Introduction

There cannot be many things in man's political history more ancient than the endeavor of governments to direct economic affairs. The need for state action—or the need for state withdrawal from action—has been a constant and fundamental theme of economics in its much shorter history. The endeavors of eighteenth-century England to direct economic policy called forth the splendid scorn of Adam Smith as he wrote the first and greatest masterpiece in economics. His successors continued to cultivate the policy area, and it has been a rare economist of importance whose opinions on economic policy were not well known to his contemporaries.

A persuasive case can be made that our strong interest in economic policy has not been reciprocated by a corresponding interest in economists' views by our society. One may suggest the support for this view by citing the widespread disregard of what is still the widely held preference of economists for free international trade. The customary reasons for the political disregard of professional economic opinion have been that (1) our theories are incomprehensible, and (2) "special interests" triumph in the political process. The former explanation is most unconvincing; our theories are not that difficult, and more difficult theories of physical scientists are accepted with alacrity. The second is a question rather than an answer: which interests control public policy, and why? Doubts such as these gradually grew upon me and created dissatisfaction with the traditional role which we economists have played in the discussion of public policy. These essays reflect the development of my own thoughts on public regulation during the past fifteen years.

Let us consider for a moment the traditional role of the economist in public policy, in which he analyzes, with the aid of economic theory, a specific problem in policy. If he found that a competitive market did not solve the problem efficiently, he recommended that the state take over the solution of the problem —with never a serious question on the comparative efficiencies of

x Introduction

market and government (see chapters 4 and 7). If the competitive market solved the problem well (a quite routine example, not reprinted here, is my article, "The Economics of Minimum Wage Legislation/' the American Economic Review, 1946), the economist suitably lamented the intervention of the state. The idea that minimum wage laws were the expression not of confused benevolence but of the well-informed desires of particular regions and classes of workers was not seriously considered by economists.

Several studies in this volume were stimulated by a desire to pass beyond the formal economic theory to determine more precisely the effects of the policies actually adopted. In the first of these (chap. 5), Claire Friedland and I searched for the effects of regulation of electrical utility rates by state public service commissions, and in the second (chap. 6) the review of new issues by the Securities and Exchange Commission was studied to determine whether purchasers of these new issues were benefited by the SEC reviews. The study of the announced goals of a regulatory policy is useful work, and I am delighted that these essays contributed to the development of the now widespread practice of studying the actual effects of public policies.

Often, but of course by no means always, the public policies seem not to achieve much toward fulfilling their announced goals. We found little effect of public regulation on the level of electrical rates or rates of return on investments in utility stocks, or, in the second study, little benefit to the purchasers of new stock issues from the SEC reviews. Eventually the question insists upon posing itself: in such cases, why is the policy adopted and persisted in?

It seems unfruitful, I am now persuaded, to conclude from the studies of the effects of various policies that those policies which did not achieve their announced goals, or had perverse effects (as with a minimum wage law), are simply mistakes of the society. A policy adopted and followed for a long time, or followed by many different states, could not usefully be described as a mistake: eventually its real effects would become known to interested groups. To say that such policies are mistaken is to say that one cannot explain them. I now think, for example, that large industrial and commercial users of electricity were the chief beneficiaries of the state regulation of electrical rates (and in our essay there is some unintentional evidence supporting this hypothesis).

This line of thought leads directly to the view that there is a market for regulatory legislation—a political market, to be sure. Some groups (industries, occupations) stand to gain more than others from boons the state can confer, such as subsidies, control of entry of new firms, and price control—just as some industries gain more than other industries from forming a cartel. Again, some groups are better able than others to mobilize political power, whether through votes or money. Where high benefits join low costs, there we should expect early and strong public regulation. This is the explicit theme of chapter 8—and the implicit theme of chapter 11.

This new focus of economic studies of regulation changes the economists' role from that of reformer to that of student of political economy. The change seems to me eminently desirable. Until we understand why our society adopts its policies, we will be poorly equipped to give useful advice on how to change those policies. Indeed, some changes (such as free trade) presumably are unattainable without a fundamental restructuring of the political system which we are unable to describe. A measure of restraint in our advice on policy would seem to be dictated by a sense of responsibility on the economists' part, and not only by the sense of caution of the body politic to whom we address the advice.

Of course we shall not, and need not, abandon all policy advising until we have unraveled all of the mysteries of the political-regulatory process. The very measurement of the costs and benefits of a policy will influence opinion and policy: one perfectly tenable hypothesis is that a society supports its economists simply because they provide complex kinds of information with speed, elegance, and increasingly more tolerable accuracy. I go beyond this humble but useful role in prescribing how to enforce laws (chap. 10). In any event, the basic assumption of the present approach is not that the traditional theory of economics is unhelpful in studying regulation but, on the contrary, is most helpful when it is applied directly to the understanding of the regulatory process.

I wish to acknowledge two heavy debts. The first is to the remarkable group of colleagues at the University of Chicago who constitute a unique intellectual environment: in addition to that

profoundly wise man to whom this book is dedicated, I must name Gary Becker, Ronald Coase, Harold Demsetz (now of UCLA), Milton Friedman, Reuben Kessel, William Landes, Peter Pashigian, Sam Peltzman, Richard Posner, and Lester Telser. My second debt is to Claire Friedland. She is listed as co-author of one paper (chap. 5), but in fact she is the full and indispensable co-author of every one of the empirical studies (chaps. 6, 8, and 9), and only her different economic philosophy keeps me from blaming her for much of the remainder of the essays.

George J. Stigler

Over Freedom

The Unjoined Debate

The controversy between conservatives and liberals in the United States is so ineffective that it is not serving the purposes of controversy. The quality of controversy is not only low but in fact declining, and what was once a meaningful debate is becoming completely unjoined. An unjoined debate is only an affront to the social intelligence. I intend to blame both parties for this failure, and I seek to contribute to their confrontation on several basic issues. Since I am undoubtedly conservative, and only hopefully fair-minded, you should be warned against that perennial and not always intentional gambit, the restatement of an issue in such a way that it has only one defensible side.

The use of the word extremist to characterize a man and his position on public affairs has become fashionable. A word such as this is used less to describe a position than to dispose of it.

An extreme view is one which is sufficiently different from the accepted view of the majority, or the range of views that encompasses the majority, so that few people hold views still more different. The purpose in labeling an individual an extremist is to put his views outside the range of discussion—they are simply too absurd to merit the attention of normal people. An extremist is an intellectual lunatic—allowed loose if he does not communicate violence, but without an admission ticket to ordinary discourse.

There is merit in excluding the lunatic from discourse. If a man tells me he is Napoleon, or for that matter Josephine, discussion would serve no purpose. If a man asserts that the Supreme Court is filled with loyal but well-disguised communists, I do not wish to spend time on him. Occasionally the lone dissenter with the absurd view will prove to be right—a Galileo with a better scheme of the universe, a Babbage with a workable computer—but if we gave each lunatic a full, meticulous hearing, we should be wasting vast time and effort. So long as we do not suppress the peaceful

Reprinted from the University of Chicago, Chicago Today (Winter 1966).

lunatic, we leave open the possibility that he may convince others that he is right.

If there is one lunatic in a village, there will be a hundred in a city and thousands in a nation. But they will not share the same views: each will be eccentric in his own way. A group of men will share a common outlook only because they share common factual beliefs and accept the same causal relationships. They must have tolerably reasonable logical processes in order to arrive at a common position. The larger the group, the more certain we can be that it is not insane in the sense of being divorced from apparent fact and plausible reasoning.

If a minority group rejects demonstrable truth—as when I do not allow my small child to be vaccinated—the majority may resort to coercion, or otherwise abandon rational discourse. But this is an ultimate sanction, and it is defensible only if two conditions are met: the majority must be absolutely convinced of the correctness of its view; and the mistaken minority must be very small. A decent majority must have a strong sense of self-discipline, and practice a self-denial of power except under the most urgent and unambiguous conditions.

This does not mean that large groups may not be mistaken in their facts or fallacious in their reasoning. Even majorities can be sadly wrong in both respects. The way to deal with error, however, is by the use of careful evidence and straight reasoning. We can be sure that a large group is not misanthropic nor is it mentally incapable of sensible thought, so the bases of rational persuasion are available. The use of force, or even of ridicule, is in general illicit in dealing with groups. The believer in democracy, or even more basically a believer in the dignity of man, has a moral obligation to seek to remove differences of opinion among groups by honest argument.

I do not assert that there must be an element of truth in the position of every minority, and that we ought to sift out this element. There are minority views which I find mistaken—for example, the view that we should have protective tariffs for a large number of industries in the United States. But it is one thing to reject a view, and another to refuse to discuss in detail and in good humor the evidence on which it is held.

The issue of extremism is, so to speak, the extreme form of the problem of the debate between the liberals and the conservatives

The Unjoined Debate 5

of America. Neither side seems to be able to understand the other's position. The greater part of the problem is that neither party seems really to understand the position of the other—to share the same fears, nurture the same hopes, or weigh the same evidence. It is as if there were a dialogue between two men, each of whom spoke the same words but with a different meaning. Let me try my hand as an interpreter. The discourse will be confined to economic issues.

Let us begin with the most fundamental issue posed by the increasing direction of economic life by the state: the preservation of the individual's liberty—liberty of speech, of occupation, of choice of home, of education.

The situation is presently this: everyone agrees that liberty is important and desirable; hardly anyone believes that any basic liberties are seriously infringed today. The conservatives believe that a continuation of the trend toward increasing political control over economic life will inevitably lead to a larger diminution of liberty. The liberals believe that this contingency is remote and avoidable. The more mischievous of the liberals point out that the conservatives have been talking of the planting of the seeds of destruction of liberty for decades—perhaps the seeds are infertile. Liberty is thus not a viable subject of controversy; neither side takes the issue seriously.

The lack of any sense of loss of liberty during the last two generations of rapidly increasing political control over economic life is of course not conclusive proof that we have preserved all our traditional liberty. Man has an astonishing ability to adjust to evil circumstances.

It is not possible for an observant man to deny that the restrictions on the actions of individuals have been increasing with the expansion of public control over our lives. I cannot build a house that displeases the building inspector. I cannot teach in the schools of the fifty states because I lack a license, although I can teach in their universities.

This list of controls over men can be multiplied many-fold, but it will not persuade the liberal that essential freedoms are declining. The liberal will point out that restrictions on one man may mean freedom for another. The building inspector who forces me to build in a certain way is protecting my neighbors from fire and pollution. The law that prevents me from teaching in

a high school on balance keeps incompetents out of the classroom. The restrictions on one man, says the liberal, are a grant of freedom to another man.

Clearly the debate is unjoined—two groups are talking at cross-purposes. There is an issue, and it should be faced: has the past expansion of governmental controls diminished our liberties, and if so, which ones and how much? The burden is squarely on the conservatives. If they say that federal grants to education will lead to federal control of our schools, they ought to give some proof. What has happened in educational areas in which the federal government—or for that matter, the state—has long been acting? They say the farm program takes away a farmer's freedom of choice in occupation, and saps his initiative and independence. After thirty years of this program, some objective evidence ought to be available. The seeds-of-destruction talk is sheer indolence parading as prophecy.

A second striking failure of communication is the problem of individual welfare. The academic conservative is dedicated to an efficient price system. This price system will direct resources to their most important uses, weed out inefficient entrepreneurs, induce improvements in technology, and otherwise contribute to a large national product. Many so-called welfare programs interfere with the workings of this price system and are opposed by the conservative. A minimum wage law is a direct interference with this price system in the market for labor services, and wheat subsidies are a similar interference in the market for foodstuffs—and the conservative says both interferences should be stopped.

To the liberal the conservative's preoccupation with efficiency seems outrageous. The liberal sees a numerous family supported by an ill-paid wage earner, and asserts that an economy as rich as ours can afford to pay a meager $1.25 or $2.00 an hour to this wage-earner. The liberal saw a farm family bankrupted in 1933 by the collapse of our economy, and feels that no legitimate purpose is served by again subjecting farmers to hurricanes of economic adversity. A well-bred liberal will not openly voice his doubts of the benevolence of a conservative, but it is difficult to believe that the liberal does not suspect that the conservative has greater love for profits than for people.

I venture to assert that the conservative is an earnest friend of man but that he looks at welfare in a less personal and restricted

The Unjoined Debate 7

way than the liberal. When the price of wheat is raised by a crop restriction scheme, everyone can observe the benefit to the owner of the farm, and it is this benefit that catches the liberal eye. The conservative is troubled by two other effects of the crop restriction scheme: a tax has been levied on all the consumers of bread; and the restriction scheme almost inevitably will lead to some waste of resources or, differently put, reduce the community's real income. These effects are obviously harmful to non-farmers. The conservative's opposition to minimum wage legislation is more direct: such legislation injures some of the lowest paid workers by forcing them into even lower paid occupations exempt from the act, one of which is unemployment.

