Ch. 7 Taxation and Regulation

The previous two chapters focused on discussing the effects on and response by the market overall, however as a result of a multitude of decentralized, individual exchanges. The response is undirected and taken by each individual motivated by their perceived self-interest, yet seemingly coordinated toward finding a new balance between what is possible to produce – the supply – and what is wanted or sought-after by consumers – the demand. The former of the chapters discussed limited destruction and how this causes a different chain of events to happen than otherwise would have been the case, and thereby shifts the market ever so slightly toward different types of production as well as production of different goods. A broken window, we noted, means we do not get the ripple effects that would have happened had the shoe maker made that additional sale. That is, what had happened had there been no destruction of value. Instead, we got a chain of exchanges following the additional sale by the glazier who earned additional income from replacing the broken window. The latter chapter focused on tracing the effects of, and the market’s overall responses to, changes that are much larger in scale and scope. More specifically, the chapter discussed the effects on value and exchanges due to large-scale destruction. The effect is the same in both cases. They differ only in magnitude, not in principle: the destruction causes previously satisfied wants to become unsatisfied, and therefore redirects economic action and thus reallocates resources toward satisfying this want again.

In the case of disaster, the wants that are being “unsatisfied” is a set of very basic and thus vital needs such as electric power, shelter, access to food and water, and so on. Before those needs are again satisfied, very few people would waste time thinking about conveniences and the large number of wants that may be relevant or even at the top of the list when survival is not an issue (replacing an older model of a smartphone with the most recent one, for instance). In other words, survival is such an urgently felt need – or, which is another way of saying the same thing, so highly valued – that other things don’t matter much. For instance, leisure time may be of great value when the fridge is fully stocked and there is electricity to keep the food cool and, when needed, run the stove to cook it – and when other conveniences are readily available. But for anyone struggling for survival, leisure time is not an option. Leisure is valued much lower, relatively speaking, when very urgently held needs are still not satisfied. This is part of the reason we see so much more economic activity following war and large-scale destruction. People in general find securing their survival and restoring the standard of living made possible by the previous production capabilities so much more highly than they value leisure time without wants satisfaction. The tradeoff is no longer leisure or luxury consumption, but leisure or survival. So they choose to work longer hours because the destruction has set them back to a standard of living they are not comfortable with. The loss of standard of living is not by choice, but to put in the work needed to regain the previous level is. Though it is a choice made under duress, where all other available options are of terribly low value in comparison. And thus they choose to forego the leisure time they could have had.

Some things are of course impossible to do regardless of how much we would value the anticipated outcome. What is possible follows from the productive capital available, which is why destruction sets back the standard of living. In a modern society, producing an automobile is no big problem – most of us don’t need to even think about it, we just have to visit a dealership to get one. Neither is, as was the case with Adele’s entrepreneurial undertaking, planting an orchard to grow apples. Whatever inputs are needed to establish this type of production process are available in the market. For automobile manufacturing, there are already factories and model designs, supply chains, and productive capital specialized toward supporting the process available. For Adele, this includes anything from apple seeds via shovels to advanced irrigation systems and machinery to pesticides and fertilizer. All of these things increases her productivity, since with these things made available to her she can produce many more apples than she otherwise would have been able to. Had Adele instead lived in the 18th century or in a very poor or developing nation without the proper institutional support, she would perhaps need to attempt to grow apples without fertilizer and pesticides, and perhaps she wouldn’t have access to machinery and irrigation. Instead, she would be completely dependent on manual labor and simple tools such as shovels and hand-made scarecrows. She would need to use buckets to carry water from a nearby stream or lake – or collect rain water – to replace the irrigation system. So she would need to use a whole lot more of her labor and use it in a much less productive way, and she would consequently not be able to grow as many apples as she would have had all these advanced tools been available.

Destruction has a similar effect: it sets society back because some of the capital used to increase the productivity of labor, and therefore to produce the output expected, is no longer available. The productivity gain that the now destroyed capital good contributed to the overall production apparatus is lost, and therefore part of the ability to produce. In the case of the shopkeeper’s broken window, this may have only a very limited effect on his overall productivity. But in the case of natural disaster or war, the effect can be enormous and actually set back the productivity of a whole society several decades. Imagine the productivity and overall output of a modern city, then compare with what production capabilities would be possible after extensive bombing: the difference should be obvious. The inhabitants’ standard of living is a function of their ability to produce, as we noted in previous chapters, so the city after bombing is much less prosperous – because the capital that is destroyed no longer increases the productivity of labor and consequently labor must be used in less productive ways (or to recreate the lost capital). Indeed, when losing the ability to produce, a society or city loses much of their prosperity. The same goes for individual companies or persons.

