Encyclopedia of Law & Economics - 5120 LICENSING, MARKET ENTRY REGULATION



Shirley Svorny

Professor at California State University

© Copyright 1997 Shirley Svorny


1. Introduction
2. Basic Characteristics of Licensing Arrangements
3. A Brief History of Western Licensure
4. The Economics of Market Entry Regulations
5. The Debate over Occupational Licensing
6. Evidence
7. Licensure vs. Discipline
8. The Choice
9. Institutional Issues
10. Who Should be Licensed?
Bibliography on Licensing, Market Entry Regulation (5120)


Licensing describes the set of regulations that limit service provision toindividuals or entities who meet state-established criteria. Despite claims thatlicensure increases service quality, the effect of licensure on consumptionquality is ambiguous. That fact that service providers actively promote licensinghas led to the suspicion that licensing benefits these groups at the expense ofproviders of competing services or consumers. Also at issue is whetherinformation asymmetries or agency costs are strong enough to warrantgovernment intervention. Many believe that, in the absence of governmentintervention, markets would generate sufficient information through reputationand other mechanisms to meet the needs of consumers.

JEL classification: D18, H11, I18, J44, K12, L15.

Keywords: Licensure, Labor Supply Restrictions, Regulation, InformationAsymmetries, Product Quality, Consumer Protection.

1. Introduction

Licensure fits into the broad category of public policy aimed at reducingstubborn agency costs in the marketplace. Where one individual or a group ofindividuals provides services to another, a divergence of interests is impossibleto avoid. There is a fair amount of leeway for the provider (the "agent") to failto perfectly represent or serve the purchaser. Although several marketmechanisms exist to improve the position of the procurer (also called the"principal") -- to reduce the likelihood that he will encounter an opportunisticagent, or one that purposely and systematically misrepresents her product --none is perfect. Market entry regulation or licensure is most often favored for itsperceived ability to offer a layer of protection for consumers.

Licensing involves laws and regulations which limit service provision toindividuals or entities authorized to practice by the state. There are three pointsat which constraints have been imposed. The first is at the point of initial entry.Providers are denied entry if they do not meet established criteria or if legal limitson supply have been met. Second, it is not uncommon to regulate theproduction process itself. Practitioners who fail to stay within the prescribed setof permissible activities may have their license suspended or revoked. Finally,outcomes assessment can lead to the discipline of errant providers.

Despite claims that licensure increases service quality, there is a theoreticalambiguity as to the effect of licensure on consumption quality. If, under a

system of licensure, the restrictions on service provision shift a sizable portionof consumers to do-it-yourself remedies or to the black market, average qualitycan decline.

Policy debates about licensure center on justifying entry restrictions and onwhether or not the state can assure performance once individuals are grantedentry. The identification of qualified personnel is not a sufficient justification forlicensure, as this can be accomplished through certification. Certification, or"voluntary" licensure identifies entities that meet entry standards or standardsof performance, but does not restrict the practice of others. Under a system ofcertification, consumers have access to information about service providers, butthey are not constrained from purchasing services from non-certified providers;competition is not limited.

That fact that service providers, trade associations, and medical societiesactively promote and support licensing has led to the suspicion that licensingbenefits these groups at the expense of other providers or consumers (forexample, see Rottenberg 1980). Critics of market entry restrictions note thatservice providers' earnings rise as competition declines and that consumers areleft with fewer options and higher prices.

Also at issue is whether information asymmetries or agency costs are strongenough to warrant government intervention. Many believe that in the absenceof government intervention, markets would generate sufficient informationthrough reputation and other mechanisms to meet the needs of consumers.

Finally, there is the question of whether there is not some other, preferredform of public policy to insure product quality. Potential alternatives includeincreased civil and criminal penalties and other institutional arrangements whichincrease the consequences of malfeasance.

In addition to its proported value in reducing agency costs, two otherjustifications for licensure have withstood the test of time. One age-oldjustification for licensure is that it provides protection from external effectsassociated with the purchase of low quality goods and services. This is anexternalities argument. The argument is, essentially, that licensure protectssociety from the side effects of poor consumption decisions of its individualmembers. Another traditional defense of licensure is that some people need tobe guided by the state in making choices.

To justify licensure, the benefits must outweigh the losses associated withreduced competition. Not one empirical study has attempted to calculate the netgain. Rather, the focus has been on testing observable implications of licensingrestrictions -- the effect on earnings, supply, mobility and quality.

Finally, not all licensing arrangements are alike; institutional arrangementsthat govern licensing boards are of consequence. For example, there is supportfor the idea that things such as a board's level of autonomy or its source offunding will affect its actions and decisions.

2. Basic Characteristics of Licensing Arrangements

Market entry restrictions can be very simple, an agency may set quantitativelimits, precluding further entry once the designated limit has been reached.Quantitative controls are the least common, however. Instead, entry is mostoften limited by imposing costly barriers to entry. Potential entrants may berequired to make specific capital investments, to pass an examination or completecourse work in approved programs and to conform with certain personal criteria(age, character, citizenship, criminal record). Where examinations are the basisfor licensing, they may be designed and administered by the board, or the boardmay require passage of an exam administered by another organization.

Filing fees and variations in application procedures affect entry to theprofession as well. For example, the score required to pass an entry examinationand other rules, such as the number of times an individual may re-take a requiredexamination, may be modified to increase or decrease the difficulty of entry.

Only individuals who have received a license from the state may legally offerservices. In health care, "scope-of-practice" restrictions, which define the extentof the profession, make it illegal for non-licensed individuals to provide similarservices.

Reciprocity and/or endorsement in licensing refers to situations where onejurisdiction accepts the license of another as a valid basis for licensure. Withoutsuch provisions, professionals must take licensing exams and meet otherconditions of entry when they seek to practice in a new jurisdiction.

Once licensed, boards attempt to control service quality. Licensemodification, suspension, and revocation are the major tools of disciplineavailable to boards. The state may revoke a license to practice for a variety ofreasons including misconduct and incompetence. Standards of proof to whichdisciplinary hearings are held influence the ability of the board to affectivelypenalize practitioners, as does the amount of funding allocated to disciplinaryfunctions. Continuing education requirements, which require licensedindividuals to take classes or engage in training to maintain their skills, aremandated in some cases.