The conservative's preference for low prices, strong incentives to diligence and thrift and inventiveness, and similar attributes of efficiency and progress, has indeed a substantial advantage over the liberal's plan of assisting particular needy groups. There are many, many needy groups in a society, and some take a generation or two or even three before they catch the eye of the liberal, be he reformer or politician. The liberal started to care for the poorly housed in American cities a few years ago. In the preceding 300 years the private enterprise economy had sole responsibility for improving their housing. The liberal hopes to take especially good care of the poverty-stricken in Appalachia in 1966—notice the date; but he will ignore the dozens of other groups of equal or greater need until someone publicizes their need. The conservative's programs are designed to help everyone, even groups too poor to have a press agent.

These remarks are intended to illustrate a general proposition: the conservative opposition to intervention by either government or private monopoly is commonly stated in efficiency terms but could always be restated in terms of welfare, and especially in the welfare of consumers. A conservative may be truly humane. It is fair to say that the conservative is compassionate for the great mass of the population which is moderately affected by each public policy, whereas the liberal is compassionate for the special, identifiable group which is most benefited or injured by the policy in question.

Here I am inclined to argue that the liberal should be asked to do more of the work in joining the parties to the debate. If the pebble of public policy sends ripples of harm out over the economy, they

should certainly be reckoned in before deciding whether to cast the pebble. If, to do $50 of good in one place, we must do $30 or $70 of harm elsewhere, we ought at least to know about this harm.

But there is more than this to the conservative position. Suppose we wish to help a particular group of farmers or slum dwellers or a disaster-stricken community. Often it is possible—in fact, usually it is possible—to devise policies which impose a minimum of harm on other groups, or place this harm on a known group capable of bearing it. In our example of the farm program, for example, we can choose between direct income grants that do not lead to a waste of resources or—as at present—a crop restriction scheme that does waste resources. We can finance the benefits to farmers by charging more for bread, or by using general tax revenues. I may add that no economist who is outside active politics will defend the present farm program, whether he be liberal or conservative.

I shall be so absurdly fair-minded as to notice the reply to this discussion by a fair-minded liberal. True, he will say, too little attention has been devoted by us liberals to the effects of our policies on people who cannot afford to send a representative to the congressional committee hearings. We grant you conservatives humanity and shall reckon indirect effects of our policies henceforth. But do you deny that conservatives opposed social security, all farm programs, the urban renewal programs, the recent anti-poverty bill and so forth ... ? Have not the conservatives been too preoccupied with the indirect and diffused costs of programs to give due weight to their direct and immediate benefits for hard-hit groups?

On reflection I am inclined to give two answers. The first is that the rise of per capita incomes (in 1964 prices) from about $500 in 1875 to $2,600 today is a measure of the immense benevolence implicit in a private enterprise system, and this rise has not only done more to eliminate poverty than all governmental policies ever devised, but has in fact also financed these policies. The second answer is, touche.

There are two issues concerning the competence of the state which divide the conservative and the liberal. One is the capacity of the state to withstand special interests; the other is its capacity to get things done. Roughly these issues amount to the questions:

The Unjoined Debate 9

does the state do things it should not, and does it fail to do the things it should?

Everyone will admit that the state enters fields simply because a politically well-situated group wishes assistance. The oil import quota system is attributable to only one argument: there are powerful representatives in Congress from the few states which have oil fields. Our tariff history is the same story many times retold. The continuance of the farm program on its present scale and scope is attributable only to the votes of farm areas. The list of such political ventures can be extended substantially.

The conservative argues that these programs reveal the vulnerability of the political process to exploitation by special groups. The vulnerability is greater, the greater the role of government in economic life: if the oil and textiles industries have been given import quotas, it is hard to deny quotas to meat (1964) and automobiles for Canada (1965). History suggests to the conservative that the way to combat these abuses is to have a self-denying ordinance: Congress must refuse to play the game of helping individual industries or localities.

The liberal's reply is two-fold. His lesser answer is that many of the programs are not so bad as all that: the farm program, for example, has not excluded all poor farmers from its list of beneficiaries. His larger answer is: we cannot refuse to use a weapon of public welfare simply because it is sometimes abused. We cannot abolish hammers because they are also used as blunt instruments.

The failure to join issues becomes obvious if we ask how we are to rid ourselves of policies which informed and disinterested people agree are undesirable policies. The conservative replies that we should make it hard to have any such policy: create (or rather, re-create) a persuasive tradition of nonintervention by Congress in the importation of individual goods, the pricing of particular goods, and so forth. The liberal replies that we must educate the majority of the population up to the level where they understand the objections to the undesirable policies and instruct their representatives to oppose them.

A professor can hardly deny the propriety of using education to achieve enlightened policies. Yet history does not suggest that it is a quick remedy for the abuses of special groups. The level of

formal education of our population has been rising steadily for a century and it has reached historically unprecedented levels. There are probably more years of schooling in our population than world history recorded before 1925. If education of the public leads to lesser perversion of the political process by special groups, we should be able to detect this trend in legislation. The trend is painfully in the other direction: the special interest legislation has been on the rise throughout the twentieth century. The liberals owe it to themselves and to the society to start thinking about effective ways to contain the exercise of the state's economic power.

The second issue is the competence with which the state discharges its economic functions. Does regulation of railway rates keep them at proper levels? Does review of new stock issues protect the investor from loss? Does review of the truthfulness of advertisements protect consumers? Does the federal mediation service reduce the frequency or duration of strikes? Will the review of new drugs save human lives?

I ask you to believe a strange thing. No one knows the answer to questions of this sort. At most only a tiny set of policies have been studied with even moderate care. The conservative has not found it necessary to document his charges of failure, nor the liberal to document his claims of success.

The last subject of unjoined debate which I shall discuss is the question of the competence of the individual. The situation is this: the liberal finds the individual to be steadily losing the capacity to deal with the problems thrown up by an advancing industrial society. The consumer could once look at a horse's teeth, but how does he judge the quality of a motor car? The consumer once bought navy beans by the pound, but how does he know what is in the partially filled box of beans which also contains irium, or is it Pepsodent?

The conservative has several replies. One, which I shall merely note, is that even if liberals do not know how to buy an automobile, conservatives do. A second and more general response is that it is easy to exaggerate the difficulties. Even a non-mechanic can learn by the experience of his friends and of himself whether a given automobile manufacturer habitually makes reliable, durable, comfortable automobiles. And anyway, responsibility is good for a man.

This too is an unjoined issue, one that has a clear analogy to the question of the competence of the state. Take first that manly sentiment: a man should make his own decisions because this improves his character and induces him to enlarge his knowledge. This is both obviously true and plainly false. It does a man's character little good to be sold impure food, or to have his appendix removed by an incompetent doctor, or to be hit by a truck which has no brakes. On the other hand, if a man is allowed to make decisions only when unwise decisions are of no serious consequence, it is indeed hard to believe that experience will be much of a teacher.

The situation is complicated in practice by the differences among men in their ability to cope with given problems. Installment credit, for example, is a boon to the community at large: it permits men to improve the time pattern of their consumption. A few people, however, are hopelessly incompetent to resist the blandishments of salesmen, or even to understand the contracts into which they enter. How many such people must there be before credit sales are regulated to protect them—and, unfortunately, to make life more complex and expensive for the rest of the community?

The larger question of individual competence is really a very different one, however. It is, how well does our economy operate? That this is really the heart of the problem I hope to show by two examples.

The first concerns the sale of food in containers which convey an exaggerated impression of their contents: the partially empty box of a breakfast cereal. Suppose it is true that consumers do not weigh the contents or read the small print which contains this knowledge. There is another source of protection of the consumer: the rivals of the company which engages in this sort of packaging. If consumers buy the half-empty container at the same price as full containers, rivals will begin to lessen the contents and reduce the price—for of course their costs of production have fallen and they are eager to expand sales. This competition will continue until the price per unit of contents is what it was before the idea occurred. If people were as silly as the liberals say, corn flakes boxes would eventually be empty, but they would sell for the price of the cardboard.

In every case of the exploitation of the ignorance of consumers

or workers or investors by a businessman, the leading protector of the exploited class is the businessman's competitors. I need not be well informed, because if anyone seeks to profit by my ignorance, his efforts will merely arouse his rivals to provide the commodity at a competitive price. Competition is the consumer's patron saint.

To be sure, competition does not always exist, and America has an antitrust policy precisely to combat monopolies and conspiracies of nominally independent companies. But the common complaint at the failure of the market to protect consumers and workers and investors is seldom directed to monopoly, but rather to the fact the the forces of competition do not exist, or are too weak, or act too slowly. The liberals have not done a good job of showing the profitability or the prevalence of fraud and deception. They have been content to rely upon scandalous incidents and a priori arguments. The defense of competition by the conservatives has also been too theoretical: the elegant economic theory which describes a competitive system has received entirely too little statistical elaboration.

There is a second resource of a non-expert in a complex world: he can hire an expert. If I want a reliable television set, I can purchase it from a reputable department store, one of whose main services is indeed to find good quality goods as my agent, and to guarantee their quality. If I want my son to get an education, I can hire a college to insure that his instructors are qualified. Our economy is simply plastered with institutions which specialize in providing knowledge, and in some fashion guarantee the accuracy of the knowledge.

The appearance of institutions supplying specialized information does not completely solve the information problem. My teacher, Frank H. Knight, used to say that in order to choose the best physician, a person would have to know how much medicine every physician knew, and if he knew that much, he would have sense enough to treat himself. How do I know that my department store is reliable, that the college will really go out and get good teachers?

I can't be sure of these things, just as I can't be sure a government agency will be staffed by competent men. But time is on my side. These specialized agencies have fairly long lives so I can judge them by results. Marshall Field and my university have been selling appliances and selecting professors for many years,

so I can make a reasonably good prediction of how they will act in the years ahead. The reputation for rendering good service over long periods is the most priceless asset of a knowledge-supplying agency, and I can be sure that even dollar-chasing merchants and dollar-chasing college presidents will struggle hard to preserve this reputation.

These homely examples are not intended to answer the charge that the individual is losing the competence to make his own decisions. They are intended to suggest that a private enterprise economy has the powerful resources of specialization and competition to assist the consumer, the laborer, and the investor. New problems are constantly arising for the individual in modern society. The liberals have no right to assume that the individual is helpless in meeting them; the conservative has no right to assume that the market place will automatically protect the individual.

It is disturbing to look back upon these four grave issues: the preservation of liberty, the humanitarian treatment of the needy; the competence of the state, and the competence of the individual —and in each case observe a failure of the debaters to join issue. It is disturbing because both liberals and conservatives are honest, intelligent, and public-spirited. There are no villains in the picture. It is all the more disturbing that the good humor and good will of the participants to the debate are declining. The intellectual bears a heavy responsibility to restore cogency and mutual respect to the discussion.

The joining of the debate, and the collection and analysis of large amounts of the information I have called for, will not eliminate differences of opinion on public policy. We shall still have men disagreeing on the comparative roles of individual responsibility and social benevolence. No matter how we multiply our researches, there will be unresolved factual and theoretical questions which permit alternative policies to be followed. But an effective joining of the debate should put focus on our controversies and build progress into our policies. We need them.

Reflections on Liberty

For at least the past forty years the conservatives have been in high alarm at the encroachments on liberty by the state. It would be possible to amass a volume of ominous predictions—and not by silly people—on the disappearance of individual freedom and responsibility. Yet if we canvass the population, we shall find few people who feel that their range of actions is seriously curtailed by the state. This is no proof that the liberties of the individual are unimpaired. The most exploited of individuals probably does not feel the least bit exploited. The Negro lawyer who is refused admission to a select club feels outraged whereas his grandfather was probably a complaisant slave. But neither is complacency a proof of growing tyranny. So let us look at what liberties, if any, the typical American has lost in the recent decades of growing political control over our lives. Let us face this American as he completes his education and enters the labor force. Of what has he been deprived?

Some additional barriers have been put in the way of entrance into various occupations. Some barriers consist of the direct prescription of types of training; for example, to teach in a public school one must take certain pedagogical courses. More often, the state imposes tests—as for doctors and lawyers and barbers and taxi drivers—which in turn require certain types of training in order to be passed. But few people consider such restrictions on occupations to be invasions of personal liberty. The restrictions may be unwise—those for school teachers are generally viewed as such by the university world—but since the motive is (we shall assume) the protection of users of the service, and since the requirements are directed to competence even when they are inefficient or inappropriate, no question of liberty seems involved. No one, we will be told, has a right to practice barbering or medicine without obtaining the proper training. The freedom of men to choose among occupations is a freedom contingent on the willingness and ability to acquire the necessary competence.

The mentally and physically untalented man has no inherent right to pilot a commercial plane—or any other type of plane.

For consider: we surely do not say that a man born with weak or clumsy legs has been denied the portion of his liberty consisting of athletic occupations. At most a man is entitled to try to enter those callings which he can discharge at a level of skill which the community establishes. "Which the community establishes": the obverse of the choice of occupations is the choice of consumers. It can be said that the denial of my right to patronize lawyers or doctors with less preparation than the majority of my fellow citizens deem appropriate is the complementary invasion of my liberty. Why should the community establish the lowest levels of skill and training with which I satisfy my needs? The answer is, of course, that on the average, or at least in an appreciable fraction of cases, I am deemed incompetent to perform this task of setting standards of competence. I am, it is said, incapable of distinguishing a good surgeon from a butcher, a good lawyer from a fraud, a competent plumber from a bumbler, and so on.