So far we have only discussed the market and how it responds to temporary changes. We have intentionally left out a specific category of influence that has a large effect on all existing modern markets: regulations and policy, primarily through taxation and regulation. This type of influence is of a different nature than what we have previously discussed, which is why we dedicate this chapter to discuss the effects of taxation and regulation on production and productivity. The relevance to what was previously discussed in terms of destruction is the following: policy is intended to completely do away with certain types of production, perhaps because they are considered illegitimate or harmful, or alternatively limit their production, and thus steer production into the production of different types of goods. We will first look at the effectiveness of regulation overall, and then at regulation intended to steer and do away with specific types of production, respectively. The next chapter is dedicated to a discussion on policy used not to restrict but to improve productivity.

Effective Regulation

Before we venture into discussing how regulations affect production and thereby the choices – optionality – that consumers enjoy, it is necessary to distinguish between effective and ineffective regulation. Ineffective regulation would be policy that has little real effect and therefore does not effectuate the level of change that was intended. Indeed, the purpose of regulation is to change completely or influence behavior in some specific way to thereby cause a different outcome of the production and activity that take place in the market. Were this not the case, then there would be no purpose of the regulation. It is intended to do something – to have some effect – which means it must also change something. Ineffective regulation fails to bring about change, and therefore has no effect.

There are several reasons why regulations may be ineffective, but the outcome is the same: no change. Consider for instance regulation intended to force certain production techniques to be adopted in apple growing. The regulation is here effective if it changes Adele’s behavior away from the technique she is currently using (if we assume it is an unwanted technique) and therefore instead toward techniques that are considered better from the point of view of policy-makers. We would consider the regulation ineffective if it does not change Adele’s behavior at all, if it changes it too little. It would be a failure if it changes it in the wrong way.

The regulation would not affect how Adele does business if it simply doesn’t apply. A real life example of this, often used in economics courses, would be a legally mandated price floor such as a minimum wage that is set lower than the going market price. So enacting a law prohibiting employment at wages lower than $1.00 per hour, for instance, would have very little if any effect. It certainly wouldn’t bring about the type of change intended by enacting and enforcing a minimum wage. The reason is obvious: there may be no jobs that pay less than $1.00 per hour, so the regulation would not apply to any (or only very few) real cases. If the minimum wage, on the other hand, is set to $100 per hour, then it will have a significant effect since there are many jobs that pay less than this new mandated minimum. As all jobs paying less than $100, according to this hypothetical minimum wage law, are prohibited, anyone paying or making less in the present will be affected. To not break the law and risk penalties or other consequences, either employers must raise the wages to the legal requirement, or the jobs will be terminated (that is, people will be let go). It is reasonable to expect both to happen so that some jobs disappear whereas others pay more, but we cannot be sure which will happen in what quantities.

Let’s look at an example: if Adele grows Granny Smith apples and the law states that apple-growing must use a certain technique but the law does not include this type of apple, then it is ineffective with respect to Adele. The same is true if the law is written to apply to all orchards, regardless of cultivar, located in the valley but Adele has established her orchard on the mountain side. Perhaps it is instead the case that the law defines an orchard as a continuous piece of land with at least 25 apple trees used for production of apples to be sold in the market place. In this case, the law does not apply if Adele’s orchard has less than 25 trees, if it has more than 25 trees but on two separate and non-adjacent pieces of land, or if she has 30 trees but uses 6 of them for non-business purposes. In this way, it is possible for businesses to avoid specific regulation by making sure that they fall just outside the law’s applicability. It is also possible for policy makers to tailor regulation to penalize specific sets of businesses and thereby, as a consequence, favor other businesses.

