisingly, then, this is an industry in which exogenous technological change and pervasive economic dynamism in the rest of the economy has been so slow to penetrate, because traditional cost-based regulation of vertically-integrated monopolists presents sizable barriers to economic experimentation. If Rosenberg and Greenstein and Shane and others are correct that the freedom to engage in economic experiments is one of the most significant causal factors in economic growth, the limit on economic experimentation in an industry that is so intimately connected to innovation and well-being and thriving in so many dimensions of our lives is an exceedingly costly limit that electricity regulation imposes on all of us.

In another post I’ll say more about what costs might arise from economic experimentation in the electric industry.

Experimentation, Jim Manzi, and regulation/deregulation

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Lynne Kiesling

Think consciously about a decision you contemplated recently. As you were weighing your options, how much did you really know that you could bring to bear, definitively, on your decision? Was the outcome pre-determined, or was it unknown to you? For most of the decision-making situations we confront regularly, we don’t have full information about all of the inputs, causal factors, and consequent outcomes. Whether it’s due to costly information, imperfect foresight, the substantial role of tacit knowledge, the inability to predict the actions of others, or other cognitive or environmental factors, our empirical knowledge has significant limits. And yet we make decisions ranging from the color of socks to wear today to whether or not to bail out Bear Stearns or Lehman Brothers. But we do so despite these significant limits of our empirical knowledge.

We build, test, and apply models to try to reduce this knowledge constraint. Models hypothesize causal relationships, and in social science we test those models largely using quantitative data and statistical tests. But when we build formal models, we make simplifying assumptions to make sure that the model is mathematically tractable, and we test those models for causality using incomplete data because we can’t capture or quantify all potentially causal factors. Sometimes these simplifying assumptions and omitted variables are innocuous, but then how useful will such models be in helping us to understand and predict outcomes in complex systems? Complex systems are characterized by interdependence and interaction among decisions of agents in ways that are non-deterministic, and specific outcomes in complex systems are typically not predictable (although analyses of complex phenomena like networks can reveal patterns of interactions or patterns of outcomes).

One person who’s been thinking carefully through these questions is Jim Manzi, whose new book Uncontrolled: The Surprising Payoff of Trial-and-Error for Business, Politics, and Society is generating a lot of discussion (and is on my summer reading list). On EconTalk this week he and Russ Roberts talked about the ideas in the book, and their implications for “business, politics, and society”. Russ summarizes the books focus as

Manzi argues that unlike science, which can produce useful results using controlled experiments, social science typically involves complex systems where system-wide experiments are rare and statistical tools are limited in their ability to isolate causal relations. Because of the complexity of social environments, even narrow experiments are unlikely to have the wide application that can be found in the laws uncovered by experiments in the physical sciences. Manzi advocates a trial-and-error approach using randomized field trials to verify the usefulness of many policy proposals. And he argues for humility and lowered expectations when it comes to understanding causal effects in social settings related to public policy.

Experimentation in complex social environments is a theme on which I am writing this summer, with application to competition and deregulation in retail electricity markets. Manzi’s ideas certainly flesh out the argument for experimentation as an approach to implementing institutional change that can identify unintended consequences and head costly design choices off at the pass before they become costly or disruptive. I made similar arguments in an article in Electricity Journal in 2005 for using economic experiments to test electricity policy institutional designs, and Mike and I discussed those issues here and here. In broad brushstroke, traditional cost-based economic regulation typically stifles experimentation, because to implement it the regulator has to define the characteristics of the product, define the boundaries of the market, and erect a legal entry barrier to create a monopoly in that market. Experimentation occurs predominantly through entry, by product differentiation that consequently changes the market boundaries. To the extent that experimentation does occur in regulated industries, it’s very project-based, with preferred vendor partners and strict limits on what the regulated firm can and cannot do. So even when regulation doesn’t stifle experimentation, it does narrow and truncate it.

Recently Manzi wrote some guest posts at Megan McArdle’s blog at The Atlantic, including this one summarizing his book and providing an interesting case study to illustrate it. His summary of the book’s ideas is relevant and worth considering:

  1. Nonexperimental social science currently is not capable of making useful, reliable, and nonobvious predictions for the effects of most proposed policy interventions.
  2. Social science very likely can improve its practical utility by conducting many more experiments, and should do so.
  3. Even with such improvement, it will not be able to adjudicate most important policy debates.
  4. Recognition of this uncertainty calls for a heavy reliance on unstructured trial-and-error progress.
  5. The limits to the use of trial and error are established predominantly by the need for strategy and long-term vision.

That post is rich with ideas, and I suspect Mike and I will want to pursue them here as we delve into the book.