Now, one could quarrel with both sides of this position: neither has my own incompetence been well demonstrated (especially when account is taken of my ability to buy guarantees of competence) nor has anyone established the ability of other judges to avoid mistakes or at least crudity of judgment. But these are questions of efficiency much more than of justice, so I put them aside not as unimportant but as temporarily irrelevant.

The real point is that the community at large does not think a man should have the right to make large mistakes as a consumer. The man who cannot buy drugs without a prescription does not really rebel at this indubitably expensive requirement. The man who is denied the services of a cheaper and less well-trained doctor or teacher does not feel that he has been seriously imposed upon.

The call to the ramparts of freedom is an unmeaning slogan in this area. If we were to press our typical American of age 22, he would tell us that some infringements on his liberties would be intolerable, but they would be political and social rather than economic: free speech should not be threatened—at least not by the first Senator McCarthy—and minorities should not be discriminated against. No economic regulation of consumers would

elicit serious objection, and this younger person would often be prepared to go even farther in regulating consumers in areas such as health and education. We would have to propose policies remote from current discussion, such as compulsory location of families to hasten racial integration, before we should encounter serious resistance to public controls in principle.

Governmental expenditures have replaced private expenditures to a substantial degree, and this shift poses a related problem of liberty. The problem seems less pressing because private expenditures have increased in absolute amount even though public spending has risen in this century from perhaps 5 to 35 percent of income. Yet the shift has been real: we can no longer determine, as individuals, the research activities or dormitory construction of universities, the directions or amount of medical research, investments abroad, the housing of cities, the operation of employment exchanges, the amount of wheat or tobacco grown, or a hundred other economic activities. But again the typical American finds each of these activities worthwhile— meaning that he thinks that the activity will not be supported on an adequate scale by private persons.

On a closer view of things, some restrictions on individuals as workers will strike most Americans as unfair, especially if they are presented as indictments. Complaints will be aroused by a demonstration that political favorites have been enriched by governmental decisions which excluded honest competitors—and of course this can be demonstrated from time to time, or perhaps more often. The complaint, however, will involve equity much more than liberty.

This conclusion—that Americans do not think that the state presently or in the near future will impair the liberties that a man has a right to possess—is of course inevitable. It is merely another way of saying that our franchise is broad; our representatives will not pass laws to which most of us are opposed, or refuse to pass laws which most of us want. We have the political system we want.

The conservative, or the traditional liberal—or libertarian, or whatever we may call him—will surely concede this proposition in the large. He will say that this is precisely the problem of our times: to educate the typical American to the dangers of gradual loss of liberty. One would think that if liberty is so important that

a statue is erected to her, then the demonstration that a moderate decline of personal freedom leads with high probability to tyranny would be available in paperback at every drugstore. Such a book is not so easy to find. In fact, it may not exist.

No one will dispute that there have been many tyrannies, and indeed it is at least as easy to find them in the twentieth century as in any other. Moreover, the loss of vital liberties does not take place in a single step, so one can truly say that a tyranny is entered by degrees. But one cannot easily reverse this truism and assert that some decrease in liberties will always lead to more, until basic liberties are lost. Alcoholics presumably increased their drinking gradually, but it is not true that everyone who drinks becomes an alcoholic.

An approach to a demonstration that there exists a tendency of state controls to increase beyond the limits consistent with liberty is found in Hayek's Road to Serfdom. But Hayek makes no attempt to prove that such a tendency exists, although there are allegations to this effect. 1 This profound study has two very different purposes: (1) A demonstration that comprehensive political control of economic life will reduce personal liberty (political and intellectual as well as economic) to a pathetic minimum. (I may observe, in passing, that this argument seems to me irresistible, and I know of no serious attempt to refute it. It will be accepted by almost every one who realizes the import of comprehensive controls. 2 ) (2) If the expansion of control of economic life which has been under way in Britain, the United States, and other democratic western countries should continue long enough and far enough, the totalitarian system of Nazi Germany and Fascist Italy will eventually be reached. This second theme is not a historical proposition—and no historical evidence was given: it is the analytical proposition that totalitarian systems are an extreme form of, not a different type from, the democratic "welfare'' states to which the book was addressed. Hayek was telling gentlemen drinkers, and especially some Englishmen—who were becoming heavy drinkers—not to become alcoholics.

The thirty-five years that have passed since the outbreak of World War II have seen further expansions of political control over economic life in the United States, and in most western European nations except Germany. Yet no serious diminution of

liberties deemed important by the mass of educated (or uneducated) opinion has taken place. Another hundred years of governmental expansion at the pace of these recent decades would surely destroy our basic liberties, but what evidence is there that such an expansion will continue? Quite clearly, no such evidence has been assembled. But it is one thing to deny that evidence exists for the persistence of present trends to the point where they will endanger our liberties, and quite another to deny that such a momentum exists. Or, differently put, where is the evidence that we won't carry these political controls over economic life to a liberty-destroying stage?

This may be an impeccable debating point, but it will carry much less conviction than an empirical demonstration of the difficulty of stopping a trend. When men have projected the tendency of a society to a distant terminus, they have invariably committed two errors. The tendency develops in a larger number of directions than the prophet has discerned: no tendency is as single-minded as its observer believes it to be. And the tendency encounters in the society other and contradictory forces which eventually give the course of events a wholly different turn. We have no reason to believe that the current prophets are any wiser.

So I conclude: we should fish or cut bait. On the subject of liberty the conservative should either become silent or find something useful to say. I think there is something useful to say, and here is what it is.

The proof that there are dangers to the liberty and dignity of the individual in the present institutions must be that such liberties have already been impaired. If it can be shown that in important areas of economic life substantial and unnecessary invasions of personal freedom are already operative, the case for caution and restraint in invoking new political controls will acquire content and conviction. We cannot scare modern man with incantations, but we can frighten him with evidence. The evidence, I think, will take a variety of forms:

1. A full study of the barriers to entry in occupations, and of the extent to which the barriers can be defended on social grounds, will demonstrate, I believe, that the area of occupational freedom has been seriously restricted simply for reasons of

ignorance or special interest. If this is correct—if the present practices will not bear close review—then the danger of further extensions of such barriers will be substantially reduced.

2. The widespread belief in the incompetence of the individual and the efficacy of economic censorship of tastes is the second large area of potential invasion of personal freedom. This development has surely not benefited from close study: it has happened that errors of judgment or deficiencies of knowledge of a tiny fraction of consumers have led to restraints being imposed on all consumers, without even checking what gains are achieved by the censorship. My own study of the SEC [chap. 6], indeed, reveals a clear instance of where the gains are not worth the cost. If consumers are wiser than the public believes, and if political intervention is not infallible and economical, we shall be better able to stop future invasions of the consumer's freedom.

I do not know whether justice is more or less important than liberty, or whether they are even fully separable. The standards of justice under political direction of economic life, I conjecture, are deplorably low:

3. The state is now the giver of many valuable rights. The favorites get TV channels, or oil import quotas, or FDIC charters, or leases on federal grazing lands, or N.Y. state liquor store licenses, or waivers from the local zoning board. Who has studied the bases on which these favors are allotted? I suspect that a careful study would display vast caprice, much venality, and a considerable number of calluses on applicant's knees and navels. The harshness of competition may mellow somewhat in public repute when alternative systems of distributive justice are studied.

Studies of the types here proposed will, I am reasonably confident, give vitality and content and direction to fears for liberty in our society. But whether the studies confirm the need for reform and vigilance in preserving freedom, or suggest that such fears are premature, they are essential to remove this subject from the category of cliche. It is no service to liberty, or to conservatism, to continue to preach the imminent or eventual disappearance of freedom: let's learn what we're talking about.

TWO The Traditional

Regulatory Approach: The Absence of Evidence

The Tactics of Economic Reform

We are a well-meaning people. We are unanimously in favor of a healthy population, also fully employed, well housed, and deeply educated. To a man we wish prosperous and peaceful nations in the rest of the world, and possibly we are even more anxious that they be prosperous than that they be peaceable. We ooze benevolence, and practice much charity, and could easily become smug in our self-conscious virtue.

The denunciation of American complacency, however, is not my purpose, at least not my explicit purpose. I admire the humane and generous sympathies of our society—sympathies that extend now more than ever before to persons of all colors of skin, to the uneducated and the uncultured and the unenterprising and even the immoral as well as to the educated and the cultured and the enterprising and the moral. We are a people remarkably agreed on our basic goals, and they are goals which are thoroughly admirable even to one, like myself, who thinks one or two less fashionable goals deserve equal popularity.

Fortunately our agreement on basic goals does not preclude disagreement on the way best to approach these goals. If the right economic policies were so obvious as to defy responsible criticism, this would be an intolerably dull world. In fact I believe that each generation has an inescapable obligation to leave difficult problems for the next generation to solve—not only to spare that next generation boredom but also to give it an opportunity for greatness. The legacy of unsolved problems which my generation is bequeathing to the next generation, I may say, seems adequate and even sumptuous.

The Need for Skepticism

It is not wholly correct to say that we are agreed upon what we want but are not agreed upon how to achieve it. When we get to

Reprinted from Graduate School of Business, University of Chicago, Selected Papers, no. 13 (1964).

24 Traditional Regulatory Approach: Absence of Evidence

specific goals, we shall find that our agreement does not always extend to orders of importance. For example, some people are willing to preserve personal freedom of choice for consumers even if the choice is exercised very unwisely in some cases, and others will be more concerned with (say) the health of consumers which these unwise choices may impair. Nevertheless, it is roughly true that we know where to go.

We do not know how to get there. This is my fundamental thesis: we do not know how to achieve a given end. We do not know the relationship between the public policies we adopt and the effects these policies were designed to achieve.

This surely sounds absurd: I am saying that although we have had a Securities and Exchange Commission for thirty years, we do not know how to improve the securities markets. I am saying that we have regulated the railroads for seventy-seven years [1964] and do not know how to achieve a sensible railroad rate structure. I am saying that no one knows whether a fair employment practices act will serve to reduce the discrimination against nonwhites in the labor markets. We can get on a bus labelled Economic Reform, but we don't know where it will take us.

You will find it hard to assimilate immediately a challenge to a belief which is so deeply implanted in you that it is simply self-evident. I am reminded of the equally formidable task undertaken in 1819 by a young English clergyman named Richard Whately. In a pamphlet with the title, Historic Doubts Relative to Napoleon Buonaparte, he argued that the evidence that Napoleon had ever existed was very unsatisfactory and inconclusive. He recognized, as I have just done, the difficulty of getting men to rethink an undisputed position.

But is it in fact found that undisputed points are always such as have been the most carefully examined as to the evidence on which they rest? that facts or principles which are taken for granted, without controversy, as the common basis of opposite opinions, are always themselves established on sufficient grounds? On the contrary, is not any such fundamental point, from the very circumstance of its being taken for granted at once, and the attention drawn off to some other question, likely to be admitted on insufficient evidence, and the flaws in that evidence overlooked? Experience will teach us that such instances often occur: witness the

well-known anecdote of the Royal Society; to whom King Charles II proposed as a question, whence it is that a vessel of water receives no addition of weight from a live fish being put into it, though it does, if the fish be dead. Various solutions, of great ingenuity, were proposed, discussed, objected to and defended; nor was it till they had been long bewildered in the enquiry that it occurred to them to try the experiment; by which they at once ascertained, that the phenomenon which they were striving to account for, ... had no existence but in the invention of the witty monarch.

Whately's case against Napoleon's existence rested chiefly upon the utter improbability of the man's career. As just one instance,

Another peculiar circumstance in the history of this extraordinary personage is, that when it is found convenient to represent him as defeated, though he is by no means defeated by halves, but involved in much more sudden and total ruin than the personages of real history usually meet with; yet, if it is thought fit he should be restored, it is done as quickly and completely as if Merlin's rod had been employed. He enters Russia with a prodigious army, which is totally ruined by an unprecedented hard winter; (everything relating to this man is prodigious and unprecedented;) yet in a few months we find him entrusted with another great army in Germany, which is also totally ruined at Leipsic; making, inclusive of the Egyptian, the third great army thus totally lost: yet the French are so good-natured as to furnish him with another, sufficient to make a formidable stand in France; he is however conquered, and presented with the sovereignty of Elba; (surely, by the bye, some more probable way might have been found of disposing of him, till again wanted, than to place him thus on the very verge of his ancient dominions;) thence he returns to France, where he is received with open arms, and enabled to lose a fifth great army at Waterloo; yet so eager were these people to be a sixth time led to destruction, that it was found necessary to confine him in an island some thousand miles off, and to quarter foreign troops upon them, lest they should make an insurrection in his favour! Does any one believe all this, and yet refuse to believe a miracle?