But even if the regulation formally applies and there are no loopholes, it may still be ineffective. Examples of this include laws that are unenforceable because they mandate something that is very difficult or even impossible to measure. It could also be the case that it is very costly or impossible to uphold the mandates in the regulation so that the authorities tasked with enforcing it in practice have very limited or completely lack ability to do so. For instance, what if apple-growing is regulated in such a way that those orchards producing more than 1,000,000 apples are affected by a certain type of policy. Does Adele produce 1,000,000 apples? It may be very difficult to count, she can easily claim she doesn’t or eat a few to make sure her orchard makes less than the stated number available for purchase. Do apples that are half eaten by birds or larvae count as full apples or half apples or no apples? It could also be the case that there are plenty of orchards of a size that produces approximately 1,000,000 apples, which means the authorities need to physically count the number of apples produced in each orchard. This may not be possible, perhaps because there are not enough bureaucrats to count all apples. Or the apple-growers are mandated to report the number of apples produced, and policy enforcement is based on those numbers. Why would anyone report just over 1,000,000 apples when they might as well report just under that number and thereby avoid being regulated?

Such “toothless” regulation will not cause actual change even if it is formally applicable, for the simple reason that the threat of consequences for actions violating the regulation is not credible. This is not only the case if the authorities are unable to enforce the regulation because they lack the necessary resources, power, or are limited by the practical possibility of doing what is stated in the law, but there can be political pressures that undermine the regulation. For instance, the only large employer in a small town burdened with high unemployment rates could likely “get away with” violating certain regulations because the community, and therefore the politicians in charge, are dependent on the jobs it supplies. If there is a risk that this business could either move elsewhere or close its doors if the regulation is enforced to the letter of the law, the authorities may choose to indirectly allow them to violate the regulation by simply not enforcing it. This may also be the case where this business has contributed to the campaigns or otherwise helped get influential policy-makers elected, so that they may feel obliged to return the favor by looking the other way or pulling strings.

In particular situations where the authorities lack the trust of the general population, it may be impossible for them to enforce any laws, including regulations, even when they want to. Where the people holds such deep skepticism towards those in power, the authorities cannot rely on the implicit support by the population, which means any action that triggers dislike or contempt among the populace would endanger the position and influence of the policy-makers. In these situations, any indiscretion could potentially cause uproar and upheaval and this may be sufficient reason for policy-makers to tip-toe and self-regulate their behavior in their official capacities. In any event, an apparent trespass or action taken beyond what is recognized as legitimate by the populace would endanger the continued influence and position of the policy-maker. We see this in some nations where the population has no or very little trust in politicians and officials of government. For regulation to effective the political apparatus, and its dealings, must be considered legitimate by a large part of the population. If this is not the case, then it will be very difficult to enforce regulations. Very often, government is unable to enforce its rules on a population that is not willing to subject to those rules – or at a minimum unwilling to resist them. Indeed, the effectiveness of government, and therefore its attempts at regulation, is dependent on the silent majority sanctioning or at least accepting its claim to influence.

For what is discussed below, therefore, we consider only situations where government is deemed sufficiently legitimate to not be challenged by large sections of the populace, and where the regulation in question is effective.

Impact of Regulation

The type of regulation that is intended to steer rather than prohibit production consists of what we might refer as both “carrot” (incentive) and “stick” (disincentive). As carrot, different forms of subsidies are used to make specific types of production, the production of certain goods or the use of certain production processes, more attractive. This can be done in one of two ways, since what matters is the relative attractiveness, and therefore value, of choices.

The most intuitive form of steering production is to offer positive payments, that is financial contributions made available to the actor following certain choices, which help cover the expenses – fully or partially – and thereby lessen the real cost borne by the actor. For instance, if policy-makers consider investments in solar power to be comparatively advantageous for electric power production, for environmental or political reasons, those investing in such production could be offered a financial contribution. This, of course, changes the choice situation by making solar power production relatively more lucrative than other types of production, and this is the means by which subsidies are used in favor of certain production. This type of outright subsidy in the form of positive payment is not as straight-forward as one might think, however. Any such subsidies must follow regulation (rather than vice versa), since positive payments necessitate that government has already acquired the funds offered. As government is not an economic actor in our model (at least not yet), but has primarily a restricting role on the economic organism, either in the form of market-supporting institutions[1] or outright prohibition or by adopting means in-between the two, it does not create economic value through production and exchange. For this reason, whatever positive payments offered must first be seized by (or offered to) government by economic actors, for instance through taxation or other types of confiscation. We will therefore discuss subsidies as part of the next chapter, when we discuss attempts to perfect or improve the market through policy.

