All Commentary
Tuesday, May 5, 2015

3 Myths about Economic Intervention

Even the most popular policies can do more harm than good

Whenever a social or economic problem arises, most people’s default position is that the government should “do something about it.” Indeed, most people think that if the government does nothing, nothing will get done. It’s crazy to think our elected officials should sit idly by. But when the government does intervene, things can go wrong.

Let’s explore the empirical evidence when it comes to the effectiveness of three popular government interventions.

Myth #1: Occupational licensing increases the quality and safety of services provided in the market.

Occupational licensing has been one of the most rapidly growing labor market institutions in the United States over the last few decades. According to the Brookings Institution (the most influential think tank in the world),

In the early 1950s less than 5 percent of US workers were required to have a license from a state government in order to perform their jobs legally. By 2008, the share of workers requiring a license to work was estimated to be almost 29 percent.

Nowadays it isn’t just highly skilled professionals who need a license; florists, truck drivers, and even hair stylists in many states find that they can’t practice their trade without first overcoming expensive and time-consuming barriers.

The primary justifications for occupational licensing are to guarantee a minimum level of safety and quality for the services sold in the market. However, there isn’t much evidence that occupational licensing actually achieves these goals. A paper published by the National Bureau of Economic Research found that more difficult requirements to earn a dental license lead to higher prices for consumers but not to superior dental outcomes.

Other research has found that more stringent licensing requirements for opticiansmortgage brokers, and teachers have no impact on the quality of the services provided, while at the same time increasing the cost of these services. Even the merit of medical licenses is questionable. “The link between [medical] licensing and service quality is tenuous at best,” according to one review of the evidence on medical licensure and service quality. Most importantly, in a recent paper published by the Brookings Institution, the author notes,

The evidence from the economics literature suggests that licensing has had an important influence on wage determination, benefits, employment, and prices in ways that impose net costs on society with little improvement to service quality, health, and safety … a reduction in licensing restrictions … would lead to employment growth in affected occupations and a reduction in prices.

That evidence paints a clear picture: Occupational licensure erects entry barriers that hinder a person’s ability to practice a given profession while providing no measurable benefits to consumers. Indeed, it imposes net costs on society through higher consumer prices and lower levels of employment than would likely have been the case otherwise.

According to the Brookings paper, “Standard economic models imply that the restrictions from occupational licensing can result in up to 2.85 million fewer jobs nationwide, with an annual cost to consumers of $203 billion.”

At the very least, state and local governments ought to seriously consider slowing the growth of licensing restrictions as a means to mitigate their growing economic costs.

Myth #2: Patent protection spurs innovation.

An innovative company invests a large amount of money in research and development for a new product. The company then proceeds to release that product to the market. Soon after, other companies start producing the same product, and this competition leads to a general price decline as well as customers buying from many companies rather than just one. As a result of this competition, the original innovator’s return on investment is close to 0 percent.

When innovators understand that they likely will not recoup their investments because of the competitive nature of the marketplace, they won’t bother innovating at all — so the established wisdom goes. To provide incentives for innovation, intellectual property advocates argue, the government must provide a temporary monopoly status for the creators of new products, thus increasing the price of the product. This temporary monopoly is supposed to promote innovation by increasing the incentive to innovate.  

However, with monopoly protection comes political rent-seeking. Firms that hold government-granted monopolies seek to extend the length of their monopoly status. Similarly, firms who do not yet have monopoly status in the form of a patent attempt to obtain one.

Another problem with patents isn’t necessarily that they fail at providing an incentive to innovate; it’s that existing patents may hinder the subsequent innovation that would have been built on these patented products.

The net effect of patents on innovation seems to be neutral at best, and probably negative. According to a paper published in the Journal of Economic Perspectives,

Overall, the weight of the existing historical evidence suggests that patent policies, which grant strong intellectual property rights to early generations of inventors, may discourage innovation. On the contrary, policies that encourage the diffusion of ideas and modify patent laws to facilitate entry and encourage competition may be an effective mechanism to encourage innovation.

