The Macroeconomic Impacts of Industrial Regulation

How can governments analyse the broader economic effects of proposed regulations in an interconnected economy?

Governments change hundreds if not thousands of regulations and laws every year, ostensibly to protect citizens’ health and safety and to assure the proper functioning of free markets. These regulations are only effective with compliance, which necessarily means that businesses move labour, capital and resources from producing revenue-generating goods and services to producing public goods. For example, environmental regulations that compel powerplants to install GHG emission mitigation measures require them to purchase equipment and hire staff that they otherwise would not.

In most cases, OECD governments measure the costs of such a regulation as the costs to businesses as the additional capital costs and the additional wages. However, this is missing a large part of the economic picture. The power plant, in this case, provides electricity to manufactures, other businesses and homes. They themselves are supplied by construction firms and primary resource industries that provide the material to generate electricity. A very costly regulation will distort how the power plant operates in its market.

In fact, the purpose of the regulation is to change the market. The government wants to compel the power plant to produce electricity using cleaner sources (different suppliers) of energy and technology.

Households have a dual purpose in the economy. First, they provide labour to the industry across the whole supply chain. Secondly, they are also the consumers of electricity and from downstream sectors like manufacturers who rely on electricity as an input. Indirectly, households trade labour for goods and services. Wages and prices are just signals to households and businesses about how they should optimally allocate labour and capital.

Diagram of the flow of goods, services and labour in a simplified economy.

Often, regulators, policymakers and lobbyists want to argue that regulations create employment. Rules produce new compliance requirements that require new staff, therefore, the regulation is a benefit to the economy. Of course, this is a fallacious idea. If the economy is at full employment, then it must be that the regulation displaces labour towards regulatory compliance activities from other areas of the economy.

This displaced employment has a pernicious side effect. Not only is the labour now in an “unproductive” task (unproductive from the market’s point of view at least), but both the suppliers and downstream industries are affected. If power plants produce less or it becomes more expensive to produce, they may demand less from their suppliers and, at the same time, they may send a signal to households and manufacturers to buy less by increasing prices for both electricity and manufactured goods.

The net macroeconomic effect of this hypothetical environmental regulation will be much higher than the direct costs to power plants. The more interconnected an industry is – the more it supplies other sectors, and the more other sectors supply to it – the greater the macroeconomic impact.
It is possible to analyze these impacts by looking at the vast amounts of input-output national accounts data that countries have gathered.

What does this mean for policymakers? When developing new regulations, governments must be mindful of how new rules will affect the whole supply chain, especially when the regulated industry is a critical part of the economy. Also, it means that governments should target regulatory reform efforts to sectors that are the most connected in the economy.