As we have already stated that any act intended to make a certain type of production, or the production of certain types of goods, more attractive is a relative measure, government can offer implicit subsidies by easing the restrictions generally in place and thereby make certain acts more advantageous. This is not an actual “carrot” even though its effect will be similar. In the case of solar power, for instance, rather than offering outright subsidies, policy-makers can support this type of production through either (1) lowering existing taxes on production for the favored kind, or (2) introduce taxation on other kinds of production. In terms of the former, we could consider a situation in which the production of electric power is taxed but that an implicit subsidy is offered by explicitly lowering the existing tax rate on production specifically of solar power. In terms of the latter, government can introduce new taxation on all types of production of power except solar. In both cases, the result is that the production of solar power becomes comparatively cheaper (that is, more profitable) than the production of other types, and for this reason we would – all else equal – expect more entrepreneurs and businesses to pick solar power over the alternatives. This is, after all, the intent of steering through regulation.

Note, however, that these methods, while the starting position is different (with or without regulation), amount to the same thing: creating incentive by making a certain type of production, or production of certain types of goods, relatively advantageous (less costly) by lowering the regulatory burden on that wanted type. Both are about regulation and uneven regulatory burden across the market, and it is this difference that creates the incentive. However, if we look at the effect on prices and resource allocation – the real object of this chapter and the book – the effects are different because they have different starting positions: for a starting position with relatively burdensome regulation across the board we would assume that prices and thus resource allocation have already adjusted to the new situation, and then the regulatory burden is lowered on some type of action such as solar power production. For the alternative view, we start with no or comparatively little regulatory burden, and then introduce it unevenly so that it affects all types of production but the one to be made advantageous.

This type of regulatory change through policy attempts to steer the market indirectly by offering incentives. It therefore distorts the playing field where the entrepreneurial “game” takes place. The intent is to have entrepreneurs willingly choose what’s politically preferred because it is in their (financial) interest to do so. Such regulation is an attempt at nudging the market in a certain direction without excluding any options by force. A potential side effect of this type of regulation, therefore, is the discovery of the real value involved in not choosing a certain alternative. So, if we again consider implicit subsidies for solar power production, a minor difference in regulatory burden between solar and other types of power might or might not nudge a sufficient number of entrepreneurs or sufficiently significant investments into solar power. If the difference is not enough, this indicates that the economic disadvantage of solar power, as anticipated by entrepreneurs, exceeds the regulatory “discount.” A greater differentiation in regulatory burden could be sufficient to reach the political goals. This would then, potentially, help policy-makers discover the market valuation of the alternatives. Or, more specifically, by varying regulatory burden over time, policy-makers can discover the real cost that entrepreneurs anticipate from choosing solar over other types of power production. There is a limitation to using this method, however, since frequent adjustments to regulatory policy – which, after all, is coercive on all actors – would increase the policy-based or regime uncertainty[2] of entrepreneurship in this market sector. If regulations have changed frequently, this may cause entrepreneurs to anticipate frequent future changes and therefore strongly discount the value of investments in this sector. The result could be a sharp drop in investments.

As we discussed in previous chapters, entrepreneurs invest in production based on their anticipated value, measured in profit, which is generated by satisfying real consumer wants. When regulation is added to the market place, this constitutes a burden by increasing the cost of affected types of economic action. The cost may be both explicit, as is the case in added taxation or fees, and implicit, as would be the case for instance if certain measures restrict the entrepreneur’s ability to properly and at will respond to changes in the market place. What matters for economic action and thus our analysis of the impact of regulation is not the specific tax rates or fees or the specific restrictions placed on entrepreneurs, but how entrepreneurs assess the burden. In other words, where they see regulation as a burden on their undertaking they will discount the net present value of if, which is the same as saying that they will see the regulatory burden as an added cost, and it will therefore appear as less valuable relative other available alternatives. This is, after all, the intent of regulation: to steer by offering relative financial incentives and disincentives, and thereby produce a certain result in terms of changed economic outcome. To deny that regulation is a burden while using regulation to cause changed behavior in the market is a contradiction, since the latter depends on the former being true.

