Why do we have government regulations, and how can we improve them?

Debates over regulation are a recurring feature of economic policy, often resurfacing when governments seek to loosen or expand the rules that shape markets. Critics of regulation argue that rules can be overly burdensome, slow innovation, and impose unnecessary costs on firms. Supporters counter that well-designed regulations play a crucial role in modern economies by addressing problems markets cannot solve on their own, such as pollution, consumer deception, financial instability, or unsafe working conditions. These competing claims raise deeper and more fundamental questions that often get overlooked in debates: why do we need regulations in the first place, under what conditions is regulation economically justified, and how can it be designed to achieve its goals without creating unnecessary harm? We define “regulation” as the application of laws by the government that impose specific rules or requirements on individual or private firm behavior, backed by penalties (primarily civil, but in some cases criminal) for violations. Laws, typically enacted by legislatures, establish broad policy goals and grant authority, whereas regulations translate those laws into detailed, enforceable rules, often developed and administered by executive agencies. For example, the Clean Air Act is a federal law that establishes national goals for protecting air quality and authorizes the Environmental Protection Agency (EPA) to act, while EPA emissions standards issued under the Act are regulations that specify allowable pollution levels and compliance requirements for firms. Although the term “regulation” is associated with federal rulemaking, we use the term broadly to encompass rules or requirements stemming from laws passed by a legislature, executive branch implementation and enforcement actions, or court rulings establishing new precedents. In the U.S., regulation takes place at all levels of government—local, state, and federal.¹ For example, local governments set land-use regulations (e.g., zoning laws), state governments set professional licensing requirements, and the federal government approves new drugs.

Regulation also can take different forms. It can be highly prescriptive, detailing exactly how individuals or firms should act. Or it can be more goal or performance oriented, allowing actors freedom to choose the way they meet the goal but without detailed instructions.

We will consider these and other characteristics of regulation through the rest of this explainer.

Why do we need regulation? To correct and prevent market failures

In a well-functioning market, markets constitute a decentralized way of efficiently allocating scarce resources while incentivizing people and firms to innovate by developing new products and services. In the process, market forces determine prices and wages. When markets work well, prices and wages send useful signals. If a worker is underpaid or mistreated, they can leave to join a competing firm. If a firm charges prices well above its own costs, a consumer can buy from a cheaper competitor, or if none exists, a competitor can enter the market to undercut the incumbent’s prices and profits. If one could design an ideal market, all market participants would have perfect information about products, prices, and other market characteristics, and all costs and benefits of production and consumption would be realized only by market participants.

Unfortunately, in reality, markets can fail and subsequently produce inefficient outcomes in four major ways: excess market power, negative externalities, information asymmetries, and the “tragedy of the commons,” each of which we explore in detail below. If market failures are allowed to persist, they make the economy less efficient and reduce overall economic welfare. To correct market failures and prevent them from occurring, external intervention is necessary, most often taking the form of government regulation.

Just as markets are imperfect, however, so, too, are regulators. Regulators face a variety of incentives, capacities, and motivations that may or may not compel them to make markets more efficient. In some cases, regulators could induce greater distortions that reduce efficiency, for example by unnecessarily raising barriers to entry into a market. Finding the right balance is often difficult for regulators as they navigate opposing pressures from different stakeholder groups. Effective regulation thus requires a careful, calibrated, and transparent approach.

Types of market failures and regulatory approaches to correct them

Market power

One category of market failure relates to market power. Markets must be “workably efficient,” so that no single firm can persistently set prices without effective challenge by competitors. Otherwise, if a single firm controls all production (a “monopolist”) or is the only employer (a “monopsonist”) in a market, that firm can abuse its market power to exploit consumers or workers, extracting excess profits and reducing efficiency. In such situations, government intervention may be needed to induce greater competition. 

To remedy market failures caused by market power, the U.S. relies on antitrust enforcement, either by the Department of Justice (DOJ) and the Federal Trade Commission (FTC). Antitrust enforcement differs from other forms of regulation in that both bodies enforce existing laws, such as the Sherman Antitrust Act’s proscriptions against price fixing or monopolization (abuses of monopoly power), rather than set specific industry-wide rules of behavior. The antitrust agencies may also take preemptive actions, such as blocking a merger of two companies that threaten to substantially reduce competition in their markets. In this connection, both agencies have agreed on “merger guidelines” that inform their enforcement actions and make them transparent, though merger guidelines do not carry the force and effect of law like federal rules. Effective antitrust enforcement is critical to prevent market failures arising from market concentration.

