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ISET Economist Blog

A blog about economics in the South Caucasus.

Should We Regulate?

Last week, we argued that political decision makers have a tendency to overregulate a society, as new laws, even useless or harmful ones, create the impression that politicians are addressing problems in a society. Moreover, we outlined the theory of a military historian who claims that the Red Army was an “overregulated army”, explaining the disproportionate death toll of the Red Army in the Second World War. In today’s article, we will first look at the advantages of regulation, and we will then propose a set of tools called “Regulatory Impact Analysis” that helps to make the right regulatory decisions.


EVERYBODY WANTS TRAFFIC RULES

Every regulation should be based on at least one of two considerations: it helps to coordinate the activities of different agents, or it helps to resolve a conflict of interest between different members of the society.

Car traffic rules in fact serve both goals. If there was no law prescribing right-hand driving in the streets, some people might drive on the left side of the roads, others on the right side. Whenever a right-hand driver and a left-hand driver would have encounter while driving in opposite directions, there would be an accident. To solve this coordination problem, the government rules that either everybody must drive on the right side, like in Georgia, or on the left side, as in Japan or England.

Traffic rules also address conflicts. If two drivers approach the same crossroads from different directions, each of them would like to be the first to cross the junction. If there were no regulations, it could easily happen that both cars enter the junction simultaneously and crash. Through traffic lights or by giving one of the crossing roads priority status, this potential conflict is defused.

Traffic rules are widely accepted because car traffic is not a zero-sum game. Nobody wants to be involved in an accident, so the advantage of one driver does not come entirely at the expense of another driver, as everybody gains if an accident is avoided.

All reasonable regulations are justified by the above considerations. How, for example, about laws that were enacted to protect the environment? Also here may be a coordination problem. Everybody would be better off with a healthy nature, yet for each single individual it is more convenient to, say, throw waste into the forest, because the advantage of a healthy nature is shared with everyone, while the advantage of easy waste disposal can be pocketed privately. By forbidding waste disposal in the nature, the government solves this coordination problem.

And there are also conflicting interests in environmental issues. If somebody pollutes a river with a factory, the people living downstream may suffer from poisonous drinking water. Through smart regulation, the government can find a compromise between the opposing interests, for example through requiring that the manufacturer filters the waste water or that a certain allowance of poisonous substances must not be exceeded.


REGULATORY IMPACT ANALYSIS

There are plenty of instances of failed regulations. For example, it frequently happened that minimum wages were imposed in order to improve the situation of those at the lower end of the income scale. Yet often this led to increased unemployment among that very group. Likewise, the new labor code imposed in Georgia, intended to improve the situation of workers, may turn out to make it more difficult for them to find jobs. And while the land moratorium on land purchases by foreigners was intended to improve the situation of Georgia’s rural population, some legitimate Georgian rural land owners may suffer from lower land prices due to a lack of foreign demand.

For avoiding such failures, one can carry out a Regulatory Impact Analysis (RIA) before enacting a new law. RIA was pioneered by the United States in the 1980s, and in the 1990s it was made an obligatory precondition for new regulations by Australia and 12 other countries. Today most OECD countries make use of RIA, some of them as a requirement for each and every regulation, no matter what is its scope, some of them only for important laws.

An RIA starts with a definition of the problem, which may relate to coordination or conflict issues. Then follows a scenario analysis, predicting what would be the future situation without any action. Then it lists possible measures the government could adopt for addressing the problem, and for each alternative, a cost-benefit-analysis is conducted. This cost-benefit analysis may draw on quantitative approaches (econometrics and mathematical modeling) and qualitative assessment. Risks associated with each scenario should be clearly pointed out, and it is important that in these analyses all potentially affected justified economic interests are considered. Also indirect consequences have to be taken into account. For example, when advanced countries made the usage of seat belts in cars obligatory, this arguably delayed the development of air bags, an indirect consequence that could have been considered in an RIA.


RIA IN GEORGIA

Making RIA in Georgia obligatory may slow down policy making because of the considerable amount of time that is needed for carrying out an RIA. For a developing country, yearning for quick progress, this may be a high price to pay. In other countries, the average time of an RIA is between 52 and 56 weeks.

On the other hand, developed economies are much more robust when it comes to wrong policy decisions. A strong, diversified and competitive economy can cope with a lot of bad policy without faltering. The Georgian economy, however, is still very vulnerable.

One may compare this to the human life cycle. A young child reacts very sensitive to negative environmental influences. If something goes wrong in the childhood (even more so during pregnancy), the child may be affected throughout the whole life. Once a human has become an adult, it can cope with an unfavorable situation more easily.

For that reason, one might want to conduct RIAs particularly in a country like Georgia, despite the impatience to progress quickly.