If we again use our little society as illustration, let us trace the effects of regulation as it is introduced. We have Adele the apple-grower, Becky the maker of three-inch nails, Bart the baker, and so on. We also have David, Deborah, Eric, and Edda, the nail smiths in Becky’s employ, from chapter 4. For our purposes, let us assume that David, Deborah, Eric, and Edda have started their own businesses as nail smiths and that there is a sufficient demand for them all to stay afloat in their preferred line of business. Add to this picture two more bakers – Bob, a new acquaintance, and Charles, the consumer bidding for nails in chapter 2 – and Fred the construction worker. In all, we have five nail smiths (Becky, David, Deborah, Eric, and Edda), three bakers (Bart, Bob, and Charles), one construction worker (Fred), and one apple-grower (Adele). We also have the city councilman Luke, who’s the sole policy-maker and a millionaire by inheritance, which means he doesn’t have to live off tax revenue. Our starting point, therefore, is one of pure, unregulated market where each of the market actors (all citizens but Luke, that is) produces for consumers and where each is able to sell enough to establish sufficient purchasing power. That is, they are all able to lead comfortable lives based on their own production for the market.

One day, Luke notes that the work of the nail smiths emits quite a bit of smoke and that this smoke causes a layer of soot on buildings that turn into a thick, black mud when it rains. This is a problem, he concludes, and goes to work authoring an ordinance to help with the soot. He realizes that simply prohibiting nail production would be a bad idea, since it constitutes most of the citizens’ trade – and because consumers prefer buying the number of nails produced at current capacity. So he figures that he can use the ordinance to nudge the nail smiths toward using higher chimneys so that the wind can transport the soot elsewhere. Consequently, he produces an ordinance that provides the nail smiths with an incentive to increase the height of their chimneys. He does this by requiring a fee, which will be used for cleaning the buildings affected by the soot. Specifically, the ordinance states that owners of chimneys under the height of 20 feet that emit smoke from producing nails must pay a fee of an amount equal to no less than 5 nails for each 100 produced. The reason for this is that he figures that the more nails produced, the more smoke would be emitted. So he proudly writes the ordinance on official letterhead paper and posts it on the door of city hall.

When the nail smiths see the ordinance the next morning, they are all a little upset by having to pay a penalty for producing nails the way they’ve always been produced – and the way preferred by consumers, as far as they can tell. Becky is more upset than the others, because she’s the most productive nail smith and can produce many more nails than the others – upwards of 4,000 each year – and she therefore is burdened with paying the highest fee. This is unfair, she thinks, because she doesn’t keep the forge burning longer than anybody else – in fact, she uses this “dirty” resource much more effectively than anyone else. But she has no say in the matter and no choice, of course, but to pay the fee stated in the ordinance. With the fee set to 5-of-every-100 nails produced, all of the nail smiths are burdened by what can be thought of as a 5% tax on the business of nail smiths – unless they increase the height of their chimneys. If no one chooses to make their chimney higher, then prices of nails would need to go up by 5% to cover the cost of the new fee. But at the higher price, consumers would not be willing to buy as many nails as they bought before, so total sales would go down.

Of course, the fee of flat 5% affects all nail smiths equally in nominal terms. But they are not equally affected by this fee. Some of them are not as productive as the other once and therefore have narrower margins and lower profitability. They cannot lower the price much without suffering losses, and they don’t have the additional capital necessary to pay Fred to make their chimneys higher. Becky, who’s by far producing most nails and has the highest margins, quickly decides that it is a good investment for her to contract with Fred to make the chimney higher. Fred would only charge her the equivalent of 50 nails to do so – equal to the fee she would need to pay on producing 1,000 nails, only a quarter of what she produces every year. So in 3 months she would make up for the cost and after that she could continue to produce just like before. It’s a temporary setback of the 50 nails, but one that she can take.

