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Thursday, January 29, 2009

Atlas Shrugged: Episode #34535

Once again the heavy hand of government has created another layer of regulation (and costs) to take effect on gas stations in California.

End result? Thus far 2.4% of gas stations (the vast majority have to be privately owned) are closing up shop.

There is a perceived negative externality that is generated by the technology used to transfer gasoline from the tank in the ground to the tank in the car. The proposed regulations are predicted to save 7 tons of pollution a day. This sounds impressive, although I am not sure what 7 tons of air pollution actually means. However, the story goes on to tell that the 7 tons saving is from a total of 2,322 total tons per day.

Thus, the regulation saves 0.301% in pollution and pushes 2.4% of the firms in the industry out of the market. Thus, the pollution reduction elasticity of exit is almost 8%!! I was trained as an industrial organization economist but I don't think I ever saw a theory that looked at how regulation leads to exit and whether efficient regulation leads to inelastic, unitary, or elastic exit.

From my point of view such a high exit elasticity with respect to a policy's target variable would be socially inefficient. The high exit elasticity suggests that the costs of complying with the regulation are so high that "marginal firms," or what our new Secretary of State once famously called "undercapitalized firms," or those firms that are essentially operating in a world of perfect competition and rather low profits are pushed out of the market.

Costly regulation only appears to be feasible when it is directed towards monopolistic or monopolistically competitive markets where there are sufficient rents so that, despite the regulation's explicit and implicit costs, no firms go out of business. However, economic theory suggests that over time rents are eroded in markets in which even restricted entry can occur. Thus, many markets today are different than they were thirty or forty years ago. While rents might have been sufficient for many firms to survive yesterday, evidently today that is no longer the case.

Ever smaller marginal gains in the area of air pollution in California seem to be accompanied by ever greater costs in terms of firm survival. This suggests that the market for retail gasoline is a lot more competitive than many perceive (I think this is confirmed by research by ex-colleague Mike Ward).

Nevertheless, while many think Ayn Rand's book is prophetic and therefore look at results such as this from California as a fulfillment of the prophecy, my take is that her book is more historical than many admit and therefore what we are seeing is simply a repeat of history during the late 1920's through the 1930's. The results back then were not very good, no reason to suspect they will be better now.

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