Big Companies Can Afford Regulation, Which Is Why Some of Them Ask for More

Two claims, one assumption. The assumption: big business and big government are natural enemies. The claims: regulation exists to restrain large corporations, and when a corporation lobbies for more regulation, it must be acting against its own interest.

Both claims are wrong, and the assumption is the reason. Let me make the argument in order, define the terms, state the opposing view fairly, and take it apart.

Definitions

Compliance cost is what a business must spend to follow a regulation: legal advice, software, staff time, filings, audits, inspections and the cost of changing how it operates.

A fixed cost is a cost that does not rise in proportion to the size of the business. A rule that requires every company to file a certain report, hire a certified officer or buy a certain kind of equipment imposes a cost per company, not per dollar of revenue.

Regulatory capture is the condition in which an agency created to regulate an industry comes to serve the interests of that industry rather than the public.

Incumbent means a firm already in the market, as opposed to an entrant who would like to join it.

Those four terms are enough to build the argument.

The steelman

Let me state the best case for the opposing view, in words its defenders would accept.

Regulation exists because markets fail. Companies pollute, mislead, sell unsafe products and abuse power over workers and customers. The state sets rules to prevent it. These rules cost money, and large companies, which do the most harm, bear the largest absolute costs. If a large firm says a regulation is too expensive, it is because it does not want to be restrained. If it supports a regulation, perhaps it has come to believe the rule is right, or has been shamed into it. Either way, the rules protect consumers, and an economy without them would be a free-for-all in which the strong prey on the weak.

Part of that is true. Markets do need rules. I will say more about that below. But the argument contains a hidden premise: that the size of the cost is what matters. It is not. What matters is the cost relative to the size of the firm, and on that measure, the picture reverses.

The numbered argument

1. Compliance costs are largely fixed. A rule that requires a compliance officer, a legal review or a certified system costs about the same whether the company has ten employees or ten thousand.
2. Fixed costs weigh most on small firms. Spread over a small base, a fixed cost is a large share of revenue. Spread over a huge base, it is a rounding error.
3. So regulation raises the cost of entering and staying in a market, and it raises it more for small firms. The upstart who might have challenged the incumbent is the one least able to pay.
4. Incumbents know this. A large firm that already has a compliance department can look at a new rule and see that it will cost it something and cost its smaller rivals more.
5. Therefore, some large firms will support regulation, or at least not fight it, because it handicaps their competitors. That is not a conspiracy theory. It is the ordinary behavior of a business trying to survive.

A worked hypothetical

Here is an invented example, labelled as such, to show the arithmetic.

Suppose a new federal rule requires every firm in a certain industry to maintain a documented compliance program that costs $120,000 a year, in staff time, software and outside review. Consider two firms.

• Firm A is a small business with annual revenue of $2,000,000. The rule costs it $120,000 ÷ $2,000,000 = 0.06, or 6 percent of revenue.
• Firm B is a large business with annual revenue of $2,000,000,000. The rule costs it $120,000 ÷ $2,000,000,000 = 0.00006, or 0.006 percent of revenue.

The same rule costs Firm A a thousand times more as a share of revenue. For many small businesses, 6 percent of revenue is more than the profit margin. For Firm B, it disappears into the noise. And Firm B may well have the compliance department in place already.

Now suppose that Firm B's lobbyists spent a few weeks helping to write the rule. They did not need to hate the small firms. They only needed to make sure the rule was written in a way that they already satisfied. The result: the rule is sold to the public as a restraint on corporate power, and its effect is to make it harder to compete with the corporation.

I stress that the example is hypothetical, and that real costs vary. The point is the structure, and that the structure is the same in every case where a cost does not scale with size.

Stigler and the theory of economic regulation

This is not a new insight, and it did not originate with conservatives. In 1971, the economist George Stigler, who would later win the Nobel Prize in economics, published "The Theory of Economic Regulation." His argument ran against the grain of the public-interest theory of regulation, which assumed that regulation was designed to benefit the public.

Stigler's claim was that, as a general rule, regulation is acquired by the industry and designed and operated primarily for its benefit. Industries, he argued, are organized and have a strong, concentrated interest in the rules that govern them. The public is diffuse and each member has a small stake. A legislature that responds to organized pressure will therefore tend to produce rules that favor the organized. Stigler wrote that every industry with enough political power to use the state will seek to control entry. Control over entry is the tool that connects most directly to the fixed-cost argument above.

Stigler's theory was not universally accepted, and it should not be treated as an iron law. Economists have pointed out that some regulation does serve the public, that industries are rarely united, and that regulators sometimes act against concentrated interests. But the theory gave a name to a pattern that anyone who has watched a legislative hearing will recognize, and it changed how economists think about regulation.

Bootleggers and Baptists

A decade later, a second economist added a vivid image. In 1983, Bruce Yandle, writing in Regulation magazine, described what he called Bootleggers and Baptists.

The story begins with Sunday closing laws for liquor stores, which are the original example. Who supported a ban on legal liquor sales on Sundays? The Baptists, who thought drinking was a sin and wanted it curtailed. And the bootleggers, who sold liquor illegally and would have the Sunday market to themselves if legal stores were closed. The two groups had nothing in common except the law. The Baptists gave the law moral legitimacy, and the bootleggers gave it political muscle, and each could pursue its goals without ever meeting the other.

Yandle's point is that successful regulation often needs two coalitions: a public-spirited one that supplies the principled argument, and a self-interested one that supplies the votes, the money and the expertise. Politicians love this combination, because they can vote for the law and say they did it for the Baptists, while the bootleggers get the benefit. The pattern is not limited to alcohol. Whenever a moral cause lines up with a business's financial interest, there is a reason to look carefully at who is paying for the lobbying.