For Eric and Edda, the least productive of the nail smiths, the fee is not a temporary problem that can easily be overcome. In contrast to Becky, Eric and Edda cannot find a solution to the problem: it will take them 2 or more years to cover the 50 nails Fred charges to make their chimneys high enough, and this will eat up all of their profits during this time. But the option of paying the fee is equally bad – the fee is so close to their profit margin that they would struggle to break even when paying the fee. Even with the higher price, they would not be able to get back to the standard of living they were able to support as nail smiths before the ordinance. So they both choose to close down their businesses and seek employment elsewhere. David and Deborah are better off, since they are almost as productive as Becky and can pay off the higher chimneys in much shorter time than Eric and Edda. And with the fewer producers they get a larger share of the market and can actually increase their profits. They can also buy the equipment and other resources previously used by Eric and Edda, since this equipment is no longer of use to them. This, in turn, also increases the productivity and possible output, so Becky, David, and Deborah end up making money as a result of Luke’s ordinance – as Eric and Edda are forced out of business because of it.

While the ordinance changes the structure of nail production quite drastically, it is easy to see that there are other effects as well. While Luke doesn’t get the additional income he might have hoped for, since nobody ends up paying the fee, he gets the higher chimneys and – perhaps – this means less soot on buildings and elsewhere. Also, Fred increases his sales by getting to construct 3 chimneys that would otherwise not have been wanted. So Fred, just like the glazier in response to the added sales as the broken window needed to be replaced, starts a different chain of events by spending his new income. It is highly unlikely that he would spend this revenue in exactly the same way that the five nail smiths would have if there had been no ordinance, so this changes price signals accordingly: the effects where the nail smiths would have spent their money will not appear, the effects of Eric and Edda staying in business, including their suppliers and however they would have chosen to spend their profits, also will not happen, but the ripple effects following Fred’s new income now come into being.

But what about Eric and Edda? Being nail smiths was their number 1 choice of all alternatives available to them, which is after all the reason they were nail smiths. In the new situation, this option is not available to them anymore so they must choose something else. The options available may be different from what they were originally because of the ripple effects coming from all the changes due to the consequences of Luke’s ordinance. So what would have been their second best may no longer be an option either. But perhaps something else, that they consider a little bit more valuable, would be. In either case, they will choose the best option available to them in this new situation. Perhaps Eric can get a job in Bart’s bakery while Edda gets hired in an administrative role in Fred’s blooming business. This, in turn, increases the output of Bart’s bakery while Fred gets more time to work on construction and he can therefore increase his output as well. As they choose to employ Eric and Edda, they consider the added manpower worth the additional cost (the salaries they have to pay). This means, of course, that they anticipate that there is sufficient market demand for them can sell the additional output.

As the supply increases, the price tends to fall in order to cater to more consumers. So when Bart increases his output of bread, which is possible because he hires Eric, he can sell more – possibly all of it – if he charges a slightly lower price. In other words, this affects the other bakers, Bob and Charles, who must also lower their prices. If they don’t, they might not sell as much as they used to.[3] As Bob and Charles have not changed their production methods, their costs are the same as before and therefore, at the lower price, their profit margins decline. If one of them, say Charles, already had low profit margins because he was comparatively bad at baking bread, then the lower price may not make it worth his while to be a baker anymore. This means both Bart and Bob get larger shares of the market, can increase their prices or sell more at the present prices, and therefore make larger profits. Charles, on the other hand, needs to find employment elsewhere. The effect of Luke’s ordinance can therefore have ripple effects of its own, and cause changes to the structure of production as well as overall employment throughout the economy. The exact changes are of course very difficult, if not impossible, to predict. But that there will be effects, and that there could potentially be far-reaching such, should be evident.

The little “nudge” by Luke, intended to only limit the soot from nail production, has a much greater impact on the economy than simply limiting the emission of smoke. Indeed, we saw that it can cause a whole chain of events that can potentially change the structure of production throughout the economy. Not only are Eric and Edda forced to leave their preferred jobs while Becky, David, and Deborah increase their market share and profits, but the result of this change itself forces change to other market sectors – in this case, construction (Fred’s increased output after employing Edda) and baking (Charles is forced out of business while Bart and Bob increase their respective market shares and profits), which leads to further changes elsewhere. This reinforce the view of the market as an interconnected economic organism involved in decentralized production for individual consumption – just like we discussed in the previous chapters. It also shows how this organism responds to change by adjusting all affected production in stages just like the waves on a pond upset by a stone.

