Executive Order 13422, Part 2
The kerfuffle over 'market failure'

1 Feb 2007 in Regulatory Economics, Regulatory Policy

President Bush's Executive order 13422 changed the domain of centralized regulatory oversight, its governing philosophy, and certain procedures related to regulatory planning. Yesterday we posted on the changed domain -- the inclusion of signifcant guidance documents within the centralized oversight apparatus. Today's installment concerns the change in regulatory philosophy.

New Executive order 13422 modifies the list of criteria used for regulatory review. Several reports have suggested that this change is significant. For example, Bloomberg's Cindy Skrzycki says this "new emphasis" is significant because of the nomination of Susan Dudley to serve as administrator of the OMB office that reviews draft regulations. This view is echoed by John D. McKinnon of the Wall Street Journal, who says Executive order 13422 "sets a new standard for formal rulemaking that requires agencies to find a 'market failure' before proceeding with formal regulation," a position McKinnon says "has been championed" by Dudley.

While it is certainly true that Dudley has been an advocate of the market failure criterion, McKinnon's statement that this criterion is new is easily shown to be false. The concept of market failure simply isn't new; it is a criterion in both Executive order 12866 (issued by President Clinton in 1993) and Executive order 12291 (issued by President Reagan in 1981). Thus, a market failure criterion has been in place continuously for 26 years.

A fair question is how the description of the criterion has changed. Below we map both the new and old texts to facilitate comparison:

Note that both texts contain the following elements:

• a primary reference to market failure as the justification for regulatory action
• a secondary reference to failures of "public institutions" (i.e, government) as the justification for regulatory action
• a requirement to "assess the significance" of the relevant market or nonmarket failure

No material content from the old text has been deleted in the new text. Moreover, the new version contains the following new elements:

• a nonexclusive list of types of market failures (e.g., "externalities, market power, lack of information"), which are described in greater detail in OMB's Circular A-4 (2003), as well as previous editions of OMB's regulatory analysis guidance issued in 2000, 1994, and 1990.
• a reference to additional but unspecified justifications for regulation not previously mentioned (i.e., "other specific problem")

This, there is no textual basis for asserting that Executive order 13422 changes in any material way the previously existing emphasis on market failure as a criterion for regulation. The new text provides more detail about the meaning of the term "market failure," but the details it provides cannot be construed as controversial because they have been explicitly stated OMB guidance for more than 16 years.

What might be included in the category of "other specific problems"? One possibility is the problem of ambiguous, insecure, or unenforceable property rights. The theory of externalities has a competitor -- the property rights perspective developed by Ronald Coase and for which he was awarded the 1991 Nobel prize in economics. Quoting from the Nobel prize press release:

In ... The Problem of Social Cost , Coase introduced the set-up in terms of rights or property rights. He postulated that if a property right is well defined, if it can be transferred, and if the transaction costs in an agreement which transfers the right from one holder to another are zero, then the use of resources does not depend on whether the right was initially allotted to one party or the other (except for the difference which can arise if the distribution of wealth between the two parties is affected). If the initial holding entailed an unfavorable total result, the better result would be brought about spontaneously through a voluntary contract, as it can be executed at no cost and both parties gain from it. In other words, all legislation which deals with granting rights to individuals would be meaningless in terms of the use of resources; parties would "agree themselves around" every given distribution of rights if it is to their mutual advantage. Thus, a large amount of legislation would serve no material purpose if transaction costs are zero...

This led Coase to conclude that it is the fact that transaction costs are never zero which indeed explains the institutional structure of the economy, including variations in contract forms and many kinds of legislation. Or, more exactly, the institutional structure of the economy may be explained by the relative costs of different institutional arrangements, combined with parties' efforts to keep total costs at a minimum. Alongside price formation, the formation of the institutional structure is regarded as an integral step in the process of resource distribution. Hence, economic institutions do not require a "separate" theory. It is sufficient to render existing theory complete and formulate it in terms of the primary components, i.e., property rights.

Many public policy problems that are routinely understood as problems of "externality" are susceptible to resolution through the protection, restoration, or establishment of clear and enforceable property rights. Moreover, this is not longer a particularly radical idea. The 1990 Clean Air Act Amendments put in place a sulfur dioxide emissions trading regime that relies on property rights as its intellectual foundation. The same goes for so-called "cap and trade" schemes for reducing carbon dioxide and other greenhouse gases.

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