The subprime mortgage debacle, efforts by New York City to ban trans fats in restaurants, the discovery of lead in toys manufactured in China, and concerns about safety inspections of airplanes and laxity in regulation of new drugs have brought to the fore the issue of the optimal scope and methods of regulation designed to protect consumers.
There are two reasons to think that consumers might need more protection than is provided by competition among sellers, even as backed up by court-enforced law. Few opponents of regulation doubt the appropriateness of such judicially enforced rules as the implied warranty of fitness and safety that accompanies the sale of products.
The first reason for thinking that it might make economic sense to add a layer of regulation to competition plus court-enforced law is the high costs to consumers of obtaining information about products and services (but I will confine my attention to products). The busier people are and hence the higher their costs of time, and the more complex that products are, the higher consumer information costs will be. Product information could be thought a product in itself that a competitive market would generate in optimal quantities, but that is far from certain. The problem is what might be called "fouling one‚Äôs nest." If a cigarette producer advertises its cigarettes as "safer," it is implying that cigarettes are unsafe, and this could reduce consumption. Now in fact everyone knows about the dangers of smoking, so that is not a serious problem; but it is a problem when the hazards of a product are not widely known. A restaurant that advertises that its food contains less trans fat or less salt than other restaurants is telling consumers that there are bad things in restaurant food. Moreover, and probably more important, it is very difficult for an advertiser to explain why trans fat or salt or butter is bad for one. I believe that the obesity epidemic must be due in in part to the ignorance of many consumers, especially if they are poorly educated, of the causes and consequences of obesity.
There are three possible responses to the problem created by consumer information costs. The first is to require producers to provide more information; the second is to ban products upon on the basis of a judgment that if consumers knew the score they would not buy the product in question; and the third is to leave the burden of information on the consumer, thereby increasing the incentive of a consumer to inform himself about the products he buys. Often the preferred ranking will be 2, 1, and 3. Banning the product eliminates information costs, though to justify so drastic a measure requires a high degree of confidence that informed consumers would not buy the product if they knew the facts about it. If as I believe trans fats have close and much more healthful substitutes that cost little more than trans fats, the attempt to ban trans fats in New York City restaurants made sense.
Forcing sellers to provide more information to consumers can paradoxically raise consumer information costs by requiring consumers to sort through more warnings and interpret and evaluate them. There is also a lulling effect: required warnings create the impression that the government is protecting consumers by regulating sellers, which it may not in fact be doing; or may create resentment because consumers feel overloaded with unnecessary warnings: a "crying wolf" problem. A related problem is that consumers have very different stocks of information, making it difficult or even impossible to draft a warning that will provide a significant net increment in consumer knowledge.
Finally, encouraging consumers to become better informed about products on their own, in lieu of relying on government regulation, might be excessively costly. It would force consumers with high time costs to reallocate high-value time to the study of consumer products, at a cost and a cost of this reallocation that might exceed the cost of regulation. Take the case of health inspections of restaurants. My guess is that those inspections add little to the cost of restaurant food (I am assuming the inspections are financed by a restaurant tax). In their absence a consumer could not just drop in on a new restaurant with confidence that he would not get sick because of unsanitary conditions. (So such regulation may encourage entry into the restaurant industry.) No doubt services would spring up to rate the healthfulness of different restaurants, just as services like Zagat rate the quality of the food and service offered in different restaurants. But the inspectors employed by a private service would not have the powers of public inspectors--to inspect without notice and shut down a restaurant found to have unhealthful conditions. Perhaps some restaurants would consent to grant such powers to a private service, but then the consumer in evaluating the private inspection services might be faced with a formidable search cost to determine the best service.
Apart from costs of obaining information, there is the distinct problem of evaluating or processing information. This is the domain of the cognitive quirks that have been illuminated by the recent literature (increasingly influential in economics) in cognitive psychology. An example is the seeming inability of many consumers to appreciate the practical identity between an item priced at $9.99 and the identical item priced at $10.00. Merchants' unquestionably sound conviction that consumers exaggerate the difference between these two prices is the only thing keeping the penny in circulation, as it costs more than a penny for the U.S. Mint to produce a penny.
I do not think these quirks provide a compelling reason for additional regulation of consumer products and services. Such regulation would amount to telling consumers that they can't think straight, and would reduce consumer utility, at least in the short run, by denying them $9.99 "bargains." I would however favor incorporating into the curricula of high schools, and perhaps even elementary schools, courses in cognitive psychology that would make students alert to the pitfalls that await them as a result of cognitive defects that, though hard-wired in the brain, are avoidable if one is alert to their existence.
The existence of cognitive deficiencies may have been a factor in the subprime mortgage debacle, though on the consumer rather than the producer side. Many consumers may have been incapable of properly evaluating the risks of heavy borrowing; cognitive psychologists have found that average and even very intelligent people have difficulty handling probabilities. On the producer side of markets, however, there are forces for minimizing the effect of cognitive deficiencies. People who don't handle probabilities well are not going to thrive in the insurance business or other financial businesses. They will be selected out by competition; the analogy is to natural selection in biological evolution. I suspect that the housing bubble and ensuing credit crunch reflect, on the business side of the market, not so much irrational optimism as risk taking that was rational given asymmetries of loss and gain. Generous severance benefits truncate downside risk for the top management of large companies, and speculation in the face of a known bubble can be rational because until the bubble bursts values are rising very rapidly; the trick is to jump off the hurtling train just before it crashes.