Impact of Prohibition

A similar but larger effect is caused by regulation in the form of outright prohibition of certain types of production. Regulation forced entrepreneurs to redo their economic calculations and revisit their choices with new and different values. This is how Luke’s ordinance with the chimney height requirement caused direct and indirect effects, and how the added cost forced marginal entrepreneurs out of business. Even a small change can reshape the cost structure in such a way that entrepreneurs make different choices, which is of course the intention of the regulation. But core to this type of “nudge” is to allow entrepreneurs to make the choice, however with changed variable values or added variables to consider.

Prohibition is different because this type of regulation does not only change the cost structure but in fact affect the choice set: the alternatives available for entrepreneurs to choose from. One way of restating prohibition in terms of cost is to say that the prohibited options come with infinite (or close to it) cost. But doing this makes the distinction unnecessarily ambiguous, since a cost can be overcome – and matters little if the anticipated value from assuming it is much greater. Prohibition is not in actuality a cost in the same sense as a tax or fee or required action, because it shifts the boundary of what is legitimate or lawful action. By prohibiting a certain action, there is indeed a cost to taking it: the cost to avoiding enforcement of the law, but also the cost of not acting in the market. But this cost is not a matter of degree, as is the case with other types of regulation. Those acting in violation of outright prohibition act in a different market, one which is outside the law, and this choice is in this sense a “black or white” issue rather than one of comparing costs. It is rarely the case that a proper and legitimate business, when facing prohibition, simply compares benefits and costs and then decides whether to continue or change its line of business. For this and other reasons, the “black” market tends to be populated by other actors than actors dealing in the “white” market. In other words, it is not a matter of degree but one of kind. For this reason and for added clarity, we’ll treat prohibition as a separate phenomenon and we’ll contrast it with the regulation discussed above using the same example.

As in the example above, Luke finds a problem in the smoke and soot emitted from the forges used to produce three-inch nails, and he finds a solution in political measures. But rather than adding a cost to “nudge” the nail smiths toward picking a, from Luke’s perspective, better solution (the higher chimney), he drafts a city ordinance to prohibit the forges. This will undoubtedly take care of the problem of emitted smoke, since the forges will not be permitted to continue and therefore will not emit any smoke at all. (We will here ignore the potential side effects of such a prohibition, such as “black” market or underground forges and the increased importation of nails from adjacent cities.)

Following the new ordinance, Becky, David, Deborah, Eric, and Edda have no choice but to close their businesses and find a different line of work. The immediate effect, therefore, is different from the regulation discussed in the previous section, in which only Eric and Edda chose different employment. It also means that our limited society now is left without production of nails, which could in turn cause problems. As forges are prohibited, the option of selling the forges to other actors is not available. Instead, the equipment can only be sold if there are other uses for it. This can be the case for hammers, tongs, and similar tools, but the forge itself can only be sold in the market for used materials, scrap metal and so on. In other words, the prohibition causes a fall in the value of the resources bound in forges – a loss of value that affects the owners as it limits their ability to free the capital and invest it in other businesses. For instance, a functioning forge could be sold for a sum equal to several years’ worth of output in the market, say 5,000 nails, but following the prohibition there is no permitted use for forges so the price other entrepreneurs are willing to pay for forges is based on their other and consequently, as we saw in the discussion in previous chapters – necessarily lesser valued uses.

The prohibition thus changes the value of forges back to the value of the resources that they’re built out of. Whereas the forge, before the prohibition, was a better use for the resources, which is evident from their higher price when combined into a forge, this is no longer the case. A forge, in fact, has practically zero value, since it cannot be operated. So after the prohibition, the value of the resources combined is lower than the resources themselves, so they must be separated. Undoing the forges consequently maximizes value among the available uses, but of course still sets back their owners – they lose the value that was there when they were running the forges (and would still be there were they allowed to continue).

By prohibiting forges, Luke forces a value loss on the nail smiths while at the same time forcing them into different lines of employment. Whereas the nail smiths personally suffer the loss of resource value, there is also an unseen loss in the value that would have been produced for consumers had the former been allowed to continue producing nails for sale. This value is no longer created, at least not by our local nail smiths, so the consumers lose out. In addition to these losses, both seen and unseen, Becky, David, Deborah, Eric, and Edda now need to find employment. This process is identical to what was discussed above, but of course here involves more people. Now five of them, rather than the two above, need to find employment. All of them, of course, will need to find lines of employment that they value less than being nail smiths. If this were not the case, they would not have chosen to become nail smiths in the first place. So whatever they choose now that being a nail smith is no longer a viable option is something they would have valued lower. This too is an unseen loss to be added to the loss by consumers.

