To Regulate Or Not To Regulate - The Ultimate Conundrum

Posted in Finance Articles, Total Reads: 2378 , Published on 06 December 2011
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When markets fail the question put forth is – Why didn’t the Government regulate the market? On the other hand when exorbitant costs are incurred the companies wish there should be no regulation imposed on them. A dilemma which not only the common man but also the Government faces – To regulate or not to regulate.However certain situations demand regulations to be imposed while some need free mechanism to operate.

However the question remains “So what should the Government do? Which strategy should the Government adopt?”

Regulation

Should the Government regulate?

The 19th and 20th century economy was characterised by Laissez faire economy. As Adam Smith had said free markets work most efficiently and hence provide the most efficient and optimal outcome, the economy operated on the same principles. Markets were unregulated and free. The twist in the tale came with the Great Depression of 1920. The markets failed and unregulated free market mechanism was unable to correct the situation creating the need for regulation. Hence began the era of regulations. Further the stock market crash of 1929 initiated new regulations on sales of stocks including laws to protect citizens and prevent unemployment.

Regulations undertaken by the Government can either be Social – to ensure the welfare of the public like cleaner environment to work in or Economic – in the form of price controls to protect the customers from being exploited economically. Regulations can be imposed through laws, tariffs, quotas, taxes and other such measures.

Reasons attributable for the adoption of regulations undertaken by the Government are

  • Market Failures – market failures arise due to inefficiencies in the operating process and can be corrected through regulations
  • Externalities – oftentimes negative externalities operate such as the social cost of pollution which is not taken into account by the concerned organisations. Regulations need to be imposed to ensure that such negative externalities can be accounted for
  • Lack of competition – lack of competition can generate monopoly power of certain firms necessitating the need for regulations to control its growth
  • To ensure public safety and welfare – regulations are required to ensure the public safety and measures need to be undertaken to prevent any harmful effects on environment and employees
  • To protect certain industries – certain industries need to be protected in order to ensure that they are able to grow domestically

Another instance which highlights the need for regulations in today’s world is the recent global crisis of 2008 when the investment banks had entered the housing market offering loans to the less credit worthy customers to enjoy the benefits of the housing market which was in boom since 2005. However the housing market collapsed and the rest is known to all, the after-effects of which is felt even today. This incident once again reinforced the fact that human beings are selfish and opportunistic in nature and serve not only their needs but also their greed first. In order to maximise their profits they can go to any extent and thereby necessitate the need for regulations in the market.

Again Greece followed the model of developed countries and didn’t have regulations in place which resulted in the present Euro Crisis. Debt is more than 150% of GDP without much growth prospect in the country. This further strengthens the argument for regulations. Further due to stringent Indian Bank Regulations the impact on India was limited. Other examples of regulated markets include agriculture, electricity etc.

Why should the Government not regulate?

Common perception says free market leads to the most efficient allocation of resources and hence the most efficient outcome. Thereby providing a counter-argument for regulations. Imposition of regulations can lead to higher costs for firms and organisations as they need to adapt themselves to the new structure and policies. Another question that arises is that “Is Regulations really necessary to prevent market failures?” Because oftentimes it has been observed that fewer market failures arise than expected and most of them happen because of faulty government policy or issues of corruption.

Another argument against regulation that can be put forth is- it has been empirically observed that more the regulations in an economy the slower is the growth rate. In 1990 the average growth rate of the economy was 4.3% while Germany, France, Italy which were more restrictive had an average growth rate of only 2%.

An example to further illustrate the adverse effects of regulations is OSHA (Occupational Safety and Health Administration). Congress had created OSHA to protect the workers but it has forced many companies to close down because of exorbitant fines charged for minor infractions.

The deregulation of petrol prices is yet another example that illustrates the need to eliminate regulations and let the market function freely to ensure efficiency.

CONCLUSION

Thus given the above perspectives the point of contention remains whether to regulate or not. What is essential to understand is that there exists no one method or procedure which can be applied successfully in all circumstances. What is needed is the right combination of the two. Government intervention and regulation remains justified and the only measure to combat certain situations. On the other hand certain markets should be let to function freely for most efficient and optimal outcomes. Thus one has to regulate the markets at times and allow the markets to function freely to ensure efficiency.

This article has been authored by Ankita Shah from IIM Shillong


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