How Regulating Charlatans Could Hurt Consumers
By Jules van Binsbergen
How do you keep charlatans out of high-skilled professions like medicine or financial services? Bring more regulation, the professional organizations in those fields are likely to suggest. But regulatory barriers such as licensing or certification could end up hurting customers by reducing competition and raising prices, according to Wharton finance professor Jules H. van Binsbergen.
Binsbergen and Stanford University finance professor Jonathan B. Berk delved into those dynamics in a recently published paper in The Journal of Finance titled “Regulation of Charlatans in High-Skill Professions.“ The provocation for their study was the sharp increase over the years in licensing requirements across U.S. states and in an increasing number of professions. “The idea that regulation is in consumers’ interests is often taken for granted,” the authors stated in their paper.
In their model, the authors define charlatans as those who operate in a market where skills are in short supply and in high demand, but they do not deliver on the services they sell. They reasoned that charlatans prey on those professions with that supply-demand equation because they offer high wages. “Professions with weak trade groups, skills in larger supply, shorter training periods, and less informative signals regarding the professional’s skill are more likely to feature charlatans,” the paper stated.
The study used data for five professions: financial advisors, medical doctors, lawyers, real estate agents, and accountants. It looked at how different types of regulation – licensing, certification, and standards – play out for consumers, producers, and in terms of “overall welfare.”
“Many people think if you just remove charlatans from the market, it must definitely be in the interests of consumers,” said Binsbergen. “In their head they keep the price of the good the same, and they think that you pay the same low price and have a lower probability of having to deal with a charlatan. Yes, sure, that makes consumers better off, but it ignores the fact that the price will go up.”
Binsbergen is also worried about the many calls for regulation by professional organizations. “We often see professional organizations that are lobbying for more regulation. But if you lobby for more regulation, that of course helps you to keep your competitors out of the market, and you now have more pricing power that benefits you,” he said. “But they lobby for regulation with lawmakers under the pretense that they want to protect consumers from charlatans.” According to the paper, “the explosive growth in the last 50 years of licensing requirements [shows] that trade groups are successful in lobbying governments to act in their interests.”
How Regulation Could Hurt Consumers
According to the paper, regulators assume that disclosure helps to keep consumers more informed and thereby make better choices. “Unfortunately, this reasoning is incorrect [and] the opposite result is true,” the paper stated.
“Although both standards and disclosure drive charlatans out of the market, consumers are worse off because of the resulting reduction in competition amongst producers,” the authors added.
“Consumers get what they pay for,” the authors noted, explaining how regulation impacts that dynamic. Before government intervention, producers may offer a lower price for their services. If the government introduces regulation to keep charlatans out, that price increases “to reflect the lower probability of consumers having to deal with a charlatan.” If that were the only effect, “the increase in their expected benefit is perfectly offset by the higher price that has to be paid for the service.”
The problem is that regulation, such as a licensing or certification requirement, reduces the number of providers, thereby reducing competition. “Disclosure reduces the cost imposed by charlatans and consequently increases skilled workers’ expected wages,” the paper stated. In effect, without charlatans, the reduced competition increases prices further, thereby lowering consumer surplus, or the difference between what consumers pay and what they would be willing to pay.
Producers, on the other hand, benefit from regulation, the paper pointed out. “Instead, the primary effect of regulation is to make producers better off, providing an explanation for why trade groups often lobby for and are in favor of high standards,” the authors added.
Regulation is not the solution even if the policy objective is to maximize overall welfare where both producers and consumers benefit, the paper argued. For sure, information disclosure increases overall welfare because it allows consumers to better discriminate, and it increases the supply of skilled workers. But because information disclosure also increases producer welfare by allowing them to earn more (through higher wages), they would make such disclosure on their own without the need for regulation, the paper pointed out. “Thus, in both cases, if the objective is to maximize overall welfare within the sector, there appears little need to regulate,” Binsbergen and Berk write.
To Regulate or Not
Binsbergen said their study isn’t making the case that all regulation is bad; in fact, the researchers identify situations where it would bring good outcomes. “It depends in whose interests the regulator is regulating,” he continued. “If the regulator is serving the interests of producers and they want to maximize their wages, then licensing seems to be a particularly effective way to get those wages up.” If regulators are interested in serving the interests of consumers, “we show that in many cases, neither licensing nor certification helps very much.” Regulators rarely talk of maximizing “total surplus,” or regulation that brings overall welfare by benefitting both consumers and producers, he added.
In some settings, regulation may bring delayed benefits but higher costs in the near term. For instance, if regulators want to increase the supply of brain surgeons, they may tweak regulatory requirements. “In the short run, consumers have to pay a very high price, because it’s not like we will have new brain surgeons tomorrow,” Binsbergen said. “It takes a very long time for talent to enter the market in response to these higher wages as they have to be trained. If you think that effect is strong enough, there are situations in which you could justify regulation.”
Regulation would be justifiable also if regulators view consumers as irrational, where they don’t understand the effects of charlatans and are paying excessive prices, said Binsbergen. “As a government, you could try to protect consumers against their own irrationality. But where does that argument stop? There are tons of decisions that people make. And how paternalistic should the government be in trying to intervene in these markets? And do governments really know better who the charlatans are?”
How Licensing Affects Consumers and Producers
The study’s insights have important implications for the debate on certification and licensing. The authors noted that a professional cannot practice without a license but can practice without being certified. In other words, a licensing requirement is a minimum standard while certification requires information disclosure.
According to the paper, professions like medicine have “market-imposed standards” that benefit consumers sufficiently; they are willing to pay more for better quality treatments. Introducing government regulation on top of those market-imposed standards only makes those treatments more costly, the authors argued.
While licensing hurts consumers with reduced surplus or competition, the resulting higher wages benefit producers. Certification, on the other hand, is not preferred by either consumers or producers, according to the study. That is because certification works against consumer interests with reduced competition, but it is not as effective as licensing is in boosting producers’ wages.
Binsbergen said the goal of their study is not to argue against regulation, but to challenge the implicit assumption that consumers always benefit from it. “We have argued that for professions with a skill in short supply that is in high demand, neither information disclosure nor setting minimum standards improve consumer surplus. Instead they help producers,” the paper stated. “This raises the question why we observe so much government regulation in practice, particularly for those high-skill professionals, and whether, in light of our results, the government should adopt a different policy.”
Binsbergen suggested calls to action in specific areas such as rolling back regulation in many U.S. states. He pointed to “a huge variation” between states on which professions need licensing requirements and which ones do not. For instance, in California, “a tremendous number” of professions need certification or licensing, but many other states require those for far fewer professions, he noted. “Is it really the case that if you would go to one of these low licensing states, you’re so much worse off as a consumer? In fact, our paper suggests that you’re better off as a consumer in the states with low licensing requirements than in the states where you have a lot of those.”