Whately was a young divine when he wrote this piece, which I

26 Traditional Regulatory Approach: Absence of Evidence

interpret to assert that the evidence a typical Englishman possessed for Napoleon's existence was no better than the evidence he possessed for Biblical miracles.

I am jealous of Whately. He was arguing for miracles, which everyone wants to believe in, and in fact everyone wishes to benefit from miracles. Whately soon became an archbishop. I, on the contrary, am compelled to argue against miracles: for I assert that passing a law does not solve a problem. I shall be lucky if I am not fined for loitering on the highway of progress. But on with the task.

I doubt that I can use Whately's approach. One could indeed marvel at the credulity of reformers. In 1887 the railroads of this nation exceeded 180,000 miles, many times the length of the highways of the Roman Empire. The railroad lines and equipment had a value of perhaps 10 billions, or more than twice the expenditures of both sides on the Civil War. The railroads employed 700,000 men—itself the largest industrial army that history had ever seen. This stupendously vast empire was ruled by a set of entrepreneurs of great ability and utter determination. To establish an equitable rate structure, to govern this empire in the most minute detail, the Congress in its wisdom created the Interstate Commerce Commission. A committee of five men, aided by a staff of sixty-one and abetted by an appropriation of $149,000 (as of 1889) was to assume direction of the industry. Could anyone believe that this committee would change much the structure of rates, and not believe in miracles? But since you believe in miracles, I must part company with Whately.

When we undertake a policy reform or improve some part of the economy, there is one way, and only one way, to find out whether we have succeeded—to look and see. Now, only a naive person will believe that historical evidence is unambiguous. Some years ago a young man sued Columbia University, at which I was then professing, for a considerable sum of money because it had failed to teach him wisdom. The fact that he brought the suit was conclusive evidence of Columbia's failure. Nevertheless I agree with this befuddled ex-student that colleges should impart wisdom if they possibly can. I challenge anyone in the whole wide world, however, to prove that, on the average, colleges have taught wisdom, or that, on the average, they haven't. The burden of proof is too heavy for anyone to lift.

Still, it is easy to exaggerate the ambiguity of historical experience: after all, the past is the only source of knowledge of the future. Our trouble, frankly, is less that history speaks obscurely than that we have listened carelessly. We have not studied the experience of economic reform, and know not its successes nor its failures, its lessons on ways to proceed and ways to avoid.

And, of course, the past is instructive only if we study it. Suppose you are ill and I give you a medicine, chosen at random. You will probably survive and, since most medicines are not very potent, even get well. This is not too different from what medical research must be like, for all research involves the liberal use of trial and error. What turns this near-sighted groping into large progress is the recording of the outcome, so that recoveries due only to chance are separated from those due to the beneficial effects of a particular medicine. In a world without memory, there would be, not progress, but an endless succession of random moves, lacking any cumulative improvement.

So the results of experiment should be determined, and compiled. This may be Platitude No. 1 to the scientific investigator, but it is no platitude in the formulation of economic policy In political life it is an idea of considerable novelty, and there are those who would call it un-American except that it is also un-British and un-Russian and un-Indonesian.

Although we have studied the experience under some of our economic policies, the number and importance of those we have not studied are simply astounding. Let me give just three examples that will, I hope, suggest the problem we face in devising good policies for economic reform.

My first example is the regulation of rates for electricity, an area in which modern experimentation began in 1907 in New York and Wisconsin, and for which two-thirds of the states created special public service commissions as long ago as 1915. Yet when, in 1963, Claire Friedland and I began a study of the impact of these regulatory commissions on the level and structure of rates, we were the first investigators ever to do so on even a moderately comprehensive scale [chap. 5].

It was the implicit verdict of the many economists and political scientists who had studied the regulation of electrical rates during the last half century that a study of the effects of regulation was

unnecessary. The bounteous literature implicitly asserts that the influence of the commissions on rates was obvious. The experts knew that of course regulatory bodies are not always competent or honest, but even so the experts were confident that on average the commissions hold down the prices below what the electrical companies would be able to charge because of their monopoly position in each community. If earlier experts could know that a dead fish weighs rather more than a live one, modern experts surely could know that a commission weights down electrical rates. But our study of the effects of regulation on rates came to the conclusion that the effects of regulation are apparently too small to be detected.

You may well find this conclusion incredible. How could hundreds of members of public service commissions have failed to discover long ago the futility of their labors, if they were of negligible import? Why do electrical utilities spend fortunes on lawyers to fight rate cases if they are setting the rates they wish? My ultimate answer is: look at the evidence. My immediate answers are: the efforts displayed by both regulators and industry are no greater than men usually display pour le sport; and if men never persist in what prove to be futile endeavors, why did not the American Indians capitulate by 1700?

A more recent economic reform was the creation of the Securities and Exchange Commission, some thirty years ago, to protect investors from the flamboyant falsehoods that on occasion appeared in the prospectuses that preceded new stock issues. The prospectuses which are now issued after much delay and very substantial expenditures have substituted grim statistics for the enticing loveliness of a seed catalogue. To what end?

Again my main point is that no one had studied the effects of this elaborate machinery on the fortunes of the buyers of new stock issues until I undertook to do so last year [1964, chap. 6]. Neither the security markets nor their regulators nor the academic economists have deemed it necessary to measure the undoubted beneficial effects of three decades of regulation.

Perhaps a word on how one measures the effects of regulation may be useful, for it is no simple task to disentangle one of many influences on the course of events. The SEC study illustrates one approach. Here I hypothetically bought every substantial new issue of industrial common stocks from 1923 to 1927, a period

before the SEC, and from 1948 to 1955. The value of the stock in each of the five years following its issue was also ascertained. We can now calculate what happens to our new investment over time. There remains the problem of allowing for the considerable changes in this world between the reigns of Calvin Coolidge and Dwight Eisenhower. The differential effect of the SEC is measured by comparing values of these new investments with the outcome of buying established securities, over which the SEC has no significant control.

The main finding was that there was no important difference between the 1920s and the 1950s! I may add that it was fortunate that the purchases of new stocks were hypothetical: the investor in new issues of common stock lost twenty per cent of his shirt after two years in both periods.

My last instance is the effect of the Federal Reserve System on the stability of the American economy. This system of central banking was created fifty years ago and has controlled our money system ever since. Here economists have made studies of shorter episodes in the history of the sytem; it is widely accepted, for example, that the restrictive monetary policy of 1931-32 contributed greatly to the financial collapse of 1933. But my colleague, Milton Friedman, collaborating with Anna Schwartz, has recently published the first full-dress study of the effects of the Federal Reserve System upon the stability of prices and banking institutions throughout its history.

By now you may feel able to predict the results: that the Federal Reserve System has had no effect on monetary stability. But no—this time there was an effect:

The stock of money shows larger fluctuations after 1914 than before 1914 and this is true even if the large wartime increases in the stock of money are excluded. The blind, undesigned, and quasi-automatic working of the gold standard turned out to produce a greater measure of predictability and regularity than did deliberate and conscious control exercised within institutional arrangements intended to promote monetary stability (A Monetary History of the United States, 1867-1960, pp. 9-10.)

Many economists, and all bankers, will challenge Friedman's conclusions—in fact a fair number will challenge them even before they learn what he has written. But no one will be able in

30 Traditional Regulatory Approach: Absence of Evidence

good conscience to say that Friedman's study was anticipated or has been contradicted by any other study of comparable scope and thoroughness.

Let me assume, tentatively and hopefully, that you are prepared to acknowledge that the relationship of policies to results is surprisingly obscure. I do not say that our knowledge is nonexistent, because that statement would be distinguishably removed from truth. I do say our knowledge is extremely meager, and I wish now to pass on to you two questions which this deplorable state of affairs poses. First, why are we so poorly informed on the effective weapons of economic reform? Second, how shall we proceed with the reform of our economy?

The reasons we know so little of the effects of past economic policies are worth exploring briefly, because they tell us something about both scholars and political life. The studies that should have been made are the professional responsibility of economists and political scientists. I have no desire to criticize them. Economists are, by their own admission, learned, resourceful, diligent, and benevolent. Political scientists have accused themselves of similar traits. Why have these scholars failed to study much more intensively the relationship between public policies and the course of events? The main answers, I believe, are as follows.

The best scholars are not the best reformers. A scholar ought to be tolerably open-minded, unemotional, and rational. A reformer must promise paradise if his reform is adopted: a candid and qualified estimate of the effects of a given public policy would never arouse a majority from inertia. A reformer should have a low threshold of emotion: I am reminded of Samuel Plimsoll, of the ship line, whose sole stock in trade as a reformer, the London Times reported, was an unrivalled capacity for becoming fervidly indignant upon hearsay evidence. It follows that reformers care little for meticulous scholars—and use only those parts of the scholars' work which fit their needs—very much the way theatrical advertisements present selected adjectives from the reviews. The scholars are normally contemptuous of the reformers, whose scholarly attainments are indeed usually amateur. Reform and research seldom march arm in arm.

The economists have, until recently, been preoccupied with the workings of a comparatively unregulated economic system—what

is loosely described as laissez-faire. They have seldom been in the forefront of economic reform—the two great exceptions being their advocacy of free international trade and policies designed to stabilize aggregate economic activity. They have had a marked preference for free-market organization of economic life.

The reformers, on the contrary, have seldom conceived of any method of achieving a given result except by giving explicit directions to individuals to act in the desired way. When a reform is not achieved by a given regulatory body, the reformers know no other solution than to give this or some other regulatory body more power and more instructions.

Economic reformers, moreover, have had one wondrous advantage for a century or more: the economy was improving in its performance in most ways, so most policies could claim success even if economic progress was quite unrelated to the reform. Some policies were designed to reduce poverty, but the Western economies were all becoming richer and poverty was diminishing as a result of economic growth. Other policies were designed to improve foods and homes, but technology was also striding forward here. Still other policies were designed to improve markets, but the advance of transportation and communication was also improving markets. It is as if the college dining room were to claim sole credit for the fact that seniors weigh more than freshmen.

If close study of the effects of previous reforms had been demanded by our political conscience, it would have been supplied in the past. There is an economic law, named after J. B. Say, to the effect that every offer of goods for sale is an implicit demand for the goods that will be received in exchange. Similarly there is a Say's law of scholarship: professors will study any problem that the society really believes in need of study. Our society has not believed that a close study of the process of economic reform is essential to devise effective reforms.

If I may be permited to insert a refined advertisement, our long-run prospects for rational reform will be much improved as soon as our young people recognize the complexity of the problem. There is an absurd notion abroad that we mostly understand how our economy works and that a democracy—or, for that matter, a dictatorship—knows how to utilize the accumulated knowledge of the social sciences in legislation and

32 Traditional Regulatory Approach: Absence of Evidence

administration. On the contrary, we are far from understanding either our economy or the ways in which to improve it, and the room for creative work in the social sciences is immense. If Mr. Nobel had been a wiser man, he would have directed his prizes to the social sciences to dramatize that really difficult goal of man, the achievement of a civilized society.

The Methods of Effective Reform

Now let me turn to what we should do, pending the vast research we need to inform our actions. We are a reforming society—we have been changing things incessantly since our founding—and we shall not suspend our discontents with economic life for a generation while scholars argue and computers hum. I suggest that we have failed to make anything like adequate use of the most powerful weapon of reform, and my final remarks are devoted to this weapon.

Reformers, I have remarked, are generally rather literal and direct-minded. If they wish to improve housing, they seek to have the state erect houses. If they wish to reduce accidents in factories, they pass a law against unfenced machinery. If they wish to help farmers to have remunerative prices, they pass a law which sets a minimum price. Yet we have seen that such policies are often unsuccessful.

The powerful weapon they overlook is the appeal to the self-interest of individuals. If incentives can be contrived to persuade people to act voluntarily to the goal of reform, we can be confident that our reforms will be crowned with success. Let me spell out and defend this bold claim.

That self-interest is a powerful drive is not really disputable. We recognize its strength so fully that we are not even conscious how much and how confidently we invoke it. Consider a very simple example. A progressive income tax—a tax taking higher percentages of larger incomes—is always reinforced by penalties on rich people who fail to pay their full tax obligations. But the progressivity would also be defeated if the less well-to-do taxpayers paid more than the tax the law demanded. You would think it odd, however, if I proposed that we impose severe penalties on those lower income families which overpaid their tax: quite aside from any other question, I would be assured that overpay-

ment of income taxes was not a widespread problem in America. Or if I proposed a law prohibiting people from breaking into houses to contribute money to the tenants, I would be assured again that there really was no need for such legislation. We really know that self-interest is an extraordinarily powerful drive in man.

It may avoid useless controversy if I say at once two additional things about self-interest. First, it obviously is not the only force in man. Second, self-interest is not confined to a narrow egotism: the scholar who devotes a lifetime to arduous research is moved less by financial gains than by the respect and admiration of his fellow scholars—and if you doubt this, try publishing his work under your name.