For example, in 2024, the FTC reviewed the planned acquisition of grocery store chain Albertsons by rival chain Kroger—two of the largest supermarket chains in the U.S. These two firms encompass popular grocery store banners like Ralphs, Harris Teeter, Safeway, Vons, and others. In February of 2024, the FTC filed a lawsuit to block the merger, alleging that the deal would result in higher prices, lower quality, and lower wages. A federal judge agreed with the FTC’s arguments and signaled that the merger was likely unlawful. The two companies subsequently abandoned the deal, and the FTC claimed victory in halting the acquisition.

Notably, a number of states joined in the FTC’s lawsuit against Albertson-Kroger, and private parties can also seek compensation for damages caused by violations of antitrust laws. The combination of public and private antitrust enforcement helps to prevent and correct abuses arising from excessive market concentration.

Negative externalities

Externalities occur when some economic activity harms (or benefits) a third party, which is neither the producer nor the consumer. A classic example is that of a factory polluting a river with chemical waste, where another firm downstream is running a fishery. In a well-functioning market, all the benefits and costs of production are borne entirely by the producers and consumers participating in this market, and production only takes place to the extent that the societal benefits outweigh the costs. In this example, however, the polluting factory does not incur any costs for discharging waste into the river, but it imposes costs on the downstream fishery whose fish are harmed by the chemical waste. This means that the total cost of production is greater than the private cost to the factory. Because neither the factory nor the consumers factor this external cost into their production and consumption decisions, absent intervention, market forces will result in excessive pollution.

In principle, such externalities can be addressed through private bargaining or dispute settlement when property rights are clearly defined and parties can negotiate at low cost. This insight shows that markets can reach efficient outcomes without government intervention under very restrictive conditions. In practice, however, those conditions rarely hold. Bargaining and litigation can be costly and time-consuming, property rights may be ambiguous or difficult to enforce, parties may have unequal bargaining power, and externalities often affect many people at once, making coordination impractical. As a result, private bargaining often fails to resolve externalities in a timely or efficient way, creating a role for regulation.

Regulation addresses these practical limits by setting clear, enforceable rules that apply broadly, rather than relying on case-by-case negotiation or litigation. Well-designed regulation can provide clarity and certainty for businesses, allowing for long-term planning and investment. Additionally, the government can serve as an impartial third party with enough resources and independence to consider the market failure at hand in a balanced manner (though we discuss the possibility of “regulatory capture”² in a later section).

Take the example of acid rain, which is caused by air pollution released from burning fossil fuels. Particles in acid rain damage ecosystems and harm human health when inhaled. To address the problem, in 1990 Congress passed legislation amending the Clean Air Act and establishing a cap-and-trade program for the relevant pollutants. The program set a hard limit (a “cap”) on power plants’ total emissions but allowed plants to trade emission allowances among themselves. The Environmental Protection Agency (EPA) implemented the program through a set of federal regulations, such as those requiring power plants to install pollution monitoring equipment and send data to the EPA. The program stands as one of the most significant regulatory successes in U.S. history, decreasing acid rain by 30% which, among other health and environmental benefits, prevents twenty to fifty thousand deaths per year as well as ecosystem deterioration. The market-based regulatory approach, which allowed for trading of emission allowances, also reduced costs for power plants compared to more rigid regulatory approaches, with costs ending up about 83% lower than originally expected. The EPA and others estimate that the total benefits of the program outweigh the costs by a factor of around 40 to 1. Regulators identified an extremely costly externality and calibrated a solution to correct the market failure in a low-cost fashion: the hallmarks of efficient regulation.

Information asymmetries

Information asymmetries represent another market failure that can require regulatory intervention. They often occur when a seller possesses information about a product or service that the buyer does not. For example, in financial markets, an underwriter of a complicated security could better understand its risks compared to an unsophisticated investor or a used car salesman could better understand the car’s condition compared to the prospective buyer. In these types of situations, firms could take advantage of unsuspecting buyers. Though a firm could face reputational damage if it sells a harmful product or doesn’t provide a warranty, these actions alone may not suffice to prevent harm to consumers, especially when these harms materialize with a substantial lag or are difficult to trace.