Although governing bodies have the ultimate power over licensure anddiscipline, the actual operations are often delegated to a public agency. Someboards are fairly autonomous, others are less so. "Self-regulation" generallyrefers to a situation where the board is fairly autonomous and comprised ofrepresentatives of the profession to be regulated.

Because self-regulation includes the potential for professional groups torestrict supply unduly to raise prices, it has been strongly criticized. Proponentsof self-regulation argue its merits in circumstances where the skills to beassessed are unique to members of the profession and when consumers wouldbe put at great risk by an incompetent or malfeasant service provider (see Tuohyand Wolfson 1976).

3. A Brief History of Western Licensure

Ruben (1980) describes the historical patterns in western law that led to modernlicensing laws in the United States and other western countries. (Also seeCouncil of State Governments 1952, Derbyshire 1969). According to Rubin,vocational societies were first formed in Europe in the 11th and 12th centuries.By the thirteenth century, education became an important separating criteria ofthe professions. Crafts and trade associations turned to apprenticeshipprograms to set their members apart. By the fifteenth century, desire foreconomic security and prestige had resulted in detailed lists of qualifications forentry and practice in almost every vocation.

The private guilds of the Middle Ages -- often thought of as thepredecessors of modern state restrictions on occupational entry -- actuallyserved several purposes. Guilds served social, religious, insurance, and tradefunctions. In exchange for monopoly positions, the private guilds provided asource of tax revenue for monarchs. Hickson and Thompson (1991) suggest thatthe establishment of guilds served to resolve defense externalities associatedwith overcapitalization and to connect military-aged youths to their communitiesin medieval times.

The decline of the feudal structure of the middle ages increased mobility, andled individuals to compete with private guilds. By 1410, Ruben explains that, inEngland, rules governing entry and practice had fallen to court challenges,reflecting the attitude of the English courts that individual rights to earn alivelihood should be protected. English guilds responded by seeking statutoryprotection. Over time, representatives of guilds were successful in England andother Western European countries in establishing state controlled monopoliesin many vocations, with social, economic and religious entry standards. Onceagain, competition was prohibited and control over practice and discipline wasleft to representatives of the guilds.

This system of public monopolies was overturned in the seventeenth andeighteenth centuries, as economic forces of the Industrial Revolutiontransformed Western Europe. According to Rubin, as power shifted frommonarchs to democratic assemblies, direct licensing evolved. During thenineteenth and twentieth centuries, many new professions emerged, leading toa resurgence in vocational regulation in Western Europe.

Efforts to license physicians are said to have begun in earnest in the UnitedStates with the formation of the American Medical Association in 1846. Up untilthat time, entry was virtually unrestricted (Hogan 1983). Lack of support fornational licensing left occupational regulation to the states (Rubin 1980). Thefirst state to pass licensing laws in the United States was Texas in 1873. A WestVirginia law, passed in 1881, was challenged in the U.S. Supreme Count in 1889,and the power of the state to license was upheld (Derbyshire 1969).

The American Nurses' Association and the National League for Nursinglaunched a campaign to introduce public certification for nurses in the UnitedStates in 1900 (White 1983). By 1923 all states had enacted certification laws forprofessional nurses. The first mandatory licensing laws were passed in NewYork and California in the late 1930s.

A 1952 study by the Council of State Governments lists the dates of initialstate licensing legislation for occupations in the United States. (See also Moore1961.) Included are professionals in many groups, from accountants andarchitects to veterinarians and watchmakers. In 1994 the state of CaliforniaDepartment of Consumer Affairs licensed more than three dozen classificationsof professional and vocational personnel, the largest groups being accountants,automotive repair professionals, barbers and cosmetologists (by far the largestcategory), contractors, dental assistants, behavioral science professionals,physicians, nurses, professional engineers and land surveyors, and security andinvestigative service providers.

4. The Economics of Market Entry Regulations

The Simplest Case - Formal Quantity Controls

The simplest case of market entry restrictions is to set formal quantity controlswhich limit entry to a fixed number of service suppliers. Where more individualsapply for than are granted licenses, market entry restrictions reduce the stock ofproviders, pushing prices higher than in an unregulated market. Where entry isrestricted in this manner, individuals who secure licenses (through randomdrawings, for example) will earn economic rents; they earn more than similarlyskilled individuals in alternative professions. Examples of quantity controlsinclude restrictions on entry in local taxi markets in the United States andrestrictions on the number of pharmacists in Belgium (determined by thepopulation and distance between pharmacies).

If sale of licenses is allowed (as is the case with taxi licenses (medallions) inmany large U.S. cities and pharmacies in Belgium), the present value of expectedfuture profits will be capitalized in the sale price. The seller captures all futureprofits, leaving new entrants with a normal return on their investment. (Frankenaand Paulter 1984 describe taxicab regulation in the United States. See also Gallickand Sisk 1987. Van den Bergh and Faure 1991 discuss the licensing ofpharmacists in Belgium.)

Whether or not there is a deadweight loss associated with licensure dependson the benefits to consumers. In the extreme case, if there are no benefits toconsumers, entry restrictions necessarily result in a deadweight loss to society.As with all restricted markets, resources with a higher value in the restrictedmarket than elsewhere are prohibited from entering. Besides the potential for adeadweight loss from licensure, there may be a loss associated with rent-seekingbehavior. If entry is restricted to arbitrarily chosen service providers, there willbe a social loss associated with rent-seeking behavior. As potential entrantscompete for licenses, real resources are consumed or lost in the rent-seekingprocess. A third loss may result, depending on conditions in the market, from thenon-transferability of professional licenses. Despite not being the lowest costprovider, those who have made sunk, nontransferable investments to obtain alicense will remain in the market as long as there is a positive rent on theirinvestment [Lott (1987), (Lott (1989), Gahvari (1989), Zardkoohi and Pustay(1989)].