Granted that self-interest is a powerful machine—how can we use it for economic reform? The answer is: by arranging that the people who are acting in a given area have incentives to act the way we wish. Let me elaborate this position through two examples.

The first example is the prevention of industrial accidents. If an accident occurs to a given worker, it will be due to one of four causes:

1. The employer has a dangerous place, so even careful workmen will have numerous accidents;

2. The fellow workers of the injured man have been negligent;

3. The injured worker himself has been negligent;

4. Everyone concerned has been careful but misfortune nevertheless occurred.

If we wish to reduce accidents, we may pass laws that machines must be fenced and workers must be careful, subject to penal sanctions. But we also reduce accidents if we put the costs of accidents partly or wholly on the people who prevent them. The employer should bear financial responsibility for the injuries due either to his operating a dangerous place, or to his maintaining an undisciplined shop in which fellow workers are allowed to be negligent. The injured worker should bear the costs of his own negligence.

Several hostile questions are immediately posed by this kind of use of financial incentives. Will not the employer flirt with bankruptcy to save a few dollars of expenses? Most employers dislike a finite chance of bankruptcy but we may require insurance, as indeed we now do with automobiles, which are also

34 Traditional Regulatory Approach: Absence of Evidence

unfenced dangerous machines. Will not the worker ignore the costs to himself of negligence? Of course, especially after he has just mailed off a check for twice what he owes as income taxes. Suppose he is careless and injures himself—are we to allow his children to starve that he may learn a lesson?

This last question is more rhetorical than reasoned: in plain fact most injuries do not have major costs, and no children need be deprived of anything if a typical American worker loses a week's pay. But when major accidents occur, or the family is dreadfully poor, of course it should receive assistance. That a policy cannot work effectively in the extreme 1 percent of cases is no reason to eschew its help in the other 99 percent. Too often the argument is in effect that we should not paint the house because the paint will not protect the wood against artillery fire.

I have not studied the effect of financial responsibility upon accident rates in industry, nor has anyone else, so far as I know. Some partial use of incentives is in fact part of our system of workmen's compensation. I predict that where it has been employed it has been much more effective than direct regulation of safety practices. I predict this because the price system is so effective in directing men's energies in a thousand documented cases. I have, in short, a general theory to guide me in this area—a guide that the traditional reformer lacks.

My second example is racial discrimination in the labor market. I take this example because it is in the forefront of public discussion. It is in some ways a troublesome subject, but most reforms are.

The direct method of reducing discrimination in employment is to insist upon quotas of nonwhite workers, presumably proportional to their numbers. This is a most arbitrary standard: we cannot today staff one-tenth of the positions in theoretical physics, or for that matter in economics, with qualified non-whites. It would be unfair, conversely, to hold them to only 10 percent of the best jobs in professional sports, which pay better than professorships of physics or economics. Moreover, the method of direct legislation—or other forms of direct social pressure—seems very unlikely to achieve important results: it works sporadically in time and capriciously in space.

The basic method of decreasing discrimination in the market is to offer a class of workers at bargain rates. This method has in

fact been operative, and the large secular increase in the earnings of nonwhite relative to white workers has been due to the force of competition. The way we can best reinforce this trend is by increasing the financial incentives to employers to hire nonwhites. We do this, not by increasing their wage rates—the market place will do this—but by increasing their skills. We have a distressingly large number of teenage nonwhites who are not in school or employed. I would favor a two-pronged movement to train them for employment at good wages:

1. A comprehensive program of tuition and support grants for teenagers (of any race) who wish to obtain vocational training in any craft at an accredited school. What we did for veterans after World War II out of gratitude we should do for our nonacademic teenagers out of compassion.

2. The removal of barriers to the employment of unskilled young workers at low wages while they are acquiring training on the job. These barriers include minimum wage rates and apprenticeship restrictions.

These latter proposals will not please some people: a fine thing, they will say, to raise the economic status of the nonwhite youth by lowering his wage rate to a dollar an hour. A fine thing indeed, I reply, to raise it from zero to a dollar.

The reduction of accidents and the elevation of the economic status of the nonwhite are admirable goals, we shall all agree. But there are reforms that some of us will wish and others will oppose.

An instance of a reform with debatable purposes is the maintenance of an import quota system on petroleum to protect the incomes of domestic crude petroleum producers. But let us accept this goal for the sake of argument, or more likely for the sake of election. Then the present system is capricious and arbitrary in high degree. It confers boons on particular importing companies proportional to the quotas assigned to them, and to which they have no claim other than that they used to import petroleum. The extent of these boons, and also of the benefits to domestic oil producers, varies with every change in supply and demand conditions either at home or abroad.

A simple old-fashioned tariff would escape all these objections, and provide a designated amount of benefit to domestic oil producers. The difference between foreign and domestic oil prices will accrue to the treasury instead of the importers, and the

36 Traditional Regulatory Approach: Absence of Evidence

amount of this difference will be explicitly decided upon, not left to the whims of circumstance.

I choose this peculiar area of economic reform to show that the price system can be employed even for reforms of which many non-Texans do not approve. The price system can be used to achieve foolish as well as wise goals.

Effectiveness is a vast claim for the price system, but there may well be ruthless systems of direct control which are also effective. Two quite different considerations lead me to urge the use of the price system wherever possible.

The price system lays the cards face up on the table. Every policy benefits some people and imposes costs upon others; the fencing of machines is a cost borne by consumers of the product of the machine and a benefit to manufacturers of fences. (Paradoxically, it would require a complex analysis to determine whether workers are benefited.) With direct regulation these costs and benefits are neither measured nor located, whereas a price system displays them openly. If you believe in full disclosure at low cost, as I do, this is a great merit.

Finally, a system of reform that recognized the great diversity in men's desires and circumstances is both efficient and humane. The system of direct regulation cannot allow flexibility in the application to individual cases because favoritism cannot be distinguished from flexibility and diversity of conditions cannot be distinguished from caprice. The price system, however, possesses this remarkable power: if we make an activity expensive in order to reduce its practice, those who are most attached to the practice may still continue it. It is the system which excludes from an industry not those who arrived last but those who prize least the right to work in that industry. It is the system which builds roads by hiring men with an aptitude for roadbuilding, not by the corvee of compulsory labor.

Conclusion

Since I spent half of these pages lamenting over our disgraceful ignorance of the effects of past policies, it would seem proper to present concrete evidence of the effectiveness of the use of the price system that I have been supporting in the second half of these pages. It happens that such evidence exists, and in large quantities, but there is no third half of your time in which even to sample

it. So hold to your skepticism and apply it equally to my allegations of proof: I have much more faith in the long run benefits of the practice of demanding evidence of the effects of various economic policies than I do in the beneficial effects of the policies that you or I now prefer. If we can bring ourselves to demand the credentials or effectiveness from the proposers of reforms, we shall reduce the charm of their calling but increase the welfare of our society.

The Economist and the State

In 1776 our venerable master offered clear and emphatic advice to his countrymen on the proper way to achieve economic prosperity. This advice was of course directed also to his countrymen in the American colonies, although at that very moment we were busily establishing what would now be called a major tax loophole. The main burden of Smith's advice, as you know, was that the conduct of economic affairs is best left to private citizens—that the state will be doing remarkably well if it succeeds in its unavoidable tasks of winning wars, preserving justice, and maintaining the various highways of commerce.

That was almost two centuries ago, and few modern economists would assign anything like so austere a role to the economic responsibilities of the state. The fact that most modern economists are as confident in prescribing a large economic role to the state as Smith was in denying such a role is not necessarily surprising: professional opinions sometimes change after 188 years, and economic and political institutions are of course even less durable.

But, surprising or not, the shifts in the predominant views of a profession on public policy pose a question which I wish to discuss. That question is: on what basis have economists felt themselves equipped to give useful advice on the proper functions of the state? By what methods did Smith and his disciples show the incapacity of the state in economic affairs? By what methods did later economists who favored state control of railroads, stock exchanges, wage rates and prices, farm output, and a thousand other things, prove that these were better directed or operated by the state? How does an economist acquire as much confidence in the wisdom of a policy of free trade or fiscal stabilization as he has

Presidential address delivered at the Seventy-Seventh Annual Meeting of the American Economic Association, Chicago, 29 December 1964. Reprinted by permission from the American Economic Review, March 1965.

in the law of diminishing returns or the profit-maximizing propensities of entrepreneurs?

The thought behind these questions is simple. Economists generally share the ruling values of their societies, but their professional competence does not consist in translating popular wishes into an awe-inspiring professional language. Their competence consists in understanding how an economic system works under alternative institutional frameworks. If they have anything of their own to contribute to the popular discussion of economic policy, it is some special understanding of the relationship between policies and results of policies.

The basic role of the scientist in public policy, therefore, is that of establishing the costs and benefits of alternative institutional arrangements. Smith had no professional right to advise England on the Navigations Acts unless he had evidence of their effects and the probable effects of their repeal. A modern economist has no professional right to advise the federal government to regulate or deregulate the railroads unless he has evidence of the effects of these policies.

This position, you must notice, is not quite the familiar one that an economist's value judgments have no scientific status— indeed I shall neither dispute nor praise value judgments. The position is rather that if a subject is capable of study, a scholar ought to study it before he advises legislators. Suppose you deplore disease or, conversely, that you greatly admire the much-persecuted germ. My assertion is that however you stand, you should not support proposals to compel or to forbid people to go to a doctor until you find out whether their attendance on a doctor will increase or decrease the incidence of disease. If this particular example strikes you as absurdly pedantic, I offer two responses. First, will your answer be the same whatever the state of medical science in a country? Second, we shall come to harder problems.

My task, then, is to ask in as hardheaded a way as possible what precisely was the evidence economists provided for their policy recommendations, evidence that successfully linked their proposals with the goals they were seeking to achieve. I begin with Adam.

40 Traditional Regulatory Approach: Absence of Evidence

I

Smith bases his proposals for economic policy upon two main positions. Neither basis is presented in a formal and systematic fashion, and there are serious problems in determining exactly why he wishes most economic life to be free of state regulation.

Smith's first basis for his economic policies was his belief in the efficiency of the system of natural liberty. There can be little doubt that this tough-minded Scotsman, this close friend of that cool and clear thinker, David Hume, had a deep attachment to the natural law of the late enlightenment. But Smith did not propose natural liberty as a lay religion of political life. Instead he argued, as a matter of demonstrable economic analysis, that the individual in seeking his own betterment will put his resourses where they yield the most to him, and that as a rule the resourses then yield the most to society. Where the individual does not know, or does not have the power to advance, his own interests, Smith feels remarkably free to have the state intervene.

Thus Smith says that to restrain people from entering voluntary transactions "is a manifest violation of that natural liberty which it is the proper business of law, not to infringe but to support"; yet he continues:

But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as of the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed. (The Wealth of Nations [Modern Library edition], p. 308)

Natural liberty seems to have been little more than a working rule, and Smith proposes numerous departures from natural liberty because the participants are incompetent or fail to consider external effects of their behavior. 1 He is quite willing to outlaw payment of wages in kind, which he believes will defraud the worker, and to put a limit on interest rates, because high interest rates encourage lenders to entrust their funds to improvi-

dent projectors, and to have a complicated tax system to change the uses of land.

The second foundation of Smith's strong preference for private economic activity was that he deeply distrusted the state. This distrust, I must emphasize, was primarily a distrust of the motives rather than of the competence of the state. Smith makes very little of inept governmental conduct—indeed he clearly believes that as far as efficiency is concerned, the joint stock companies, and even more the universities, are worse offenders than the state. His real complaint against the state is that it is the creature of organized, articulate, self-serving groups—above all, the merchants and the manufacturers. The legislature is directed less often by an extended view of the common good than by "the clamorous importunity of partial interests ,, (Wealth of Nations, p. 438).

Purely as a matter of professional appraisal, I would say that Smith displayed superb craftsmanship in supporting his first argument—that free individuals would use resources efficiently— but was excessively dogmatic in asserting his second argument, which accepted the competence but rejected the disinterest of the governmental machine. He gives no persuasive evidence that the state achieves the goals of its policies, and in particular he asserts rather than proves that the mercantile system had a large effect upon the allocation of British resourses. Nor does he demonstrate that the state is normally the captive of "partial interests."

Smith's intellectual heirs did little to strengthen his case for laissez f aire, except by that most irresistible of all the weapons of scholarship, infinite repetition. Yet they could have done so, and in two directions.

Where Smith finds the competitive market incapable of performing a task, they might have corrected him, for he was sometimes wrong. To a degree this was done: Smith's belief that the market set too low a value on investment in agriculture, and too high a value on foreign investment, was properly criticized by John Ramsay McCulloch (Principles of Political Economy, 1st ed. [London 1825], pp. 144 ff.), and the aberration on usury was of course promptly challenged by Bentham. But for each of Smith's errors that was corrected, several new ones were introduced. J. S.

42 Traditional Regulatory Approach: Absence of Evidence

Mill, for example, gravely argued that the competitive market was incapable of providing a reduction in the hours of work even if all the workers wished it—a mistake I am not inclined to excuse simply because so many later economists repeated it.