The pharmaceutical market, for example, is ripe with information asymmetries that companies could exploit. Pharmaceutical manufacturers with teams of sophisticated scientists and engineers have an information advantage over patients, which could allow them to hide risks of harm. Pharmaceutical companies can profit from this information asymmetry, which could reward companies for developing barely therapeutically innovative drugs while understating their harmful side effects.

A regulatory remedy for this information asymmetry lies in the Food and Drug Administration’s (FDA’s) role in approving drugs. The FDA’s statutory mandate is to ensure that drugs are “safe and effective.” In order for the FDA to approve a drug, manufacturers must submit clinical testing results, and the FDA determines whether the drug’s benefits outweigh the risks. The FDA hires teams of expert scientists who can rigorously evaluate scientific information. In this way, the FDA ameliorates the information asymmetry by informing consumers about which drugs are safe and effective.

More generally, some regulations address information asymmetries through mandatory disclosure rather than direct approval or prohibition. For example, in real estate transactions in some states, selling agents are required to disclose known material defects in a property, ensuring that buyers receive critical information that sellers might otherwise have an incentive to withhold.

Tragedy of the commons

The “tragedy of the commons” refers to a situation in which many people are free to use a shared resource, such as a fishing ground or a public grazing area.  Because no one owns the resource, each user has an incentive to take as much as they can, even if doing so depletes it. Over time, this behavior harms the resource itself and leaves everyone worse off.

A market-based solution to this problem is to turn the common resource (public good) into a private good, incentivizing the owner of that good to preserve it. However, this solution isn’t always viable. While this could be confused with an externality, the key difference is that the harm here comes from open access to a shared resource: no single user owns the common resource or has a strong incentive to conserve it, so each person has reason to take as much as possible before others do, even though everyone is worse off in the long run.

For example, overfishing represents a tragedy of the commons that is generally thought to require regulation. In an open-access fishery, the tragedy of the commons leads to overfishing and depletion of fish populations. Simply assigning property rights is more challenging: how could one own the fish in the ocean? Instead of letting property rights and private orderings take care of things, government regulation is required.

To correct this market failure, in the U.S., the government sets an annual catch limit—a quota or total allowable catch (TAC)—for various fish populations. The TAC is set to maximize total fishing yields over the long run, an outcome unlikely to be reached without this regulation.   

Once the quotas are set, the government must allocate fishing rights. One way this is done is through individual transferable quotas (ITQs), which are permits that grant fishers a share of the TAC within fisheries. ITQs define property rights for fishing: The government allocates portions of the TAC to fishers through ITQs and allows fishers to trade ITQs amongst themselves.

ITQs address the issue of overfishing by requiring fishers to bear the cost of catching additional fish while the TAC ensures that total fishing levels are sustainable in the aggregate. Several studies have examined the economic benefits of these programs, finding that the ITQs improve efficiency, productivity, and wages. To ensure compliance with the TAC and ITQs, the government issues additional regulations governing things like permitting requirements, reporting requirements, and penalties for noncompliance. In short, although property rights assignment is one step in this regulatory process, the government mandates a fishing quota (TAC) and implements a larger regulatory apparatus to prevent overfishing caused by the tragedy of the commons.

Smart regulations: Finding the balance between over-regulation and under-regulation

Over- and under-regulation can occur for a variety of reasons, owing to the complex set of incentives regulators face. Over-regulation can happen when agencies impose overly strict or costly rules, when old rules stay on the books long after they stop being useful, or when regulators are overly influenced by the industries they oversee. Regulators may face political incentives or carry ideological commitments that lead to excessively costly regulations. Regulation can also accumulate over time when regulators face little incentive to review old or outdated regulations. Additionally, overregulation could result from well-organized industry interest groups influencing regulators to pursue regulations that benefit industry incumbents at the expense of other groups or new entrants (i.e., regulatory capture).  

Under-regulation can also occur when firms benefit from weak enforcement or regulatory gaps. While market failures can be harmful to society overall, they are usually highly profitable for companies that exploit or advance a specific market failure. For instance, in a market with limited competition, a dominant firm can earn higher profits than it would in a competitive market. When antitrust regulators enforce regulations to foster more competition in the market (e.g., by breaking up the monopoly firm into multiple companies), this reduces profits for the dominant firm while increasing welfare for consumers who benefit from lower prices. Firms therefore may aggressively fight back against regulators so that they can continue to exploit a profitable market failure. As policymakers pursue regulatory reform, they must navigate these competing pressures to strike the right balance between over- and under-regulation. We offer the following considerations to aid policymakers in striking this balance.