Raising the Cost of Entry

The most common form of entry barriers do not arbitrarily assign licenses, butraise the costs of entry by requiring investments of one sort or another. Often,educational and training requirements are specified in detail. Entrants may berequired to attend and complete an accredited program that has specific time andcontent characteristics. The explicit costs of this investment include paymentsfor tuition and books, but the primary cost is usually implicit -- the opportunitycost of the applicant's time.

Entry fees, passing marks on state-administered examinations, and otherrequirements (such as citizenship) also make entry more costly. As costs rise,service providers are discouraged from entering the market. Supply declinesthrough retirements, or as demand grows faster than supply, and the price ofservices rises. Not until earnings rise to offset the increase in costs of entry willnew professionals be attracted to the market.

In this situation, although earnings are higher after regulation, new entrantsare not earning profits. They earn only a normal return on their (higher) costs ofentry. The new market equilibrium will be one with a lower stock of practitionersand higher prices than would have been observed in an unregulated market.Adjusted for entry costs, earnings will be no more or no less than those forsimilarly skilled individuals in alternative occupations.

A common practice is to "grandfather" (exempt) existing service providerswhen entry requirements are made more stringent. This means that only newentrants must meet the stricter requirements; existing providers are not held tonew rules. As higher costs discourage new entrants and earnings andprofitability rise, existing practitioners benefit. These gains create incentives forprofessional associations to lobby for increasingly strict entry requirements overtime. It is also possible that "grandfather" clauses are included to reduce theopposition of less-trained personnel to restrictions that will limit practice to amore elite set of professionals [see White (1979)]).

Licensure necessarily results in a redistribution of wealth from consumers toproviders as limits on entry cause product prices to rise. Also, there can besignificant redistributional effects across consumer groups. For example, if thereare economies of scale in producing higher quality services, consumers whodesire higher quality services will benefit from licensing laws that requireadvanced training. In contrast, consumers who prefer lower quality care (due totaste and/or income constraints) are worse off, as the supply of lower skilledproviders is reduced or eliminated altogether.

5. The Debate over Occupational Licensing

As may be obvious by now, the debate over occupational licensing ismultifaceted. There is disagreement over whether information asymmetries aresufficiently great to justify government intervention, and whether the state canimprove upon free consumer choice. Two theories of the role of licensure -- thatlicensure eliminates a "lemons" problem for consumers and that it decreases themarginal cost of producing quality -- fail to justify licensure over certification.Two traditional arguments for licensure over certification -- that it reduces thespread of disease and protects those too ignorant to protect themselves --remain. A third justification for licensure is that it creates incentives whichmitigate agency costs. The following sections discuss these ideas in detail.

Information Asymmetries

Proponents of licensure argue that consumers have insufficient information tomake an appropriate selection from the set of available suppliers. Informationasymmetries are thought by some to be unusually strong in health care markets,justifying barriers to entry in medicine (Arrow 1963, Trebilcock 1976).

One way for consumers to acquire information about product quality is bydirect observation. Also, providers develop reputations over time as theirservice is tested and re-tested by consumers. Arguments for licensure rest onthe premise that, in some markets, direct observation is impractical andreputation fails to offer sufficient protection. If consumers lack information and,if the state (or its agent) can identify and enforce appropriate standards to whichpractitioners should be held, it follows that state regulation has the potential toimprove conditions by limiting entry to professionals who meet those standards.

Writing about medical markets, Pauly and Satterthwaite (1981) suggest thatreputation fails when there are so many providers, as would be the case in largecities, that the efficiency of consumer search declines. According to Pauly andSatterthwaite, as the number of physicians within a community increases,consumer information about each physician decreases and it is more difficult tosearch for a new physician.

Friedman (1962), Rottenberg (1980) and Havighurst (1982) resist the pressureto view consumers as incapable of making reasoned choices in medical markets.Friedman notes that licensure has never been a major source of assurance aboutphysician quality to consumers. Consumers do not choose a physician blindlyfrom the list of licensed physicians but, instead, make choices about physicianson the basis of advice and direction from others, including referring physicians,friends and family. This information, along with specialty board certification(offered by the profession, not the state), offers protection to consumers againstphysician malfeasance.

One empirical measure, the disparity in incomes among licensed physiciansin the United States, supports the premise that consumers are capable of makingjudgements about physician quality unaided by state licensing regulations.Being licensed did not make International Medical Graduates the equal of U.S.trained physicians in the U.S. medical market (see Svorny 1979).

Quality Assurance?

With respect to medical markets, critics point out how unfathomable it is thatmedical licensure provides consumers with useful information upon which tomake informed decisions (see, for example, Young 1987, Goodman 1980, Benham1991, or Rayack 1982). Licensure does not restrict physicians to practice in aparticular area of medicine. (In the United States, it is not against the law for anophthalmologist to perform heart surgery.)

Furthermore, it is hard to argue that passing a standardized exam aftergraduation from medical school (perhaps after several sittings) offers muchinformation about physician competence or success. Institutional accreditationcan only insure that the quality of education meets a set standard, not that theprogram produces qualified practitioners. Consumers can only gain fromlicensure if it is possible to assess ability and if greater ability is reflected inhigher service quality. Perhaps most important, a licensing exam cannot screenout individuals who might cheat or defraud patients.

Clearly, the case that a public agency can identify practitioners from whomcustomers may expect to receive the appropriate level of service quality is notconvincing. Even Arrow, whose 1963 paper is probably the most-quoted asfavoring government intervention to assist consumers, said: "insofar as this ispossible." (p. 966).

Surveys of practitioner quality find large percentages of individuals in themarket who do not meet standards set by researchers. These results are used toargue that licensure does not assure service quality (Hogan 1983).

A further complaint is that disciplinary procedures fail to deal withincompetence in professional practice. In the United States, critics of medicallicensure point out that the majority of disciplinary actions have nothing to dowith competence but, instead, focus on inappropriate prescription of drugs orself-abuse of alcohol or drugs (U.S. Department of Health and Human Services,1986). A study of disciplinary cases handled by the Antwerp Bar in the 1980sfound sanctions most often imposed for personal characteristics (drunk driving,nonpayment of debts) or for improper behavior towards the professionalassociation (such as failure to provide immediate or truthful information).