What I consider to be a more important weakness in Smith's position, however—his undocumented assumption that the state was efficient in achieving mistaken ends 2 —was not only accepted, but emphatically reaffirmed by his followers. James Mill's identification of the evils of government with the undemocratic control of its instruments was an extreme example, but an instructive and influential one. The holder of the power of government would always use it to further his own ends—so argued Mill with an oppressive show of logical rigor. It followed that only a democratically controlled state would seek the good of the entire public:

The Community cannot have an interest opposite to its interest. To affirm this would be a contradiction in terms. The Community within itself, and with respect to itself, can have no sinister interest.... The Community may act wrong from mistake. To suppose that it could from design would be to suppose that human beings can wish their own misery. (The Article on Government —reprinted from the Supplement to the Encyclopedia Britannica [London 1829], p. 7.)

Hence a democracy, unlike a monarchy or an aristocracy, would do no unwise thing except in ignorance. And this exception for ignorance was not a serious one:

There can be no doubt that the middle rank, which gives to science, to art, and to legislation itself, their most distinguished ornaments, and is the chief source of all that has exalted and refined human nature, is that portion of the Community of which, if the basis of Representation were ever so far extended, the opinion would ultimately decide. Of the people beneath them, a vast majority would be sure to be guided by their advice and example (Ibid., p. 32)

Education of the masses, and their instinctive reverence for the wisdom of their middle class leaders, those ornaments of society, would thus insure that the democratic state would seldom stray far from the public good. The argument meant that at the time the essay was written the American government was a reliable

instrument of public welfare and fifty years later EnglancTs government would become so. 3

It would be possible to document at length this proposition that the classical economists objected chiefly to unwise governmental intervention in economic life, but I shall give only two instructive examples.

The first example is provided by that fine Irish economist, Mountifort Longfield. Apropos of certain dubious programs to assist the laborer he wrote, "here Political Economy is merely a defensive science, which attempts to prevent the injudicious interference of speculative legislation ,, (Lectures on Political Economy [1834]). This sounds suitably conservative, but let us continue. Years later, as a witness before a Royal Commission on Railways, he complained that his timid fellow directors of the Great Southern and Western Railway underestimated the long-run elasticity of demand for rail service. To produce the necessary courage he proposed that the government appoint a director with unlimited power to vary the rates of each railroad, with the government taking half of any resulting profits and compensating all of any resulting losses. 4 Longfield wanted not laissez faire but half fare.

The second example is the major controversy provoked by the campaigns for the ten-hour day for women in factories, which reached success in 1847. This was one of the first of the modern English interventions in the contracts of competent adults, and it invited excommunication by the economic divines. This Factory Act was in fact opposed with vigor by two important economists, Torrens and Senior, but explicitly not as a violation of natural right. Torrens prefaced his criticism with a passage that reads better than it reasons:

The principle of non-interference can be applicable to those circumstances only, in which interference would be productive of mischief; in all those cases in which the interference of the central authority in the transactions between man and man is capable of effecting good or averting evil, laissez faire is a criminal abandonment of the functions for the performance of which a central authority is established and maintained. (A Letter to Lord Ashley [London 1844], pp. 64-65)

44 Traditional Regulatory Approach: Absence of Evidence

Hence Torrens, and equally Senior {Letters on the Factory Act [London 1844]), criticized the ten-hour bill because it would lower weekly wages, increase production costs, and reduce employment by impairing the competitive position of the British textile industry abroad.

Both Senior and Torrens died in 1864, so they had adequate time, one would think, to have tested their predictions of the effects of the ten hour law. It is wholly characteristic of the insulation of discussions of policy from empirical evidence that no such study was undertaken by them, or by anyone else.

James Mill's oldest son, surprisingly enough, put up a stronger case against state control of economic life than his much more conservative father had. John Stuart did not follow his father in accepting the invariable wisdom of the democratic state, possibly because he was writing well after the Reform Act. 5 He rested the case much more on the defense of individual liberty, and fully three of the five reasons he gave for favoring laissez faire as a practical maxim were variations on the importance of the dignity, independence, self-reliance, and development of the individual {Principles of Political Economy, bk. 5, ch.ll).

Although I reckon myself among the most fervent admirers of individualism, even for other people, I must concede that the younger Mill's position was ambiguous. He does not tell us how to determine whether a given public policy frees or inhibits individuals. Suppose I contemplate a program of public housing. If I bribe or force people into such housing, of course I have reduced their area of choice and responsibility. But I have also, I presumably hope, given a generation of children a chance to grow up in quarters that are not grossly unsanitary and inadequate for physical and moral health. Mill does not tell us whether this policy fosters or inhibits individualism—although I strongly suspect that he would have favored public housing, as he did free public education and limitation of hours of work for young people. If an economist is to be a moral philosopher, however—and I have do doubt that we would do this well too—he should develop his philosophy to a level where its implications for policy become a matter of logic rather than a vehicle for expressing personal tastes. 6

Let us leap on to Marshall who brought up the rear of this

tradition as of so many others in English economics. He conceded an expanding potential role to the state, in the control of monopoly, in the housing of the poor, and in the treatment of poverty generally. Yet he persevered in his preference for private enterprise wherever possible. The preference rested heavily on the belief that bureaucratic management would be burdensome and inefficient {Memorials of Alfred Mars hall [1925], pp. 274-76, 339 ff.; Industry and Trade [1919], pp. 666-72). Marshall at this point wrote the boldest sentence of his life:

If Governmental control had supplanted that of private enterprise a hundred years ago [1807], there is good reason to suppose that our methods of manufacture now would be about as effective as they were fifty years ago, instead of being perhaps four or even six times as efficient as they were then. (Memorials, p. 338)

Yet the "good reason'' was never presented, although it was more important to demonstrate this proposition if true than to answer any other question to which Marshall devoted a chapter or a book or even his life. Marshall's other reason for his distrust of government was the fear that Parliament would become the creature of special interests, and in particular the Trade Unions (Official Papers by Alfred Marshall [1926], pp. 395-96)—an unknowing but not unknowledgeable reversion to Adam Smith! So much for a century of laissez faire. The main school of economic individualism had not produced even a respectable modicum of evidence that the state was incompetent to deal with detailed economic problems of any or all sorts. There was precious little evidence, indeed, that the state was unwise in its economic activities, unless one was prepared to accept as evidence selected corollaries of a general theory. The doctrine of nonintervention was powerful only so long and so far as men wished to obey.

II

There was no day on which economists ceased to commend reductions in the government's role in economic life and began to propose its expansion. The limitation of hours of work for children was supported well before the attack on the corn laws

46 Traditional Regulatory Approach: Absence of Evidence

reached its climax. The statutes liberalizing dealings in property in the 1830s followed at a distance the regulation of passenger ships to protect emigrants.

How else could it be? The distinction between ancient police functions admitted by all and new regulatory functions proposed by some was most elusive. The same economist could and did repel the state with one hand and beckon it with the other. 7

The expansion of public control over economic life which took place in the mid-nineteenth century in England, and a trifle later in the United States, was usually of this sort: a traditional state function was expanded or a new function was adopted which had close analogies to traditional functions. Economic effects were usually incidental to protective effects: the inspection of factories and mines, the sanitation laws for cities, the embryonic educational system, and most of the controls over railroads were of this sort (David Roberts, Victorian Origins of the Welfare State [New Haven: Yale University Press, I960]; Oliver MacDonagh, A Pattern of Government Growth, 1800-60 [London 1961]).

One thing did not change at all, however, from the heyday of laissez faire: no economist deemed it necessary to document his belief that the state could effectively discharge the new duties he proposed to give to it. The previous assertions of governmental incompetence were met only by counter assertion; the previous hopes of wiser uses of governmental powers by a democracy were deemed too prophetic to deserve the discourtesy of historical test. I shall illustrate this persistent neglect of empirical evidence with the writings of two economists who have almost nothing in common except great ability.

The first is Jevons. Governmental operation of an industry was appropriate, Jevons believed, if four conditions were fulfilled: (1) The work must be of an invariable and routine-like nature, so as to be performed according to fixed rules. (2) It must be performed under the public eye, or for the service of individuals, who will immediately detect and expose any failure or laxity. (3) There must be very little capital expenditure, so that each year's revenue and expense account shall represent, with approximate accuracy, the real commercial success of the undertaking. (4) The operations must be of such a kind that their union under one all-extensive

Government monopoly will lead to great advantage and economy (W. S. Jevons, Methods of Social Reform [London 1883], pp. 355, 279,338). On what is this garbled description of a municipal water system based?—mature introspection, of course.

Jevons is equally devoted to the a priori method when he discusses public regulation. The "Principles of Industrial Legislation' ' are illustrated first with the problem posed by a dangerous machine. Neither worker nor employer, Jevons says, generally displays due concern for the dangers that lurk in the unfenced machine.

But there remains one other mode of solving the question which is as simple as it is effective. The law may command that dangerous machinery shall be fenced, and the executive government may appoint inspectors to go round and prosecute such owners as disobey the law. (Jevons, The State in Relation to Labour [London 1882], p. 4)

Several aspects of Jevons' position are instructive. There is no showing of evidence on the failure of employers and employees to curb dangerous machinery. There is no showing of evidence that direct controls are simple and effective. Direct controls surely were not effective in factories too small to catch the inspector's eyes, and it is a completely open question whether they were effective elsewhere. And finally, Jevons does not conceive of the possible role of the price system in supplementing, if not replacing, direct inspection by a law making employers responsible for accidents. 8

But let us recall who Jevons was; he was the economist whose supreme genius lay in his demand for empirical determination of theoretical relationships and his immense resourcefulness in making such determinations. This powerful instinct for empirical evidence spilled over into a proposal that wherever possible new policies should first be tried out at the local governmental level: "we cannot," he said, "really plan out social reforms upon theoretical grounds." 9 But, possible or not, he really so planned out his reforms.

We may learn how a theorist coped with the problem by

48 Traditional Regulatory Approach: Absence of Evidence

turning to my second economist, Pigou. In Wealth and Welfare (London 1912) he recited four reasons for distrusting the ability of legislatures to control monopolies. They were shallow reasons, but what is instructive is that all of them "can be, in great measure, obviated by the recently developed invention of Commissioners,' that is to say, bodies of men appointed by governmental authorities for the express purpose of industrial operation or control." Hence the government is now capable of "beneficial intervention in industries, under conditions which would not have justified such intervention in earlier times" (ibid., p. 250).

If time were not the most precious thing that one professor can give to another, I would follow in detail Pigou's travels from this inauspicious beginning. We would be instructed by the evidence which he found sufficient to a series of propositions on the state's competence:

... laws directly aimed at "maintaining competition" are practically certain to fail of their purpose, (p. 253) ... in respect of industries, where the quality of the output is of supreme importance and would, in private hands, be in danger of neglect, public operation is desirable, (p. 288) ... the relative inefficiency of public operation, as compared with private operation, is very large in highly speculative undertakings, and dwindles to nothing in respect of those where the speculative element is practically nonexistent. 10

The evidence, you will hardly need be reminded, consisted of a few quotations from books on municipal trading.

Pigou's views of the competence of the state were, like his predecessors' views, a tolerably random selection of the immediately previous views, warmed by hope. He felt that reliance upon such loose general reflections was unavoidable. On the question of whether public or private operation of an industry would be more efficient in production, we are told "at the outset, it must be made clear that attempts to conduct such a comparison by reference to statistics are fore-doomed to failure" (Wealth and Welfare, p. 274). How is it made clear? Very simply: by pointing out that it is unlikely that a public and a private enterprise operate under identical conditions of production. This test of the

feasibility of statistical research would rule out all such research, and of course Pigou throughout his life accepted this implication.

Let me say that Pigou did not differ from his less illustrious colleagues in the superficiality of his judgments on the economic competence of the state—here he was at least as shrewd and circumspect as they. He differed only in writing more pages of economic analysis of fully professional quality than any other economist of the twentieth century.

Rather than sample other economists, I shall characterize more generally their role in the period of growing state control over economic life. The traditional and inevitable economic functions of the state such as taxation and the control of the monetary system are not considered in the following remarks. These functions pose no question of the desirability of state action and very different questions of the economist's role in policy. On the basis of a highly incomplete canvass of the literature, I propose three generalizations.

First, there was a large and growing range of policy issues which economists essentially ignored. If we examine the English legislation governing shop closing hours, or pure food and drug inspection, or municipal utilities, or railway and truck and ocean transportation, or the legal status of labor unions, or a host of other questions, we shall find that as a rule economists did not write on the issue, or appear before the Royal Commissions, or otherwise participate in the policy formulation. Before 1914 the detachment from contemporary policy was Olympian, therefore it was mortal but awesome. American economists, perhaps reflecting their Germanic training, were more interested in policy, so one can cite examples like John R. Commons on regulation of public utilities and on workmen's compensation laws, J. B. Clark and a host of others on the trust problem, and so on. Even here, however, many important economic policies were (and are still) ignored, among them pure food laws, wage legislation, fair employment practices acts, the zoning of land uses, and controls over the capital markets.