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Guest - Eric on Tuesday, 25 February 2014 03:12

The RIA methodology could be used to assess the costs and benefits of making RIA an obligatory step in the introduction of any new regulation :)

The RIA methodology could be used to assess the costs and benefits of making RIA an obligatory step in the introduction of any new regulation :)
Guest - G.T. on Tuesday, 25 February 2014 07:32

RIA of RIA is not defined :)) Also, RIARIA in Georgian means "mess" :)

RIA of RIA is not defined :)) Also, RIARIA in Georgian means "mess" :)
Guest - NP on Tuesday, 25 February 2014 05:06

I like this post very much. Just a minor criticism. I think the example it adopts to explain what a "failed regulation" is not as good as it seems. The blog post says: "For example, it frequently happened that minimum wages were imposed in order to improve the situation of those at the lower end of the income scale. Yet often this led to increased unemployment among that very group". This is questionable. The empirical literature on minimum wages finds scarce evidence of noticeable negative impacts, definitely much less compared to what would be expected.

I like this post very much. Just a minor criticism. I think the example it adopts to explain what a "failed regulation" is not as good as it seems. The blog post says: "For example, it frequently happened that minimum wages were imposed in order to improve the situation of those at the lower end of the income scale. Yet often this led to increased unemployment among that very group". This is questionable. The empirical literature on minimum wages finds scarce evidence of noticeable negative impacts, definitely much less compared to what would be expected.
Guest - Eric on Tuesday, 25 February 2014 23:04

This really depends on the level at which the minimum wage is set relative to average wage. See full list of countries: http://en.wikipedia.org/wiki/List_of_minimum_wages_by_country. In many countries, including Georgia, the minimum wage is a funny small number. In other countries, for example, in Israel, the minimum wage requirement (above 1200 USD/month) is relatively close to average wage (about half).

The result is that e.g. middle class families cannot afford domestic help. At least not on a full-time basis. Cleaning personnel is often hired for a couple hours a week. The institution of private nannies simply does not exist. Many rich families import live-in domestic help and nannies from Thailand, whose wages are more difficult to regulate. However, middle class mothers get no help and have to deal with all the house chores after many hours in the office. Low skills workers, potentially willing to do domestic work, are too expensive to be hired. Is this an optimal outcome?

This really depends on the level at which the minimum wage is set relative to average wage. See full list of countries: http://en.wikipedia.org/wiki/List_of_minimum_wages_by_country. In many countries, including Georgia, the minimum wage is a funny small number. In other countries, for example, in Israel, the minimum wage requirement (above 1200 USD/month) is relatively close to average wage (about half). The result is that e.g. middle class families cannot afford domestic help. At least not on a full-time basis. Cleaning personnel is often hired for a couple hours a week. The institution of private nannies simply does not exist. Many rich families import live-in domestic help and nannies from Thailand, whose wages are more difficult to regulate. However, middle class mothers get no help and have to deal with all the house chores after many hours in the office. Low skills workers, potentially willing to do domestic work, are too expensive to be hired. Is this an optimal outcome?
Guest - NP on Tuesday, 25 February 2014 23:35

I totally agree that the level at which the minimum wage is set is crucial. Obviously if you increase the minimum wage above the productivity of labor of the least efficient workers you are making it impossible for them to find a (formal) job. One might, therefore, wonder about the "optimal" minimum wage level. What is clear from the existing evidence is that the value is very likely not zero and that increasing the minimum wage is not always worsening labor market outcomes of the low skilled workers. Actually, some studies find even that increasing minimum wage can increase employment in the category mostly affected by the increase. Surprising? Not necessarily if one considers not only elasticity of demand but also elasticity of supply and the existence of a reservation wage. To go back to Georgia, we are extremely far away from Israel not only in terms of minimum wage but also in terms of "employment protection legislation" (EPL) even after the "feared" changes in the labor code. Therefore one might argue that fears of negative impacts from "over-regulation" on this front are likely to be excessive.

I totally agree that the level at which the minimum wage is set is crucial. Obviously if you increase the minimum wage above the productivity of labor of the least efficient workers you are making it impossible for them to find a (formal) job. One might, therefore, wonder about the "optimal" minimum wage level. What is clear from the existing evidence is that the value is very likely not zero and that increasing the minimum wage is not always worsening labor market outcomes of the low skilled workers. Actually, some studies find even that increasing minimum wage can increase employment in the category mostly affected by the increase. Surprising? Not necessarily if one considers not only elasticity of demand but also elasticity of supply and the existence of a reservation wage. To go back to Georgia, we are extremely far away from Israel not only in terms of minimum wage but also in terms of "employment protection legislation" (EPL) even after the "feared" changes in the labor code. Therefore one might argue that fears of negative impacts from "over-regulation" on this front are likely to be excessive.
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