Low rates of discipline by state boards are cited as evidence that improvingquality for consumers comes second to protecting the interests of the licensedprofessionals. In contrast, Svorny (1987) shows that disciplinary procedures bystate medical boards are as common as criminal penalties in the broaderpopulation.

Licensure as a Cartel

Many observers complain that licensure fosters cartel-like restrictions whichraise prices, benefiting professionals at the expense of consumers (Friedman1962, Kessel 1958, Rottenberg 1962). The interests of professionals in licensureare seen as primarily self-serving, an attempt to establish monopoly power in anotherwise competitive industry.

Scope-of-practice restrictions, which limit paraprofessionals and others fromproviding services within the bounds of the licensed profession, contribute tothe view that licensing rules are anticompetitive. In medical markets, for example,prohibiting nurse practitioners from prescribing drugs or offering treatmentwithout physician supervision is thought to unduly restrict the potential foroptimal division of labor and efficiency in resource use.

Some argue that licensure has been used to sustain hierarchical systemsinvolving multiple occupations (see White and Marmor 1982 and Glib 1966). Inthis context, licensure may be both a vehicle for imposing control oversubordinate occupations (as when physicians attempt to limit the powers ofother allied health personnel through support of strict scope of practiceregulation) and for subordinate occupations to challenge the control ofdominant occupations (as when nurse practitioners press for the right to provideservices traditionally allowed only of physicians).

Where education and training standards are specified, critics lament the lackof opportunity for innovation and the bias toward existing methods of educationand training. Why, they ask, should everyone be trained in the same method andwith a similar philosophy? In medicine, the lack of competition is seen ashindering the development of alternative treatments that might improve orprolong lives.

In his 1958 paper, Reuben Kessel painted a damning picture of state medicalsocieties in the United States, suggesting that their actions to limit the supplyof physicians were simply efforts to enforce cartel-like restrictions that wouldraise prices and benefit physicians. Kessel argued that the cornerstone ofAmerican Medical Association (AMA) monopoly power was its control over theaccreditation of medical schools for the purpose of licensing.

In each state, medical society members had been successful in reserving theright to the AMA to determine what was an appropriate medical school forpurposes of medical licensure. Based on this power, Kessel argued that theAMA could control both the number of schools and the rate of production ofphysicians -- limiting the supply of physicians. Schools that did not heed thedemands of state societies to limit enrollment could be sanctioned by excludingthem from the list of acceptable schools for licensure. As further evidence ofcartel behavior, Kessel pointed to AMA efforts to enforce price-fixing schemes(price discrimination) and medical society-enforced prohibitions on advertising.

Resolving a "Lemons" Problem

One justification offered in support of licensure is that it solves a "lemons"problem in markets where information about service quality is costly to obtain.Leland (1979, 1980) points out that when consumers can't identify high qualityphysicians, all physicians must charge the same fee (equal to the averagequality). As a result, the most talented individuals choose other professions(where their superior ability can be revealed). Only the low quality providers (the"lemons") are left. Under these conditions, Leland shows that setting minimumquality standards will raise the average price and quality of the product. Theintuition is that barriers not only exclude the least skilled, but they increaseearnings, attracting more able individuals to the market.

Leland emphasizes that his work should be seen as a counter-example to themonopoly/cartel effects of limiting entry. His work shows that it is not true thatminimum quality standards can never improve welfare. He does not concludethat licensure is desirable. In fact, he supports certification over licensure as aless intrusive way of achieving the same improvement in service quality.

Benefits to a Third Party

In the search for benefits from licensure, White (1987) notes that there may bebenefits to firms that hire licensed providers, such as hospitals. He agures that,even if the firms are low-cost monitors of the skills of the service providers and,therefore, do not gain from licensure directly, they may benefit indirectly. First,if consumers' perceptions of service quality increase with licensure, largeproviders of services (such as health maintenance organizations) benefit fromthe short-run profits that accompany an increase in demand for their services.Also, licensure may benefit employers of service providers if it limits theirliability. In the case of nurses, White concludes that it does not, as employersof nurses (hospitals and physicians) have been the most active in lobbyingagainst nurse licensing.

A Principle-Agent Framework

It is clear that attempts to justify licensure must rest on quality assurance. Thereare two issues associated with quality assurance, finding individuals who arequalified, and motivating them to perform in the interests of the individuals theyserve. The second problem is a principal-agent problem. One individual (theprincipal) hires another (the agent) to do some work, but the disparity in theirself-interests causes problems for the principal in getting the agent to do as heor she would like.

Carl Shapiro (1986) describes how licensure might be seen as a means toresolve the incentive problem associated with the agency relationship in medicalmarkets. In Shapiro's model, entry restrictions magnify physicians' incentives toacquire reputation by reducing the marginal cost of producing quality. Thepremise is that physicians who have made investments in medical education canproduce high quality services with less effort. Because it is easier for them to doa good job, they do so more often.

The value of licensure in Shapiro's model is predicated on their being somemarket value to professional reputation (due to imperfectly observableoutcomes), but insufficient production of reputation in an unregulated market.Shapiro justifies standardized training requirements (often seen as evidence ofAMA control) on the basis that it is otherwise costly to reveal training levels toconsumers.

Licensure vs. Certification

Like that of Heyne, Shapiro's model provides a theoretical justification forlicensure in response to complaints that licensure is motivated by self-intereston the part of practitioners

who want to limit competition. But, both authors explicitly state that a system ofcertification would produce the same results, neither argues for licensure overcertification.

Economists have long favored certification over licensure (see Friedman1962). Economists favor certification because consumers can use certification asa guide, but may purchase care from non-certified practitioners if they sochoose. As Leland notes, under certification "buyers have a wider range ofchoice...they can buy low-quality goods or services if they wish." (p. 283)

Support for licensure over certification comes from two traditional arguments.First, there may be significant externalities associated with the consumption ofphysician services. If the bad care that one person receives makes someone elseworse off -- as is the case if infectious disease is not treated properly -- then itmight be desirable to constrain the sale of physician services (through licensure)to those individuals who have been trained to keep infectious disease fromspreading.