Second, even when economists took an active and direct interest in a policy issue, they did not make systematic empirical studies to establish the extent and nature of a problem or the probable efficiency of alternative methods of solving the problem.

50 Traditional Regulatory Approach: Absence of Evidence

It is difficult to support allegations about the absence of a given type of scientific work; often the allegation illuminates only the reading habits of its author. I am reasonably confident, however, that the following subjects were not investigated with even modest thoroughness: (1) the effects of regulation on the level and structure of prices or rates of public utilities; (2) the extent to which safety in production processes and purity in products are achieved by a competitive market and by a regulatory body; (3) the cost to the community of preventing failures of financial institutions by the route of suppressing competition compared with the costs by the route of insurance; (4) the effects of price support systems for distressed industries upon the distribution of income, as compared with alternative policies; and (5) the effects of policies designed to preserve competition. This list is short, but I submit that the examples are important enough to give credence to my generalization on the paucity of systematic empirical work on the techniques of economic policy. From 1776 to 1964 the chief instrument of empirical demonstration of the economic competence of the state has been the telling anecdote.

Third, the economist's influence upon the formulation of economic policy has usually been small. It has been small because he lacked special professional knowledge of the comparative competence of the state and of private enterprise. The economist could and did use his economic theory, and it cannot be denied that the economist's economic theory is better than everyone's else economic theory. But for reasons to which I shall immediately turn, economic theory has not been an adequate platform. Lacking real expertise, and lacking also evangelical ardor, the economist has had little influence upon the evolution of economic policy.

Ill

If economists have lacked a firm empirical basis for their policy views, one might expect that guidance could be derived from their theoretical systems. In fact, to the degree that a theoretical system has been submitted to a variety of empirical tests, it is a source of more reliable knowledge than an empirical uniformity in solitary confinement. The theory allows tests of the relationship incorporated in the theory that are outside the view of the discoverer of the theory, so these tests are more challenging.

The economists' policy views have in fact been much influenced by their theories. The vast preference for free international trade is surely based in good part upon the acceptance of the classical theory of comparative costs. The general presumption against direct regulation of prices by the state is surely attributable in good part to the belief in the optimum properties of a competitive price system. The growth of support among economists for public regulation of economic activities is at least partly due to the development of the theory of disharmonies between private and social costs, and partly also to the increasingly more rigorous standards of optimum economic performance.

If it would be wrong to deny a substantial influence of economic theory on economists' policy views, it would be wronger still to suggest that the policies follow closely and unambiguously from the general theory. Our first example of free trade will suffice to illustrate the looseness of the connection. Smith supported free trade because he believed that tariffs simply diverted resources from more productive to less productive fields, and the absence of an explanation for the rates of exchange between foreign and domestic commodities did not bother him. A century later Sidgwick argued that on theoretical grounds tariffs were often beneficial to a nation, but that "from the difficulty of securing in any actual government sufficient wisdom, strength, and singleness of aim to introduce protection only so far as it is advantageous to the community'' the statesman should avoid protective duties {Principles of Political Economy [London 1883], pp. 485-86). To the extent that theory was guiding Sidgwick, surely it was a theory of government rather than of economics.

There is one primary reason why the theory is not, as a rule, coercive with respect to the policies that a believer in the theory must accept: a theory can usually be made to support diverse policy positions. Theories present general relationships, and which part of a theory is decisive in a particular context is a matter of empirical evidence. Consider the wages-fund doctrine, if I may be permitted to refer to it without its almost inseparable prefix, notorious. This theory asserted that there was a relatively fixed amount to be paid in wages in the short run, and that if one group got higher wages, other groups would get lower wages or be unemployed. It followed that if a particular group of workers formed a union and managed to raise their wages, other workers

52 Traditional Regulatory Approach: Absence of Evidence

would bear the burden, and numerous disciples of the wages-fund doctrine accepted this policy view. (For example, J. E. Cairnes, Some Leading Principles of Political Economy [London 1873], pp. 258-60). But John Stuart Mill could argue, quite in the opposite direction, that since most workers would be at a subsistence level, at most the successful union would inflict only short-run harm on other workers, whereas its higher income could be permanent. (Principles of Political Economy, Ashley ed. [London 1929], p. 402). And obviously it is a quantitative question whether the short-run costs or the permanent benefits were larger.

What is true of the wages-fund theory is true of other theories: an empirical question always insists upon intruding between the formal doctrine and its concrete application. The truly remarkable fact is not that economists accepting the same theory sometimes differ on policy, but that they differ so seldom. The wide consensus at any time comes, I suspect, from a tacit acceptance of the same implicit empirical assumptions by most economists. All classical economists accepted as a fact the belief that wage earners would not save, although they had no evidence on the matter. All modern economists believe that they will never encounter Edgeworth's taxation paradox, with no more evidence. All economists at all times accept the universality of negatively sloping demand curves, and they do so without any serious search for contrary empirical evidence.

These empirical consensuses have no doubt usually been correct—one can know a thing without a sophisticated study. Truth was born before modern statistics. Yet generations of economists also believed that over long periods diminishing returns would inevitably triumph over technological advance in agriculture, a view that agricultural history of the last 100 years has coolly ignored.

A second and lesser source of the loose connection between theory and policy has been the difficulty of translating theory into policy because of practical politics or administration. The economist refrains from drawing a policy conclusion because its implementation would pose large social or administrative costs. Mill dismissed an income tax because of the inquisitorial burdens it would put on taxpayers; one would have thought that he would remember that an earlier inquisition had been wel-

corned to Spain. For at least 100 years economists have recommended that a nation proceed to free trade gradually over a five-year period to ease the transition, and the period is usually lengthened if protectionism is on the ascendant. I have often wondered why we deem it necessary to tell a confirmed drunkard not to reduce his drinking too rapidly.

A third, and fortunately a moderately rare, reason for separating theory from policy is flagrant inconsistency, usually stemming from that great source of inconsistency in intelligent men, a warm heart. Marshall proved—rather unconvincingly, I must say—that the doctrine of consumer surplus instructed us to tax necessaries rather than luxuries (Alfred Marshall, Principles of Political Economy , 8th ed. [London 1920], p. 467 n.). The idea was disposed of in a footnote because it disregarded ability to pay. The economic arguments against minimum wage legislation have usually been refuted by reference to the need of poorer people for larger incomes.

The essential ambiguity of general theoretical systems with respect to public policy, however, has been the real basis of our troubles. So long as a competent economist can bend the existing theory to either side of most viable controversies without violating the rules of professional work, the voice of the economist must be a whisper in the legislative halls.

IV

The economic role of the state has managed to hold the attention of scholars for over two centuries without arousing their curiosity. This judgment that the perennial debate has refused to leave the terrain of abstract discourse is true, I believe, of the continental literature as well as the English and American literature. Economists have refused either to leave the problem alone or to work on it.

Why have not the effects of the regulatory bodies on prices and rates been ascertained, even at the cost of a 1 percent reduction in the literature on how to value assets for rate purposes? Why have not the effects of welfare activities on the distribution of income been determined for an important range of such activities, even at the cost of a 1 percent reduction in denunciations of the invasion of personal liberty? Why has not the degree of success of

54 Traditional Regulatory Approach: Absence of Evidence

governments in bringing private and social costs together been estimated, even at the cost of a 1 percent reduction in the literature on consumer surplus? Why have we been content to leave the problem of policy unstudied?

This variously phrased question can be considered to be a request for either a formal theory of state action or a set of empirical studies of the comparative advantages of public and private control.

Consider first the control over economic life as a formal theoretical problem. Why do we not have a theory to guide us in ascertaining the areas of comparative advantage of uncontrolled private enterprise, competitive private enterprise, public regulation, public operation, and the other forms of economic organization? This theory would predict the manner in which the state would conduct various economic activities, such as protecting consumers from monopoly or fraud, assisting distressed industries and areas, or stimulating inventions. The theory might yield rules such as that a competitive system is superior for introducing new products, or public enterprise is superior where there are many parties to a single transaction. That we have not done so is attributable, I conjecture, to two difficulties.

The first difficulty is that the issue of public control had a constantly changing focus: it was the relations of labor and employers one year, the compensation to tenants for improvements on farms and the control of railroad rates the year thereafter. At any one time few areas of economic life were seriously in dispute: most economic activities were uncontrover-sially private or public. That a single theory should be contrived to guide society in dealing with these various and changing problems was perhaps too great an abstraction to encourage serious efforts.

Moreover, and this is the second difficulty, the standard apparatus of the economist is not clearly appropriate. Ordinary maximizing behavior, with the ordinary rewards and obstacles of economic analysis, does not seem directly applicable to the problem. The bounds of state competence, and the areas of its superiority over variously controlled private action, are difficult to bring within a coherent theoretical system.

In short, the theory of public policy may be a difficult theory to

devise, although until we have tried to devise it even this opinion is uncertain.

A usable theory of social control of economic life was not essential, however, to professional study of policy: could not the economist make empirical studies of the effects of various ways of dealing with specific problems? The state regulates machinery in factories: does this reduce accidents appreciably? The state regulated the carriage of emigrants from England and Ireland to the new world—what did the regulations achieve? A thousand prices had been regulated—were they lower or stickier than unregulated prices? The empirical answers would obviously have contributed both to public policy and to the development of a general theory of public and private economy.

Here we must pause, not without embarrassment, to notice that we could ask for empirical studies in areas traditional to economics as well as in the netherland of half economics, half political science. We need not be surprised, I suppose, that we know little of the effects of state regulation, when we also know very little about how oligopolists behave. Marshall's theory that the differences between short- and long-run prices and profits are regulated by the differences between short- and long-run reactions of supply will be 75 years old next year [1964]. Despite its immense influence, this theory has yet to receive a full empirical test. If such basic components of modern economic theory have escaped tests for quantitative significance, it is hardly surprising that our antitrust laws, our motor carrier regulation, and our control of insurance company investments have also escaped such tests.

Still, there has been a difference. Empirical tests of economic theories have been made for generations, and with greater frequency and diligence than we encounter in the area of social experiments. Already in 1863 Jevons had ascertained the serious fall in the value of gold consequent upon the Californian and Australian gold discoveries—it was 26 percent over the 13-year period, 1849-62. No such diligence or ingenuity can be found in the study of state controls at that time. A half century later Henry Moore was calculating statistical demand curves; again the study of the effects of public policies was lagging.

The age of quantification is now full upon us. We are now

56 Traditional Regulatory Approach: Absence of Evidence

armed with a bulging arsenal of techniques of quantitative analysis, and of a power—as compared to untrained common sense—comparable to the displacement of archers by cannon. But this is much less a cause than a consequence of a more basic development: the desire to measure economic phenomena is now in the ascendant. It is becoming the basic article of work as well as of faith of the modern economist that at a minimum one must establish orders of magnitude, and preferably one should ascertain the actual shapes of economic functions with tolerable accuracy.

The growth of empirical estimation of economic relationships, please notice, did not come as a response to the assault on formal theory by the German Historical School, nor was it a reply to the denunciations of theory by the American Institutionalists. It has been a slow development, contributed to by an earlier development in some natural sciences but mostly by the demonstrated successes of the pioneers of the quantitative method—the Jevons, the Mitchells, the Moores, the Fishers.

It is a scientific revolution of the very first magnitude—indeed I consider the so-called theoretical revolutions of a Ricardo, a Jevons, or a Keynes to have been minor revisions compared to the vast implications of the growing insistence upon quantification. I am convinced that economics is finally at the threshold of its golden age—nay, we already have one foot through the door.

The revolution in our thinking has begun to reach public policy, and soon it will make irresistible demands upon us. It will become inconceivable that the margin requirements on securities markets will be altered once a year without knowing whether they have even a modest effect. It will become impossible for an import-quota system to evade the calculus of gains and costs. It will become an occasion for humorous nostalgia when arguments for private and public performance of a given economic activity are conducted by reference to the phrase, external economies, or by recourse to a theorem on perfect competition.

This is prophecy, not preaching. You have listened to sage advice on what to study and how to study it for well over a century. If you had heeded this advice, you would have accomplished almost nothing, but you would have worked on an immense range of subjects and with a stunning array of approaches. Fortunately you have learned that although such advice

is almost inevitable on such occasions as the retirement of an officer of a professional society, it is worth heeding only when it is backed by successful examples. I have no reason to believe that you left your tough-mindedness at home tonight, and I shall respect it. I assert, not that we should make the studies I wish for, but that no one can delay their coming.

I would gloat for one final moment over the pleasant prospects of our discipline. That we are good theorists is not open to dispute: for 200 years our analytical system has been growing in precision, clarity, and generality, although not always in lucidity. The historical evidence that we are becoming good empirical workers is less extensive, but the last half-century of economics certifies the immense increase in the power, the care, and the courage of our quantitative researches. Our expanding theoretical and empirical studies will inevitably and irresistibly enter into the subject of public policy, and we shall develop a body of knowledge essential to intelligent policy formulation. And then, quite frankly, I hope that we become the ornaments of democratic society whose opinions on economic policy shall prevail.

