Thoughts on economics and liberty

Optimal level of regulation in society

When a government regulates our activities, it must ensure that the restrictions imposed on our freedoms serve a proven good purpose – in terms of increasing accountability and justice.

The only objective way of testing the claims of a regulatory intervention or other government action are through a proper cost-benefit analysis.

True, the idea of conducting a (social) cost-benefit analysis on matters related to health, education and environment, among others, can raise many curly questions both at the philosophical and practical level. In particular, the implicit utilitarianism of such analysis can be bothersome, and it has often been too easy to use a cost-benefit approach to reduce our freedoms unnecessarily. It also involves valuing everybody's preferences equally, and that, too, is a major problem (except that we must all be equally free hence our freedoms must be valued equally). Unintended consequences of regulation or other government  intervention can also contaminate a cost-benefit analysis [the policy approaches to eliminating corruption highlighted by Baba Ramdev come to mind, but also the entire socialist rigmarole in India].

Having said that, there is no better tool of decision making than cost-benefit analysis, that can be used transparently (objectively) by public policy makers. At the very least this method forces one's assumptions into the open and highlights potential weakness of the analysis. It is better to know precisely what we don't know than to rush into government interventions on the basis of our gut feel for what might work.

Despite cost-benefit analysis,some decisions will remain very hard. However, if we weigh the results of such (cost-benefit) analysis against the requirements of freedom, then a good judgement could potentially be formed to suitably frame  regulatory interventions. 

Rules of thumb for use of cost-benefit approaches

The following basic rules of thumb should apply to all regulatory activity:

  • Benefits should exceed costs (B>C) for all regulation. Net benefits (B-C) should be as high as possible.
  • The marginal benefit to cost ratio should be equalised for all regulatory activity. Thus, the incremental cost imposed on society to save one life in the workplace should be the same incremental cost imposed to save a life on the roads or in the air (or through terrorist activity).
  • All regulation should be periodically reviewed to increase B and to decrease C further, thus increasing the B/C ratio, and increasing net benefits to society.
  • Only a certain level of regulation is 'optimal' – there should be neither more nor less.  

The diagram below shows how the net benefits of regulation can be increased by reducing costs.

It also cautions against excessive use of regulation by showing that there is an optimal quantum of regulation in society. (This is similar in concept to the diagram I showed in this blog post in relation to the optimal size of the public sector.)

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