New Research Highlights the Role of Regulations and Lobbying in Business Dynamism

By Tyler Richards of Mercatus.

"Business dynamism⁠—the process whereby new, innovative, or highly productive businesses outperform their competitors—is a key feature of any healthy economy. In fact, researchers have tied high rates of dynamism to positive outcomes such as aggregate employment growth and higher standards of living. By standard metrics, however, dynamism in the US has been falling since the 1980s—and worse, we don’t know why.

In a new paper titled “The Failure of Free Entry,” New York University researchers Germán Gutiérrez and Thomas Philippon offer a new take on the slowdown of business dynamism in the US and provide evidence that regulations and lobbying have played a significant role. The authors reach this conclusion by a combination of new approaches to measuring business dynamism and using the power of RegData.

A common way that we measure dynamism is by observing the rates at which new businesses are created while others die off—what we call entry and exit rates. But focusing just on entry and exit is a bit oversimplified. What’s really important is that resources like workers and machinery are reallocated from lower- to higher-value uses. So, a better metric of dynamism might be whether entry is higher in industries with a higher potential for profitability (more output value relative to the input value), as compared with other industries. In other words, whether supply (here, the supply of businesses) is properly responding to demand. This is the metric that Gutiérrez and Philippon propose.

When the costs for a new business to enter the market are low, entrepreneurs should (and do) flock to industries where there is a high potential for gain—that is, industries with a high Tobin’s Q (market value divided by value of total assets). This dynamic process is apparent in the US data prior to the 1980s, when industries with a high Tobin’s Q had higher rates of entry. But throughout the 1980s and 1990s, something changed. Since 2000, there has been no relationship between business entry and Tobin’s Q. Thus, the “dynamism” that is occurring is no longer reallocating resources the way it is supposed to. The authors propose and test multiple hypotheses to explain why this happened. They find that only two things can explain this recent phenomenon: regulations and lobbying.

The authors find that regulations and lobbying reduce the entry and growth of small businesses relative to large businesses (we found something similar), and combined with rising entry costs, this has led to a less dynamic and adaptable economy. They also find that regulatory changes to an industry now increase the profits of incumbent businesses—something they do not find in the years prior to 2000. And since the confluence of regulations and lobbying have a strong negative effect on any potential competition, this leads the authors to a theory explaining what happened: regulatory capture. At some point, regulations started shifting away from the public interest and toward the interest of those they are meant to hold in check.

One example of this shift toward regulatory capture may be evidenced by the recent tendency of the Federal Aviation Administration (FAA) to view airlines as its “customers,” and to cater to their interests. In the 2000s, two inspectors-turned-whistleblowers from inside the FAA came forward with claims that their supervisors (who were “friendly” with the airlines) had instructed them to look the other way when they encountered problems during inspections, and added that this attitude was widespread within the agency. Academics have also noted that FAA pricing regulations for airport slots discouraged airports from charging airlines for the costs that these airlines impose on travelers. Just in the last few months, some reporting on the topic have even suggested that regulatory capture may be responsible for the two recent Boeing 737 crashes in Indonesia and Ethiopia.

The FAA is just one example, but if Gutiérrez and Philippon are right, this trend extends to many other agencies. Furthermore, their findings imply that the mechanism through which existing businesses benefit from regulatory capture is not as obvious as the examples described above. Instead, their findings imply that these benefits come in the form of regulations that make it more costly for new businesses to enter and compete. This also allows existing businesses to lobby for benefits from agencies under the guise of altruism by claiming that these regulations are needed for other reasons such as safety (so how do you tell altruism from greed?).

However, if the authors are right that regulations and lobbying are driving down dynamism, there may be a way to reverse the trend. If either increasing regulation created the opportunity for regulatory capture, or regulatory capture led to increasing regulation, there is an obvious remedy: reduce the regulatory burden, particularly on small businesses, so that entry costs are no longer inhibiting. But that doesn’t just mean exempting small businesses. It means substantially cutting down on the mass of complex regulatory text currently on the books. Even if small businesses are exempt from a regulation, the business owners still have to spend time and resources figuring out whether it applies to their businesses. And with over a hundred million words in the Code of Federal Regulations, that task is substantially more daunting for the owner of a small business than for a large corporation with an army of lawyers.

There is no shortage of ideas for reducing the regulatory burden. But if we want a dynamic economy that allows us to reap the full benefits of a well-functioning market, ideas alone are not enough—we need action."