Of course, if the higher cost of licensed professionals shifts large numbersof consumers into do-it-yourself remedies, infectious disease may spread evenmore under a system of licensure than without it. Or, if the high price of licensedelectricians causes consumers to attempt electrical repairs themselves, the resultmay be an increase in externalities -- home fires that threaten adjacent properties.

A second common justification for licensure is paternalistic. Society may, asa whole, decide that some people are not smart enough to make their ownchoices and that the government should decide for them. However, a counterargument is that if this not-smart-enough group of individuals is also poor, thehigher prices under licensure may lead them to even poorer choices in the blackmarket than they would have made in an unregulated market.

Theoretical Support for Licensure over Certification

Is it possible to justify licensure over certification on grounds other thanexternalities and the need to make choices for others? Svorny (1987, 1992)suggests that licensure is useful in reducing agency costs in the market forphysician services, an objective that certification is unable to accomplish.

Licensure's barriers to entry result in (1) abnormal profits and (2) investmentsin medical training that are lost when malfeasance leads to license suspensionor revocation. Profits and the return on investments are accessible to thephysician as long as he or she acts in ways deemed appropriate by the statemedical board. Svorny argues that the profits created by simple restrictions insupply may serve as a premium stream to discourage agent malfeasance.

Similar to an "efficiency wage" arrangement which pays workers a wageabove their value elsewhere, licensure produces an earnings stream that is lostupon license suspension or revocation. The higher earnings and potential forloss create incentives for agents to act in the interest of the principle, toself-monitor. Such arrangements are thought to prevail when monitoring costsare high. (See Lazear 1981.) Along the same lines, Van den Bergh and Faure(1991) suggest that a "confidence premium" in price fixing arrangements may bejustified on the basis that trust of a professional economizes on informationcosts.

By requiring internships and apprenticeships, licensing can steepenprofessional earnings profiles, creating strong penalties for malfeasance. Wagesare depressed initially, but then rise above market values later in professionalcareers to compensate for the initial investment. This means that, as they enterthe profession of their choice, new entrants to a licensed profession earn lessthat they would earn elsewhere. For example, those who wish to be certifiedpublic accountants in California must work for two years in jobs that pay verylow wages and require long hours to qualify for licensure. Once licensed, wagesrise above what could be earned elsewhere. Fear of losing this return throughthe revocation of one's license discourages malfeasance.

In medicine, a malfeasant physician loses not only the return to his or herrequired investment in training, but also the profits generated by restrictingentry. Discipline results in a substantial loss. Blair and Kaserman (1980) andGellhorn (1956) emphasize the incentive effects of disciplinary sanctions, but donot emphasize the potentially valuable role of licensure in increasing thoselosses by making medical practice more profitable. Under a system ofcertification, non-certified individuals would compete with certified practitioners,making it impossible to maintain abnormal profits to discourage physicianmalfeasance.

Svorny proposes that the value of licensure rests on the inability ofalternative methods of government intervention to provide a severe enoughpenalty for opportunistic behavior. Because agents can avoid civil and criminalfines (through asset flight or bankruptcy), the maximum penalty that can beassessed through alternative methods may not be sufficient (see also Eaton andWhite 1983). Similarly, if it is not feasible to fully bond agents because ofconcerns about moral hazard by principles (Shapiro and Stiglitz 1984), licensuremay be preferable to bonding arrangements.

Taking the view that profits in the market for physician services arewelfare-enhancing, one can argue that restrictions on advertising (oftenmentioned as evidence of cartel activity) are desirable as they protect theabnormal profitability generated by restrictions on entry. Following the samelogic, state requirements that physicians be U.S. citizens (now illegal) may haveserved the purpose of maintaining profitability in the market for physicianservices.

The physician price fixing schemes that Kessel found so offensive mayactually have been socially useful. In contrast to profits created by limiting thequantity of services provided, price discrimination raises physician income in anefficient way. Price discrimination transfers wealth from consumers (consumersurplus) to physicians without affecting resource allocation. At the extreme,perfect price discrimination (where each consumer is charged the most he or sheis willing to pay), allows large wealth transfers with no social cost or deadweightloss. Quantities sold are as they would be in a competitive market.

Barriers to Taxicab Entry

Barriers to entry can similarly benefit consumers of taxicab services. In manycities, restrictions on entry to taxi markets result in substantial profits. Onlytaxicabs drivers that own medallions issued by the government are allowed tooffer taxi services, making the medallions very valuable. Gallick and Sisk (1987)describe how the profits associated with ownership of a medallion benefitconsumers. They argue that regulating taxi rates makes consumers better off byreducing redundant search, allowing riders to cheaply estimate the price of anyparticular trip without searching among alternative drivers. One problem is thataverage pricing encourages drivers to seek out trips to locations where theprobability of finding a return fare is relatively high. To mitigate this negativeeffect of average pricing rules, incentives must exist to encourage drivers toaccept trips randomly, to reject no one. Gallick and Sisk suggest that thepotential loss of a valuable asset, the taxi medallion, discourages drivers fromviolating the law that requires drivers to accept all trips, assuring all riders ofaccess to average priced service.

The "Value" of Licensure Falls when Incentives of Other Actors Change

Changes in institutional arrangements can increase or decrease the societalvalue of licensure arrangements. For example, in the United States, where thecourts have shifted liability for physician malfeasance to hospitals and healthmaintenance organizations, incentives have surely changed. Coupled withgrowing concern over reputation in increasingly competitive markets, hospitalsand HMOs have moved toward serious internal peer review. Also, recordkeeping has progressed to the point that profiling physician practice andmaintaining disciplinary databases is possible, making it possible to identifyphysicians who practice outside of professional norms. This includes physicianswho inappropriately dispense narcotics, a large share of disciplined physiciansin the United States. Under these circumstances, the argument for licensure toassure quality in medical markets is weakened significantly (see Ginsberg andMoy 1992, Svorny 1992, Stevens 1986 and Haug 1980).