THREE The Traditional

Regulatory Approach: Some Evidence

Regulate?: The Case of Electricity

(In Collaboration with Claire Friedland)

The literature of public regulation is so vast that it must touch on everything, but it touches seldom and lightly on the most basic question one can ask about regulation: does it make a difference in the behavior of an industry? This impertinent question will strike anyone connected with a regulated industry as palpably trivial. Are not important prices regulated? Are not the routes of a trucker and an airline prescribed? Is not entry into public utility industries limited? Is not an endless procession of administrative proceedings aging entrepreneurs and enriching lawyers?

But the innumerable regulatory actions are conclusive proof, not of effective regulation, but of the desire to regulate. And if wishes were horses, one would buy stock in a harness factory.

The question of the influence of regulation can never be answered by an enumeration of regulatory policies. A thousand statutes now forbid us to do things that we would not dream of doing even if the statutes were repealed: we would not slay our neighbor, or starve our children, or burn our house for the insurance, or erect an abattoir in the back yard. Whether the statutes really have an appreciable effect on actual behavior can only be determined by examining the behavior of people not subject to the statutes.

An order to a trucker not to haul goods between cities A and B is even more difficult to assess. He may not wish to have this route, in analogy to the laws governing our personal behavior. But let him wish with all his heart to have it, and be denied; there still will be no economic effect of the regulation if others are allowed, in adequate number, to have the desired route.

The point at issue may be restated in the language of economics. An industry's output and price are normally governed primarily by the basic economic and technological determinants of supply and demand: by whether the demand curve is D, or £> 2 ,

Reprinted by permission from the Journal of Law and Economics 5 (October 1962).

61

Traditional Regulatory Approach: Some Evidence

Fig. 1

and the supply curve is S { or S 2 (see fig. 1). Regulation will affect price and output only if it shifts the curves or the point on a curve where the industry operates. Does regulation introduce shifts in curves of the magnitude of S { to S 2 or S l to S' 2 ? In the latter event its effect will be negligible. Does regulation shift the effective operating point from p x to p 2 ? Then its effect will again be negligible.

The test of the economic effect of regulation is essentially independent of the content of the formal regulations. No degree of care in analyzing the regulations, or even their administration, will tell us whether they rubber-stamp or slightly heckle the state of affairs or substantially alter it.

What does one mean in saying that regulation has had large or small effects? He means that of the observed economic behavior in a certain industrial sector, a large or small part can be explained only by recourse to regulation. Consider these examples:

What Can Regulators Regulate?: The Case of Electricity 63

1. Is the decline of railroading due in any important part to ICC regulations? If in other economies with rising incomes and extensive adoption of automobiles and trucks the railroad traffic shows a pattern similar to ours, then regulation has not been the primary influence.

2. Do utility commissions reduce the differential in prices of utility services to large and small buyers? If in a group of unregulated markets we observe a mean ratio of rates of large to small buyers of m nr , and in regulated markets a ratio of m r , do m nr and m r differ significantly? If of the total variance among markets in the ratio of rates of large to small buyers only 2 percent can be explained by regulation, the regulations have negligible impact.

3. Do regulatory bodies succeed in preventing monopoly profits? We take it that they will usually prevent such profits from appearing explicitly in accounting statements. Whether they go beyond this may be judged, for example, by the fortunes of investors in stocks of regulated companies over periods extending from pre-regulation on, compared with those of investors in similar but unregulated enterprises.

These summary remarks will deceive no informed person as to the analytical and empirical complexity of the task of isolating the effects of regulation. They are intended only to suggest why one does not read the regulations to reach the answer.

We propose now to make an investigation of one regulated industry to explore techniques and hopefully reach tentative results. This is the electric utility industry. Here we face three major problems: (1) What firms are regulated? (2) What effects of regulation shall we study, and how shall we measure them? (3) How do we explain our findings?

When is a Firm Regulated?

Every enterprise producing and distributing electricity has been regulated since its founding by way of charter limitations and franchises; its use of public thoroughfares was enough to insure this. It would therefore be possible to say that there is no unregulated sector to provide a base for judging the effects of regulation. This statement would not be acceptable to the professional writers on public utilities: they hail the beginnings of effective regulation with the establishment of the public service

commissions in New York and Wisconsin in 1907 (L. S. Lyon and V. Abramson, Government and Economic Life 636 [1940]; Twentieth Cent. Fund, Electric Power and Government Policy 65, 235 [1948]). Yet these specialists have assuredly not faced the problem of measuring the effects of regulation, so their judgments are suspect. Indeed, if we accepted their judgments our problem would be solved, for they never question the importance of (effective!) regulation.

There is no substitute for an objective measure of regulation, and the one we choose is the creation of a special state commission endowed with the power to regulate rates of electric utilities. 1 It may be complained that some of these commissions were long ineffective, or that municipal regulation was effective earlier in some states. Such assertions can only be tested by a study invoking another criterion of the existence of regulation: the year the commission issued its first rate order upheld by the courts, the year the commission first spent $100,000 or published 100 pages of orders, and so forth. But it is intrinsic to the problem that there be an independent criterion of regulation, and that findings on effectiveness be conditional on acceptance of that criterion. There is a strict analogy with the problem of estimating the influence of monopoly, where the result is conditioned by the criterion of monopoly (concentration ratio, number of firms, etc.). The classification of states by the existence of regulatory commissions with jurisdiction over electric utilities is given in table Al in the appendix [to this chapter]. The beginning of regulation by this criterion varied as shown in the accompanying tabulation. Two-thirds of the states had commissions by 1915, three-quarters by 1922.

States

Before 1910 6

1910-20 29

1920-30 1

1930-40 3

1940-50 2

1950-60 2

The Effects of Regulation on Rates and Returns

There are two basic purposes of the public regulation of prices:

What Can Regulators Regulate?: The Case of Electricity 65

the curtailment of the exercise of monopoly power and the elimination of certain forms of price discrimination. There will no doubt be other effects on prices, including unintended effects such as the short term rigidity of price commonly associated with regulation, but we shall concentrate upon these basic purposes. Our analysis of effects will be limited to the period up to 1937, simply because by that time 39 states had regulating commissions. By that date every unregulated state had at least two adjoining states with regulatory commissions, and even a showing of no difference in rates thereafter would be ambiguous: it could be argued that the threat of regulation was always latent in the unregulated states. This position does not seem wholly convincing to us—in a sense the threat of regulation was operative as soon as the Interstate Commerce Commission was created —but the small number of unregulated states, after 1937 offers statistical support for this terminus.

The Level of Rates

We shall make little use of the direct comparison of the average level of rates in regulated and unregulated states, of which a sample summary is given in table l. 2 The ambiguity of simple differences may be illustrated by the data for 1917. In this year the average revenue per KWH was 1.88 cents in regulated states and 3.20 cents in unregulated states, which might suggest that regulation lowered rates by almost 40 percent. But we can classify the rates of these states in several ways (see table 2). This classification makes clear the fact that rates were lower on average

TABLE 1

AVERAGE REVENUE PER KWH, STATES WITH AND WITHOUT REGULATION, 1912-37

A state is considered regulated in a given year if commission regulation was established three years previously.

Traditional Regulatory Approach: Some Evidence

TABLE 2

in the regulating states, not only after but also before regulation.

The basic fact is, of course, that regulation is associated with economic characteristics which also exert direct, independent influences on rates—the size and urbanization of the population, the extent of industrialization, etc. To isolate the effects of regulation we must take direct account of these economic factors. We do so by the following procedure.

The main determinants of the level of rates for an unregulated monopolist are assumed to be the size of the market and its density (which affect both production and distribution costs), the price of fuel, and the incomes of consumers. We approximate the market size and density by the population in cities with 25,000 or more population; the fuel costs by an equivalent BTU cost and by the proportion of power derived from hydroelectric sources; and consumer incomes by per capita state income. We fit the equation,

logp =a +b log U +c log p F + dH + e log Y +fR, where

p = average revenue per KWH, in cents;

U = population in cities over 25,000 (in thousands);

p F = price of fuel (in dollars per BTU equivalent ton

of bituminous coal); H = proportion of power from hydroelectric sources; Y = per capita state income, in dollars; R — dummy variable, 0 if an unregulated state, 1 if a

regulated state.

The results of fitting this equation to 1922 data are presented in

What Can Regulators Regulate?: The Case of Electricity 67

table 3. The regression of millions of KW's of output, in logarithms, on these variables is also added.

The effects of regulation may be expressed in two ways: by the regression coefficient of the dummy variable representing regulation or by the difference in the coefficient of multiple determination including and excluding regulation. By either standard, regulation had no effect upon the level of rates in 1922.

For the other census years we use the abbreviated regression equations summarized in table 4. No effect of regulation is observable through 1932. The 1937 equation does display a regulation effect, but it is localized in the sales to commercial and industrial consumers—the class of consumers that regulation was not designed to protect. We believe even this modest 1937 effect would be eliminated by a fuller statistical analysis. 3

We conclude that no effect of regulation can be found in the average level of rates.

The Rate Structure

We have examined two aspects of the rate structure for possible influences of regulation. The first is the ratio of monthly bills of domestic consumers for larger amounts of electricity relative to smaller amounts. Here our expectation was that the regulatory bodies would recognize the greater potential political popularity of low rates for the numerous consumers who buy small quantities. The evidence is essentially negative (table 5): in only one of four comparisons was the ratio of monthly bills significantly different in regulated states from unregulated states. 4 The quantity rate structure for domestic consumers seems independent of the existence of regulation.

A second aspect of the rate structure where regulation might be expected to be influential is in the comparative charges to domestic and industrial buyers. The regulatory bodies would reduce domestic rates relative in industrial rates if they sought to reduce discrimination; the industrial users presumably have better alternative power sources and therefore more elastic demands. Or, again as a political matter, the numerous domestic users might be favored relative to the industrial users. To test this expectation, the average ratio of charges per KWH to domestic users to charges to industrial users was calculated for two years

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Traditional Regulatory Approach: Some Evidence

DIFFERENTIALS BY SIZE OF MONTHLY CONSUMPTION 1924 AND 1936

Source: U.S. Federal Power Commission, "Trends in Residential Rates from 1924 to 1936" (Washington, D.C., 1937), table 11. The observations are unweighted average rates for cities of over 50,000 population in each state.

(see table 6). The ratios are therefore directly opposite to those which were expected. 5 But a scatter diagram analysis reveals that the ratio of domestic to industrial rates depends primarily upon the average number of KWH sold to domestic customers divided by the average number of KWH sold to industrial customers, and the relationship does not not differ between regulated and unregulated states. 6 Again no effect of regulation is detectable.

Stockholder Experience

The final area to which we look for effects of regulation is investors' experience. Our basic test is this: did investors in companies which were not regulated, or were regulated for only a few years, do better than investors in companies which were regulated from an early date?

TABLE 6 AVERAGE RATIO OF DOMESTIC TO INDUSTRIAL PRICE PER KWH

Regulated states Unregul ated states ..

1.616 (29 states) 1.445 (16 states)

2.459 (32 states) 2.047 (7 states)

What Can Regulators Regulate?: The Case of Electricity 71

To answer this question, we invest $1,000 in each electrical utility in 1907, reinvest all dividends and cash value of rights, and calculate the accumulated investment in 1920. 7 The year 1907 was chosen as the first date to reduce the possible impact of expectations of regulation, and even this date—which is later than we should like—reduced the number of companies we could trace to 20. The basic data are given in table 7.

The pattern of increases in market values appears erratic. A simple regression of market value as a function of the increase in dollar sales of the utility system and the number of years of regulation is presented in table 8. There is thus a slight, statistically insignificant effect of regulation on market values. 8

MARKET VALUE IN 1920 OF INVESTMENT OF $1,000 IN 1907 (20 Electric Companies)

Traditional Regulatory Approach: Some Evidence

REGRESSION EQUATIONS OF MARKET VALUE IN 1918 AND 1920 OF $1,000 INVESTMENT IN 1907, ON GROWTH IN SALES AND REGULATION*

(20 Electric Companies)

Market values in logarithms; growth in sales = log (sales./sales, Qn7 ).

Conclusion

Our study was undertaken primarily to investigate the feasibility of measuring the effects of regulation, but our inability to find any significant effects of the regulation of electrical utilities calls for some explanation. This finding is contingent upon our criteria of regulation and of the areas in which we sought effects, but both of these criteria are accepted by much of the literature of public utility economics.

The ineffectiveness of regulation lies in two circumstances. The first circumstance is that the individual utility system is not possessed of any large amount of long run monopoly power. It faces the competition of other energy sources in a large proportion of its product's uses, and it faces the competition of other utility systems, to which in the long run its industrial (and hence many of its domestic) users may move. Let the long run demand elasticity of one utility system be on the order of -8; then the system faces demand and marginal revenue curves such as those displayed in figure 2. Given the cost curves we sketch, price will be MP, 9