Monday, November 17, 2008

Economic fire codes

A new rationale for regulatory oversight

An extract from Written Testimony of Andrew W. Lo Prepared for the U.S. House of Representatives Committee on Oversight and Government Reform November 13, 2008 Hearing on Hedge Funds

Left to their own devices, market forces generally yield economically efficient outcomes under normal market conditions, and regulatory intervention is not only unnecessary but often counterproductive. However, under atypical market conditions—prolonged periods of prosperity, or episodes of great uncertainty—market forces cannot be trusted to yield the most desirable outcomes, which motivates the need for regulation.

A simple example of this dynamic is the existence of fire codes enacted by federal, state, and local governments requiring all public buildings to have a minimum number of exits, well-lit exit signs, a maximum occupancy, and certain types of sprinklers, smoke detectors, and fire alarms. Why are fire codes necessary? In particular, given the costs associated with compliance, why not let markets determine the appropriate level of fire protection demanded by the public? Those seeking safer buildings should be willing to pay more to occupy them, and those willing to take the risk need not pay for what they deem to be unnecessary fire protection. A perfectly satisfactory outcome of this free-market approach should be a world with two types of buildings, one with fire protection and another without, leaving the public free to choose between the two according to their risk preferences.

But this is not the outcome that society has chosen. Instead, we require all new buildings to have extensive fire protection, and the simplest explanation for this state of affairs is the recognition— after years of experience and many lost lives—that we systematically under-estimate the likelihood of a fire.5 In fact, assuming that improbable events are impossible is a universal human trait (see, for example, Plous, 1993, and Slovic, 2000), hence the typical builder will not voluntarily spend significant sums to prepare for an event that most individuals will not value because they judge the likelihood of such an event to be nil. Of course, experience has shown that fires do occur, and when they do, it is too late to add fire protection. What free-market economists interpret as interference with Adam Smith’s invisible hand may, instead, be a mechanism for protecting ourselves from our own behavioral blind spots. Just as Odysseus asked his shipmates to tie him to the mast and plug his ears with wax as they sailed past the three Sirens of Circe’s islands, we use regulation as a tool to protect ourselves from our most selfdestructive tendencies.

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