6. Evidence

Much of the discussion of the value of licensure includes arguments that are notempirically testable. For example, the fact that licensure has existed in many partsof the world and for many years is used to suggest that it must have some valueto society [Leffler (1978)]).

Empirical Problems

Where researchers do attempt to empirically test for the consequences oflicensure, or the factors that lead to licensure, they run into problems.Researchers often use licensing examination pass rates to proxy the strictnessof licensing regulations in a particular jurisdiction. The problem with this is thatpass rates are not exogenous, they are determined by both the supply ofpotential entrants and the degree of strictness of the regulatory authority.Similarly, attempts to assess the wage impacts of licensing regulations may behindered by a relationship between wages and the ability of a professional groupto lobby for entry regulation. If the passage of licensing laws is endogenous tomarket conditions, then attributing high wages to licensing laws may beinappropriate.

Another empirical problem that seems to pervade much of the literature isthat of potentially spurious correlation. A researcher who finds an inverserelationship between licensing exam pass rates and service provider earningsoften concludes that there is causality between these two variables. It is notuncommon to draw the conclusion that licensing boards manipulate pass ratesto benefit service providers at the expense of consumers. However, whereconsumers are relatively wealthy, there may be a relatively high demand forquality that results in both strictness of licensing criteria and high serviceprovider earnings.

This literature is not alone in having to deal with problems of spuriouscorrelation by any means. As always, researchers must be careful in assigningcausality to observed empirical relationships.

A caveat is appropriate as well for the empirical studies that examine theeffect of licensure on quality. Because quality is very hard to measure,researchers must use proxies whose connection to service quality can only bepresumed. The studies of Carroll and Gaston (discussed below) have usedinnovative measures to proxy for quality. But, clearly, the usefulness of thesestudies in assessing the outcomes of licensure depend critically on the abilityto find good proxies for quality.

The Demand for Licensure

Examining the market for physician services, Leffler (1978) finds licensing lawsto be most restrictive (he uses examination pass rates and other proxies) in stateswhere consumer demand for quality would be expected to be relatively great,suggesting that consumer interests influence the political decision-makingprocess.

Proxies for the demand for service quality have been empirically studied tosee if they are associated with licensing in two other studies. A study ofCertified Public Accountants by Donabedian (1991) finds stricter licensingrequirements in states having high concentrations of large businesses, his proxyfor a demand for quality. In a study of nurse licensing, White (1987) findsadoption of mandatory licensing for nurses to be positively related to a relativelyhigh demand for the services of registered nurses (the nursing category thatinvolves the most training). Whether it is easier to get licensing laws through inthese states because consumers have fewer objections, or whether the lawsactually improve consumer welfare, cannot be determined from these results.

Professional Influence

Although individual service providers have much to gain from licensingrestrictions, their ability to control the regulatory arena depends on severalfactors. As Stigler (1971 ) and Peltzman (1976) note, the odds of passage ofmarket entry regulations are greatest where gains are concentrated among asmall group of service providers, where the costs of professional organizationare relatively low, and where costs are spread across a large segment of thepopulation (this reduces organized consumer opposition).

Looking at self-regulating professions in Illinois, Moore (1962) concludesthat the set of licensed professions reflects the relative advantage of certainoccupations in lobbying the legislature. In his view, self-interest has played alarge part in the establishment of licensing restrictions.

White (1987) notes that state nursing associations have uniformly led localefforts to pass licensing laws. But a nursing lobby variable in his regressions onthe introduction of mandatory licensing of registered nurses (RNs) is notsignificant. Nor do Svorny and Toma (forthcoming) find evidence thatnumerically strong state medical societies influence either board structure or thenumber of physicians in a state.

In contrast, Begun, Crowe and Feldman (1981) find evidence of professionalinfluence over the degree of state regulation of optometry. Work by Graddy(1991) suggests that a range of organized interest groups influence occupationalregulation, and that the public interest also plays a role. Noether (1986a,1986b)interprets evidence of increased competition in medical markets in the UnitedStates since 1965 as suggestive of declining professional influence overphysician licensure.

Paul (1984) examines the effect of state medical society lobbies on the onsetof licensure. He finds a positive relationship between AMA membership and theearly onset of licensing. However, AMA membership per capita is highlycorrelated with the physician/population ratio in a state, which is not includedin the regression. Paul's results may simply confirm what the demand forlicensure studies have found; where consumers already purchase largequantities of physician services relative to other health care services, licensurerestrictions on practice face less opposition from consumers.

Evidence Relating to Cartel Restrictions

Attempts have been made to use measured profitability to provide evidence ofcartel-like supply restrictions on the part of the medical profession. Early studiesfound a medical career to be profitable (Friedman and Kuznets 1945, Sloan 1970and Fein and Weber 1971). Lindsay (1973) argued that there were a variety ofissues in measuring returns that these papers failed to address. Differences inwork hours and non-pecuniary benefits make direct comparisons of professionalincome less than perfect in assessing physician profitability. Also, Lindsaysuggests that the appropriate rate to use to discount future earnings shouldinclude a risk premium, as investments in medical education leave the individualundiversified. Lindsay's recalculation of the returns to training estimated inprevious studies produced no evidence of above normal returns to medicaltraining.

Psacharopoulos (1975) reviews the literature and concludes that the evidencedoes not fully support the existence of monopoly incomes. Of course, normalreturns for new entrants can be consistent with above-normal returns for thosemembers of the profession "grandfathered" as entry barriers are increased.

Two studies challenge the premise in Kessell (1958) and elsewhere that thesupply of physicians is constrained through the ability of the AMA to limitenrollment in medical schools. Leffler and Lindsay (1981) find that a traditionalmarket model, focusing on supply and demand, is sufficient to explain therelationship between the market for care and the market for medical education.Hall and Lindsay (1980) examine enrollment in medical schools in the UnitedStates. They find medical school output positively related to donor andapplicant demand. These results are inconsistent with the hypothesis thatmedical school enrollments are controlled by organized medicine.