Similarly, the authors of a working paper published by the Federal Reserve Bank of St. Louis find that “there is no empirical evidence that [patents] serve to increase innovation and productivity, unless the latter is identified with the number of patents awarded — which, as evidence shows, has no correlation with measured productivity.”

Even if there are some industries (pharmaceuticals, perhaps) where government intervention can promote innovation, patent laws can heavily distort the direction of those innovations, subsidizing some consumers at the expense of the rest of us.

A paper by economists from Harvard, MIT, and the University of Chicago found that distortions in the US patent system cause the pharmaceutical industry to invest more in drug development for people who are late-stage cancer patients than for people who are in the early stages of cancer or for cancer prevention.

The Economist summarized the findings:

The patent system encourages [pharmaceutical companies] to pump out drugs aimed at those who have almost no chance of surviving the cancer anyway. This patent distortion costs the US economy around $89 billion a year in lost lives.

Distortions like these cast doubt on the belief that society can rely on government to produce efficient patent laws.

Myth #3: Antitrust laws benefit consumers.

Competition is vital to a thriving market economy. It increases productivity, increases the availability of consumer goods, and reduces consumer prices. Many people believe, therefore, that government intervention is necessary to ensure that large firms do not dominate entire markets of goods and services and end up exploiting consumers.

According to the conventional wisdom, 19th-century “robber barons” were monopolists who used such techniques as predatory pricing to drive out competitors and then charge obscene prices. Consequently, on behalf of the people, the government stepped up and passed antitrust legislation, most notably the Sherman Antitrust Act of 1890, which put an end to the rapacious monopolists.

But is this popular version of history accurate? That some firms dominate large shares of a given market does not necessarily imply that they are acting as monopolists (that is, restricting output and raising prices). Indeed, these firms often gained their market share by expanding output, lowering prices, and offering the best prices to consumers. In other words, they were so good that their competitors simply couldn’t keep up.

Historian Thomas E. Woods writes,

Mainstream economics identifies monopolists by their behavior: they earn premium profits by restricting output and raising prices. Was that behavior evident in the industries where monopoly was most frequently alleged to have existed? Economist Thomas DiLorenzo, in an important article in the International Review of Law and Economics, actually bothered to look. During the 1880s, when real GDP rose 24 percent, output in the industries alleged to have been monopolized for which data were available rose 175 percent in real terms. Prices in those industries, meanwhile, were generally falling, and much faster than the 7 percent decline for the economy as a whole. We’ve already discussed steel rails, which fell from $68 to $32 per ton during the 1880s; we might also note the price of zinc, which fell from $5.51 to $4.40 per pound (a 20 percent decline) and refined sugar, which fell from 9¢ to 7¢ per pound (22 percent). In fact, this pattern held true for all 17 supposedly monopolized industries, with the trivial exceptions of castor oil and matches.

In other words, the conventional wisdom justifying antitrust laws isn’t based on an accurate representation of economic history.

Still, it may be worth asking if antitrust policy in the United States has achieved the supposed goal of saving consumers from predatory monopolists. The answer appears to be no.

In a highly cited paper published in the Journal of Economic Perspectives, the authors assessed the evidence regarding the efficacy of federal antitrust policy and found that there was “no evidence that antitrust policy in the areas of monopolization, collusion, and mergers has provided much benefit to consumers.” Further: “in some instances … [anti-trust policy] may have lowered consumer welfare.”

That’s a pretty shocking conclusion given how casually most people accept the efficacy of anti-trust law. Instead of relying on government intervention to break up monopolies, perhaps the government should start dismantling the barriers it creates that inhibit competition in the first place. According to a paper by economists at the Federal Reserve Bank of Minneapolis, “Government policies themselves, such as tariffs and other forms of protection, are an important source of monopoly” that lead to “significant welfare losses.”

The solution to monopoly — and professional licensure, and the incentives of innovation — is less government intervention, not more. 

  • Corey Iacono is a Master of Business graduate student at the University of Rhode Island with a bachelor's degree in Pharmaceutical Science and a minor in Economics.