I will say this plainly and fairly: a Baptist who supports a rule is not a hypocrite, and the people who sincerely want a safer product are not tools of a cartel. The lesson is not that every rule is a trick. The lesson is that the people who support a rule are not necessarily the people who benefit from it, and a citizen should ask who benefits.

The law that tried to fix it

Congress has known about the small business problem for decades, and in some ways has tried to do something about it.

The Regulatory Flexibility Act of 1980 requires federal agencies, when they publish a proposed rule that is likely to have a significant economic impact on a substantial number of small entities, to prepare an analysis of that impact and to consider alternatives that would reduce the burden, such as exemptions, simplified reporting or longer deadlines. It was one of the first laws to say, in statute, that rules do not hit all firms equally.

An office to speak for small business already existed. The Office of Advocacy at the Small Business Administration, created in 1976, is led by a Chief Counsel for Advocacy, who is charged with representing the interests of small business in the rulemaking process. Under the Regulatory Flexibility Act, the Office of Advocacy monitors agencies' compliance, files comments on proposed rules and trains agencies on how to do the analysis.

In 1996, Congress strengthened the law through the Small Business Regulatory Enforcement Fairness Act, which added judicial review of agency compliance with the Act and created panels, for certain agencies, that gather input from small businesses before a rule is proposed. The same 1996 law, as it happens, contained the Congressional Review Act described in The Congressional Review Act Lets Congress Veto a Rule, if It Moves in Time.

The record of the Act is mixed. Agencies can often certify that a rule will not have a significant impact, and that certification ends the obligation to analyze. Critics say the process is a box-checking exercise. Supporters say it gives small firms a seat that they would not otherwise have. Either way, the law concedes the central point of this post: that regulation has distributional consequences, and the small are the ones who pay.

The Founders and the competitive economy

Is there a constitutional dimension? A little. The Founders assumed that economic liberty, the freedom to enter a trade and compete, was part of ordinary freedom. The Declaration lists the pursuit of happiness among unalienable rights, and the history of American law is full of cases about the freedom to work and trade. A regulatory system that tilts the field toward the established, by design or by accident, runs against the spirit of the thing. The deeper principle is the one in Article I: laws should be made by the legislature, in public, where the people can see who is asking for them. Agencies Write Thousands of Rules a Year While Congress Passes Hundreds of Laws shows how much rulemaking happens elsewhere, and Sue and Settle, the Friendly Lawsuit That Writes Rules Without You in the Room describes one channel through which well-organized interests shape it. A government that makes rules in public, through a legislature, has fewer places for a bootlegger to hide.

The objection: markets need rules

I have promised to answer the strongest objection, and here it is. Markets cannot function without rules. Property rights, contracts, fraud laws, safety standards, disclosure requirements: all of these are regulation of a kind, and the conservative tradition has always supported them. If you complain about regulation, the objection runs, you will end up defending the fraudster and the polluter.

That is correct, and I do not complain about all regulation. The argument here is about something narrower.

First, there is a difference between rules and discretion. A clear rule, announced in advance and applied equally, is part of the foundation of a free market. A rule that requires an expensive compliance apparatus, applied by an agency with broad discretion, is a different thing. The first gives everyone the same chance; the second favors whoever can hire the best advisors.

Second, a good rule can be written to spare small firms. Exemptions for the smallest businesses, phased deadlines, simplified forms and flat standards instead of detailed process requirements are all tools that the Regulatory Flexibility Act contemplates. A rule that does the job at less cost is better for everyone, and the burden of showing that a rule cannot do so should fall on the agency.

Third, the right question to ask about any rule is not only "does it do some good?" but "who pays, and who benefits from the paying?" A rule that stops a real harm at a reasonable cost is a good rule. A rule that stops a trivial harm and walls off a market is a bad one, even when it is well-meant. The honest defenders of regulation should welcome the scrutiny.

Fourth, a free-market conservative's quarrel is not with the business that wins a market. It is with the business that wins a market by using the government to disable its rivals. That is the opposite of capitalism. It is what an earlier generation called mercantilism, and the Founders fought a revolution against its colonial version.

Here is a practical consequence. When you hear a corporation's executives praise a new regulation, do not assume they are being noble, and do not assume they are being cynical. Ask for the arithmetic. Does the rule cost them more or less, as a share of revenue, than it costs a company one-hundredth their size? If the answer is less, you are looking at a bootlegger, and perhaps a Baptist standing next to him.

For more on how the structure of agencies shapes who wins, see Departments, Commissions, Corporations and Who Really Controls Each One and A Regulatory Budget Would Make Washington Count the Cost of Its Rules, which proposes a way to force the government to count what its rules cost. For the way small-firm costs show up in the data, the numbers page and the red tape page are good places to start.

The case in brief

1. Compliance costs are largely fixed, so the same rule costs a small firm far more, as a share of revenue, than it costs a large one, as the labelled hypothetical shows: 6 percent against 0.006 percent.
2. George Stigler's 1971 theory of economic regulation argued that regulation is often acquired by the industry it covers and used to control entry, a pattern consistent with the fixed-cost logic.
3. Bruce Yandle's 1983 image of Bootleggers and Baptists shows how a moral cause and a business interest can combine to pass a rule that benefits the second while the first supplies the principle.
4. The Regulatory Flexibility Act of 1980 and the SBA Office of Advocacy concede the problem and offer a partial answer, though agencies can often avoid the analysis.
5. Markets need rules, but the right rules are clear, equal, cheap to follow and written in public, and the test of any rule is who pays and who benefits.

What you can do: the next time a federal agency proposes a rule that affects your trade or town, ask in a public comment whether it has completed a Regulatory Flexibility Act analysis of the effect on small businesses, and send your representative a note asking the same.