Removing or revising outdated regulations

Over time, overly burdensome regulations can accumulate as regulations become outdated or captured by individuals or groups with special interests. When this happens, regulators should consider removing or revising regulations that restrict innovation and do not address market failures. Agencies could adopt systematic review mechanisms to flag regulations that are outdated, unnecessary, duplicative, or impose disproportionate costs. In addition, open public comment periods, as required at the federal level by the Administrative Procedure Act (APA), can be helpful for understanding real-world burdens. Public input enables regulators to identify priorities for repeal, amendment, or consolidation of rules. However, concentrated interest groups can use public-input mechanisms to their benefit by pursuing a narrow agenda at the expense of the broader public. To preserve the benefits of public input, regulators should solicit a broader range of stakeholders who may be underrepresented or less well-organized. Additionally, necessary regulatory reform may require strong leadership from policymakers to stand up to concentrated interest groups and make the case to the public that reform is needed.  

One mechanism to manage outdated rules and regulations is regulatory budgeting, which is the process of placing constraints on the volume of rules. Since the costs of regulations already in place are not borne by regulators themselves, there is often little incentive for regulators to remove existing regulations. For political reasons, regulators may prefer to pursue new rulemaking activities rather than review old ones. Regulatory budgeting can help rebalance the focus of regulators to eliminate old, ineffective, or inefficient regulations and avoid implementing additional regulations that do not lead to significant benefits relative to their costs. This can involve setting a cap on the number of regulations, or ideally, on the estimated annual (or lifetime) costs of regulations. Several states have experimented with some form of regulatory budgeting, including Virginia, Kentucky, and Ohio. The first Trump administration set a target of repealing two regulations for every new regulation, and the current Trump administration set the ambitious goal of removing 10 regulations for every new regulatory action. While not a panacea for deeper governance challenges like undue influence by entrenched interest groups, moderate regulatory budgeting or periodic regulatory reviews of old regulations can reduce regulatory accumulation and improve efficiency.

The permitting process for clean energy infrastructure represents an example of overregulation resulting from both accumulated outdated regulations and use of regulatory process by interest groups to their benefit. Permitting delays have slowed progress on many energy projects. These projects often require dozens of permits and reviews across multiple agencies and government levels (e.g., local, state, and federal), including reviews under the National Environmental Policy Act (NEPA), the Endangered Species Act, the Clean Water Act, and the Clean Air Act. For example, NEPA reviews alone can take a median of 3.5 years, and some projects like transmission lines or critical mineral mines face even longer delays. These regulatory hurdles, while intended to ensure environmental protection and community input, have not adapted to the urgent scale and speed required for energy deployment to meet rising demand.

Permitting regulation was largely intended to prevent market externalities from imposing costs on local communities and the environment. Long permitting processes at the federal level developed as a proactive defense against lawsuits by local community interests. The problem is that over the years, the costs of delays from permitting regulation have far surpassed the costs of externalities to local communities. The case of energy permitting illustrates that even regulations intended to address market failures can spiral out of control and require significant reform.

Adjusting regulations dynamically to market developments

In many markets, new risks and market failures can emerge rapidly and dynamically. In these environments, Congress may choose to delegate more discretion to regulatory bodies, as future risks may be hard to foresee and guard against static rules.

Financial markets represent an example of a complex and highly dynamic market awash with potential market failures. For example, asymmetric information can arise when financial firms offer new investment products to less sophisticated investors or savers, and externalities can arise when risk-taking by financial institutions jeopardizes wider economic and financial stability.

To deal with these risks, the U.S. has created an array of financial regulatory bodies including  the Consumer Financial Protection Bureau (CFPB), the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), Federal Deposit Insurance Corporation (FDIC), Board of Governors of the Federal Reserve System (the Fed), and the Office of the Comptroller of the Currency (OCC). These bodies issue federal rules within their statutory authorities but with a large degree of flexibility. For example, the FDIC, the Fed, and the OCC enforce regulations through bank supervision. Bank supervision is governed by intentionally broad and vague rules that grant large degrees of discretion for regulators to make recommendations or require banks to shore up their finances. Without this flexibility and discretion, it would be difficult for regulators to ensure that banks are not socializing risk.

