Government intervention can lead to more efficient markets by limiting externalities.
Proposition 1
Governments should pass laws that limit externalities.
Example 1
In Thailand, utility companies charge ~4 THB per unit of electricity, however many landlords charge tourists upwards of 12 THB/unit. As there is a large stream of tourists to Thailand, a significant portion of the rental market there is naturally a short term or one-play game for many landlords. They can trick tourists into thinking they’re getting a good deal on their rent by lowering it compared to the market then overcharging for electricity as a hidden cost. If there were not tourists and it were just locals, this would naturally correct over the long term as locals discovered which landlords were most honest. As this long term behaviour that identifies and rewards honesty and transparency doesn’t naturally emerge for a large segment of the industry, this is why I call it a naturally “short term” system. In contrast, in rental properties primarily occupied by locals, the electricity rates charged by landlords match the rates the electricity companies charge.
To deal with this, in 2018, the Thai government passed a law that landlords can only charge 20% more than the rate the utility company charges them for electricity. Naturally, rent prices increased. For example, assuming an actual electricity cost of 1,500 THB, before you may have had the following charged to the tenant:
Rent: 10,000 THB Electricity: 3,000 THB
The landlord effectively earns 11,500 THB for the room - the rent, plus the electricity, minus what they pay to the electricity company. Now, as they can only charge 20% more than the actual rate, the breakdown looks like this:
Rent: 11,200 THB Electricity: 1,800 THB
The landlord still makes a profit of 11,500 THB and the renter still pays the same amount overall. So, you might ask, what has actually changed? The difference is subtle but important: the system is now more transparent and it allows for renters to more accurately compare rental prices. The law bridges the information asymmetry gap and leads to a more efficient market. Properties have to compete based on their merits rather than based on how they can best deceive renters. It also increases trust in the Thai economy, encouraging more tourists to come visit.
In the long term, the landlords behaviour leads to decreased trust in Thailand, less tourists coming, and the Thai economy as a whole suffering. However, the people that will bear the cost of that will not only be the landlords, who have already profited from their dishonest behaviour, but the Thai people as a whole. The new law removes the externality that landlords were placing on their fellow citizens.
Proposition 2
Regulations that limit externalities can make markets more efficient.
Example 2
I originally saw this thought experiment on Slate Star Codex. Imagine a lake with 1000 fish farms. Each farm earns $1000 per month. However, each farm’s fish produce waste that decrease the value that can be extracted per farm by $1/month. This means that on aggregate, the value of the lake is $0 with everyone there. So the farmers get together and they all agree to install filtration systems that each cost $200 per month to run. Everyone is now only making $800, but it’s better than making $0. Inevitably one farmer will turn their filtration system off. Now the cheater makes $999/month, and everyone else makes $799/month. The defector is making more money by not cooperating, but the average yield per farm is now only $799.20. As this spreads it just gets worse: if 300 farmers stop running their filtration systems, 700 farmers will be making $500/month and 300 farmers will be making $700/month - for an average yield per farm of $560. Now everyone is making less than they’d make if they just cooperated, so they get together and all agree to run their filtration systems again. Inevitably some jackass will turn his off and the cycle continues.
Thus it follows that the lake could be made more efficient with a regulatory body that requires people to run filtration systems. Enforcing that a farmer cannot turn off his filtration system because he devalues everyone else’s use of the lake by $1 each ($999 total) for a gain of only $199 for himself. This example shows is that the regulation itself creates at least $800 of value per month assuming a modest filtration system cheating rate of 0.1% (1 in 1000). If it costs less in taxes for that to be implemented, it makes sense to do so. For each farmer that means a $200/month filtration system and a tax of just under $1/month to pay for regulation enforcement. Of course, it’d be even more efficient if people were honest and we didn’t need the regulatory body in the first place, but that is currently an unachievable utopia.