Andrew Lo, professor MIT Sloan School of Management, in congressional testimony last week:
Why are fire codes necessary? In particular, given the costs associated with compliance, why not let markets determine the appropriate level of fire protection demanded by the public? Those seeking safer buildings should be willing to pay more to occupy them, and those willing to take the risk need not pay for what they deem to be unnecessary fire protection. A perfectly satisfactory outcome of this free-market approach should be a world with two types of buildings, one with fire protection and another without, leaving the public free to choose between the two according to their risk preferences.
But this is not the outcome that society has chosen. Instead, we require all new buildings to have extensive fire protection, and the simplest explanation for this state of affairs is the recognition—after years of experience and many lost lives—that we systematically under-estimate the likelihood of a fire. In fact, assuming that improbable events are impossible is a universal human trait …, hence the typical builder will not voluntarily spend significant sums to prepare for an event that most individuals will not value because they judge the likelihood of such an event to be nil. Of course, experience has shown that fires do occur, and when they do, it is too late to add fire protection. What free-market economists interpret as interference with Adam Smith’s invisible hand may, instead, be a mechanism for protecting ourselves from our own behavioral blind spots.
I don’t think Smith would necessarily have a problem with fire standards, as long as the playing field was level for all.
Our patchwork system of state regulation explains a lot about corporate movement. So far mostly to escape the unions of the east, but I am sure other factors play into it. Such as corporate taxation.
More complicated than mere underestimation. The other problem is collective risk. A building that catches fire or collapses puts guests and neighbors at risk, who have no say in the decision. And, we have to spend public funds to prevent these risks from spreading, so we also create fire departments. Indeed, the fact that fire departments are public is another reason for building codes.
Some people are always going to be less accurate than others. Even if 98% of builders are sensible and build fire safe buildings, the 2% who aren’t can threaten us all.
Compare building codes, which are one response to fires, to fire insurance, which we usually don’t require by law unless mortgages are publicly guaranteed. If the building burns and is uninsured, only the owners suffer the loss, not their neighbors. So, it isn’t important to require.