While bank supervision can adapt to dynamic environments and shifting risks, updating underlying statutes and federal rules is often a long and arduous process. Even if Congress delegates broad powers to regulatory agencies to update rules, federal agencies must adhere to the requirements of the APA, and rules are often challenged in court. The process of drafting and publishing a proposed federal rule, considering public comments, and finalizing a rule typically takes two to three years. In inherently dynamic and complex environments like finance, this creates a fundamental mismatch where rules are static and risks are dynamic. While APA procedures were meant to provide transparency into the regulatory process, a more flexible, streamlined, and holistic approach is needed in certain environments. Balancing the need for transparency and public input with the need to update regulations dynamically remains an open challenge for regulatory reform.

Avoiding regulatory capture

Though earlier we described the potentially adversarial relationship between the regulator and the regulated, regulatory capture describes the situation when the regulator ends up serving the interests of the industry groups they are supposed to regulate. This theory of regulation was popularized by scholars such as economist George Stigler, who boldly claimed that “regulation is acquired by the industry and is designed and operated primarily for its benefit.” Specifically, he argued that industries typically seek various forms of direct subsidies, restrictions and controls over new entrants, protection from foreign competition (tariffs and quotas), and price controls.

Stigler also argued that regulations thus can benefit large incumbent firms at the expense of consumers, taxpayers, and potential competitors. Even with no overt corruption, industries can get away with this because democratic processes are a crude aggregator of voters’ preferences and can be biased to favor concentrated, powerful, and well-organized industries.

Regulatory capture can operate through a variety of mechanisms. For example, in Washington, people often speak of the proverbial “revolving door,” in which government officials move onto lobbying jobs on behalf of the private sector and vice versa. Powerful and well-organized industries can attract knowledgeable and well-connected former government officials and leverage this to influence regulatory policy to benefit the industry. Regulators may tacitly favor regulations that benefit their future employers or clients.

Not all interest groups lobby on behalf of industry. Regulatory capture can arise from a convergence of interests among disparate stakeholder groups, occasionally resulting in strange bedfellows. To capture this idea, Clemson University economist Bruce Yandle coined the theory of “bootleggers and Baptists.” The namesake example describes the interests of the profit-motivated, black-market alcohol traffickers (bootleggers) and morally motivated religious groups (Baptists) converging to support the banning of alcohol sales on Sundays. The bootleggers could seize greater market share and profits by limiting legal competition on Sundays, while the Baptists pursued moral or religious motivations. Regulation can thus arise out of converging interest-group desires that may or may not make markets more efficient.

To give a modern-day example, take the case of calls for AI regulation. There are public interest groups earnestly concerned about AI safety. However, large incumbent AI firms could borrow the language and talking points of these interest groups to advocate for regulation that may indeed address safety concerns but that also makes entry into the AI market more difficult, thereby limiting potential competition. Politicians and regulators may receive support from these concentrated industry interests while cloaking their arguments in safety-related motivations to justify regulations.

Ultimately, the efficacy of regulation to remedy market failures comes down to the regulator’s competence, administrative capacity, and vulnerability to subversion by private interests. This depends on both institutional arrangements and on the motivations of those in charge of regulation. The appropriateness of regulation in different contexts depends primarily on the nature and severity of the market failure, rather than the demand by concentrated interest groups. In short, what is appropriate regulation requires careful case-by-case analysis of individual regulations and markets, a transparent regulatory process, a well-informed public to hold policymakers accountable, prudent governance and guardrails against subversion by special interests, and earnest regulators motivated by the public interest.

Conclusion

Ultimately, the core economic rationale for regulation is to correct for market failures like excessive market power, negative externalities, information asymmetries, and tragedies of the commons. Although non-regulatory solutions can effectively solve simple or low-stakes market failures, regulation often is needed for high-stakes or complex situations. When the government correctly identifies market failures and implements carefully considered and calibrated regulations, this often improves aggregate economic outcomes.

On the other hand, inefficient regulation can accumulate for a variety of reasons. Regulators may become zealously adversarial to industry and impose unnecessary costs on corporations and consumers, or they may become captured by industry interests and pursue regulation that benefits politically organized industry groups at the expense of consumers, workers, or other industries. Regulatory budgeting can help reduce the accumulation of outdated regulations, but may not solve governance challenges relating to regulatory capture or administrative capacity.

As policymakers consider regulatory reform, they should let the core economic rationale of regulations as solutions to market failures guide their decisions and consider how reforms to administrative processes or revisions to specific regulations enhance or diminish the ability of regulations to serve this core purpose.