Empirical evidence supports the premise that earnings rise with restrictivelicensing policies, that supply declines, that mobility is restricted, that inputs arecombined inefficiently, and that consumers lose access to low quality services.Studies by Benham and Benham (1975) (the optometric profession), Benham,Maurizi and Reder (1968) (physicians and dentists), Pfeffer (1974) (insuranceagents and brokers, real estate brokers and salesmen, plumbers), Shepard (1978)(dental care), White (1978) (clinical lab personnel), Perloff (1980) (theconstruction industry), Pazderka and Muzondo (1983) (Canadian licensure),Haas-Wilson (1986) (optometry) and van den Bergh and Faure (1991) (Belgianattorneys, architects, physicians, and pharmacists) have shown measures oflicensing strictness to be positively associated with costs, prices or earnings.

Efficient Division of Labor

Two studies have looked at the effect of licensure on the efficient division oflabor. Examining the eyewear industry, Maruizi, Moore and Shepard (1981) finda low representation of opticians where restrictive regulations favoroptometrists. DeVany, Gramm, Saving and Smithson (1982) examined dental firmsin the United States. They find evidence that state legal restrictions on the useof paradentals have resulted in dentist-paradental labor input ratios higher thanwould be observed in unregulated markets.

Labor Market Mobility

Licensing may be used to limit mobility of service providers across politicaljurisdictions. For example, the costs of preparing for unique state exams has thepotential to deter movement across state borders. But limited mobility does notnecessarily accompany licensure. In medical markets in the United States, thetrend has been to move away from state specific toward standardized exams,which then allows almost perfect mobility across states.

Holen (1965), Pashigian (1979), Pratt (1980), and Kleiner, Gay and Greene(1982) examine the effect of entry restrictions on professional mobility. Prattexamines sixteen occupations in the United States and finds that the more statesthat license a profession, the less mobile are its workers. Kleiner, et. al, look atfourteen occupations and find that where rules are the most strict, mobility islimited and earnings enhanced by licensure. Both Holen and Pashigian findmobility restricted for dentists and lawyers.

That earnings are higher and professionals less mobile should come as nosurprise. Restrictions on entry, by definition, reduce mobility, raise professionalincomes, and shift the sale of low quality services to the black market, reducingtheir availability. The real question is whether consumers gains are sufficient tooffset the negative effects of licensure.

Svorny (1987) suggests a test for the relative influence of consumer andprofessional interests over licensure. If licensure benefits consumers (bylowering search and monitoring costs), licensure should cause the demand forservices to increase, increasing consumption despite higher costs of entry. Ifthere are no benefits to consumers, there will be no increase in demand, and theequilibrium quantity of services will be lower where barriers are the most strict.Finding this, she is led to conclude that physician interests dominate theregulatory process. This, however, assumes homogeneity among consumers.Licensure may have redistributional effects, so that benefits accrue to somegroups of consumers and practitioners (for example, those in the high qualitysector of the market), but make other members of both groups worse off.

Service Quality

Despite claims that licensure enhances service quality, it is possible that highprices shift some consumers to do-it-yourself remedies. Aggregate quality mayrise or fall, depending on the extent and consequences of such shifts (Carrolland Gaston 1983). Attempts to measure the effects of licensure on productquality are limited by the difficulty in measuring quality.

Carroll and Gaston (1981a) identify variables likely to proxy poor quality inseven licensed occupations. For example, in the market for electricians thenumber of accidental deaths by electric shock is used as a proxy for quality.Electrical shock deaths could result when ill-skilled professionals provideservices or when consumers turn to do-it-yourself repairs. Carroll and Gastonfind a negative association between proxies for strict licensing regulations andthe number of licensed professionals, from which they conclude that licensingrestricts entry. Also, where there are fewer licensed professionals, their proxiesfor quality suggest lower quality services are being consumed. They concludethat licensure reduces quality. Turning to real estate markets, Carroll and Gaston(1979) find lower quality (proxied by the proportion of vacant houses on themarket for more than six months) where licensing restrictions were the moststrict.

Maruizi (1980) looked at contractor licensing in California. Over the periodfrom 1954 to 1975, he found average quality (measured by the number ofcomplaints) declined. He attributes this decline to the rapid growth inexam-preparation schools, which allowed relatively poorly trained individuals topass the exam.

Other results suggest that entry barriers are quality enhancing. Carroll andGaston (1981b) found measures of attorney quality to be higher in those stateswith the most restrictive licensing policies. Johnson and Loucks (1986) findlicensing in real estate improves quality; a reduction in licensees results in adecrease in complaints per transaction. Using length of eye exams, officeequipment and examination complexity as proxies for service quality, Begun(1981) found quality to be positively related to optometry standards.McChesney and Muris (1979) provide evidence that eliminating barriers (in thiscase on advertising) does not reduce the quality of legal services provided toconsumers and appears to increase it.

The empirical work on quality suggests the effect of licensure on servicequality varies across occupations. The need to proxy quality, with what areclearly imperfect measures of how consumers view a product, makes it hard todraw strong conclusions about the effects of licensure on quality.

7. Licensure vs. Discipline

Where markets fail to protect consumers, it is possible to view licensure anddiscipline as substitutes in the production of service quality. Dollars spent onlicensing could be shifted to efforts to identify and discipline incompetent andmalfeasant practitioners, with a potential loss or gain, depending on the relativeincentives generated. Guntermann and Smith (1988) address this issue, but withvery weak data. They find that dollars spent on compliance and enforcementefforts reduce complaints against licensed real estate agents. Finding noevidence that prelicensing education requirements reduce complaints, theyconclude that state governments are best off allocating more of their dollars toenforcement efforts and less to efforts to assure prelicensing educationalattainment. (See also Phelan's 1974 examination of TV repair in three cities.)