In the case we discussed in the previous section, the construction worker Fred received additional business and could therefore expand and employ Edda. Whereas the additional business was not value creating in the strict sense, but rather the result of nail smiths attempting to avoid the larger cost of regulation (the fee), it was still a redistribution of value. The price charged, equivalent to 50 nails, is value that would otherwise have been created and earned by the nail smiths. But the regulation redirects this income to Fred, which is the reason – at least in our example – he can employ Edda. With prohibition, there is no redirection of value since the market directly affected by the prohibition is essentially destroyed (not permitted to continue) – and with it, its value. This loss is seen in the discrepancy between the value of a forge before the regulation and the value of the resources after it. It is also observable in the loss in consumer welfare as they cannot buy locally produced three-inch nails. So while the regulation we discussed in the previous section caused an inefficiency by forcing some profitable nail smiths out of business by forcing upon them an additional cost, which redirected value to the more productive producers, prohibition causes a loss of value to be borne by the entrepreneurs in the specific market sector affected and a loss of previously realizable value for the consumers who demand the product in question. Prohibition thus has a much greater effect on the market’s ability to satisfy consumer wants than the type of regulation discussed above, since some goods or services that could have been the actual choices made by consumers are forcefully removed.

Prohibition, therefore, restricts the optionality of consumers, whose choice sets are restricted as products they valued are banned, as well as producers, since banning a certain type of production makes their preferred production impossible. The value that this would have generated is lost, but could partially – but not fully – be made up for by increasing other types of production. The difference is lost. Regulation, in contrast, redirects value within production so that some producers (the “insiders” or beneficiaries of that piece of regulation) gain while others lose. It may lead to restricted supply of goods, but the exact effects depend on price elasticity and the competitive situation after the change.

Both types of regulation cause responses within the overall structure of production, as discussed in the previous section, because some actors need to find employment in other lines of business than their preferred choice (which is now either restricted through policy or altogether prohibited). The flow of labor into some specific industries change the balance in the market by causing the relative wage rates and/or profitability in these industries to go down. In other words, there are ripple effects in response to regulation just as there are ripple effects to any other change. The difference between regulation and destruction, as we discussed in previous chapters, is that regulation necessarily is a restriction on market action and is likely to remain in the longer term. While destruction causes reallocation of remaining resources to make up for the loss, and incentivizes people to choose labor over leisure and therefore invest more of their time and effort, it is temporary but with potential long-term effects. This will affect the optionality of anyone affected, but as we saw in chapter 6 there is a concomitant increase in the relative urge felt for some values (such as shelter, food, etc.). Regulation, in contrast, causes a cost by restricting what production is carried out by adding artificial prohibition or cost that affect choices of both producers and consumers – while their preferences remain largely the same. In other words, the response to prohibition is not an increase in the labor invested in production to make up for a loss, but an overall and continued loss of value available for consumption.

It follows, then, that it is important to treat destruction and regulation differently, because they are different phenomena with different effects on the market. What we’ve discussed so far, however, are restrictions only – temporary setbacks through destruction or disaster, and longer-term restrictions through policy. We’ll now head to discuss what appears as positive rather than negative influences, which are taken to improve or even perfect the market.


Higgs R. 1997. Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War. The Independent Review 1(4): 561-590.

North DC. 1990. Institutions, Institutional Change and Economic Performance. Cambridge University Press: Cambridge.


[1] Institutions, such as property rights protection or contract enforcement, are in the words of Douglass C. North the “humanly devised constraints that shape human interaction” (North, 1990: 3). Their productive, if not empowering, influence on the market are therefore through restricting what is legitimate action.

[2] See (Higgs, 1997)

[3] If Bob and Charles sell exactly the same types of bread as Bart, then they might not be able to sell much at all unless they lower their prices to match Bart’s. If they sell different kinds of bread, then their sales depend on consumers’ valuation of the different kinds of bread in the new price situation.