8. The Choice

Despite years of debate, there is no clear agreement on whether state licensingimproves consumer welfare. Where consumers can easily buy low qualityservices on a black market, there will be little impact on consumer welfare. Butwhere black market provision of services is costly (as, perhaps, with surgicalprocedures, where the consumer must travel to another country), consumersseeking to purchase low quality services are worse off. Because they restrict thesupply of professional services available to consumers, market entry restrictionscan be welfare enhancing only if the gains to consumers offset the welfare lossassociated with the reduction in supply.

Because service providers tend to be more organized than consumers andindividual service providers have much to gain from restricting licensure,economic theory tells us that a democratic political process will overshoot theoptimal/socially desirable level of entry restrictions. (Ramseyer (1986), however,discusses the lack of success lawyers have had in Japan in furthering their owninterests.)

Only where consumers are well-organized or jointly represented by largerentities, as is increasingly the case in health care markets in the United States,will service providers have problems in securing protective regulation that goesbeyond socially optimal levels of control (Stigler 1971). What this means is thatour choice is not between socially optimal regulation and an unregulated market,but between sub-optimal regulation and an unregulated market.

Horowitz (1980) suggests that the persistence of self-regulation suggests adeal between society and the profession. Consumers can be sure of a minimallevel of competence in exchange for allowing self-serving licensing restrictionsto persist.

Finally, an attraction of licensure to politicians is that its costs are hidden toconsumers. Stigler (1971) makes the point that politicians prefer regulationwhose primary cost is indirect and hard to identify over regulation involvingpublic funds and tax expenditures. Licensing arrangements are attractivebecuase their costs are off-budget, they are generally funded through theassessment of periodic fees on service providers. With a licensing scheme, allconsumers -- those who find value in regulation, and those who do not, pay ahidden cost of regulation in the form of higher priced services.

9. Institutional Issues

Given the incentive for the regulated profession to lobby for rules which benefitthe profession at the expense of consumers, a corollary question is whether it ispolitically possible to achieve an institutional structure which will reduce oreliminate the major imperfections associated with state regulation.

Institutional arrangements have the potential to influence the regulatoryoutcome by affecting the costs special interest groups face in lobbying theagency (see Svorny and Toma, forthcoming). For example, in the United States,variations in institutional arrangements across states include differences inboard autonomy in the nomination and selection of members, the ratio ofprofessional to public or lay members on the board, standards for disciplinaryprocedures, and whether the board is self-funded, through fees, or receives anallocation of funds from the state legislature. The challenge is, first, to identifyinstitutional arrangements that lower the costs of special interest lobbying and,second, to reach a political equilibrium where such arrangements are precluded.This is not a simple task, as interest groups will fight to protect arrangementsthat increase their influence over public policy.

10. Who Should be Licensed?

Given the lack of clear evidence that licensure benefits consumers, some areasof practice are clear targets for eliminating state regulation over entry. Whereservices are characterized by repeat purchases and where outcomes are clearlyobservable, as is the case with the services of barbers or hair stylists, it seemshard to justify state controls.

Similarly, the benefits of licensing dental and physician assistants mayoutweigh the costs. The employing professional or the employing facility hasthe ability (through observation, reputation and knowledge of professionaltraining) to ascertain the quality of an assistant. Where there is also a stronglegal incentive to assess quality, licensing professional assistants appearsredundant.

In the case of physicians, a system of certification would work as well inmost circumstances. The only suggested theoretical value of licensure overcertification is in creating a profit stream that discourages malfeasance.

In the United States, because physicians practicing in hospitals and workingfor health maintenance organizations are subject to peer review (with teethadded by the increased liability assigned to such institutions by the courts),perhaps it is only physicians working in sole practice, or in small communitieswith no institutional liability and no professional peer oversight, for whomcontinued licensure is desirable.

The ironic part is that states with disproportionate rural or medicallyunderserved communities have been the first to innovate away from physicians,extending the legal scope of practice for physician assistants (Jones and Cawley1994). Shortages of medical doctors in rural areas have led governments to bemore flexible, allowing greater latitude for paraprofessionals to offer services. Ifexisting law shifts from licensure in areas where, theoretically, it can be of valuerelative to certification, it is hard to argue the benefits of licensure's restrictionson entry for the population as a whole.

Institutional licensure has been proposed to reduce the burden of licensingon state agencies. Hershey (1969) proposed replacing licensing with a systemthat invests health services institutions and agencies with the responsibility ofregulating the provision of services. He argues that the rigidity of the currentsystem deters hospitals from grouping skills and capabilities in ways that bestserve patients. Replacing the current system with one of institutional licensurewould allow a greater degree of flexibility in assigning personnel, reducing thecost of providing services.

Each market is different and broad prescriptions about licensure just don'tapply. For example, the licensing of taxicabs may be of value where taxicabsprimarily service travelers. The lack of repeat customers, and the externalitiesassociated with treating travelers well (i.e. more tourism), may call for largepenalties for malfeasance, exactly what a medallion system can supply. Althoughit is not clear that national or international brand name would not be establishedto provide quality assurance at airports and other tourist locations if local taximonopolies were to be eliminated, the externalities with respect to tourism mayjustify local control.

Taxicabs operating within a community, serving the needs of those who donot drive, are subject to repeat purchases, so that licensure is an unnecessaryexpense. On the other hand, if taxis serve a very elderly population, one that mayhave greater than average difficulty in protecting itself from unscrupulousproviders, then penalties offered by the medallion system for malfeasance takeon value (and perversely, given the population, raise prices). The potential forlarge losses if malfeasance is caught creates incentives for licensed individualsto behave in ways that benefit their clientele, even if that clientele is not a goodmonitor of quality.

Future Research

One area that has received little attention is the allocation of public fundsbetween licensing and discipline. Clearly substitutes for one another, it wouldbe interesting to see if most jurisdictions allocate their spending efficiently,equating the marginal product of both activities at the margin.

Also useful would be research assessing the net value of licensure tosociety. Ad hoc presumptions that licensure benefits consumers are clearlychallenged by researchers that have studied regulated occupations. Trading animperfect regulatory solution for an imperfect market solution may not be worththe cost.

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© Copyright 1997 Shirley Svorny