Fettering the Markets

Vince Cable recently said that corporate behaviour was murky, bankers were greedy, capitalism was a competition-killer. Well, Mr. Cable gets certainly no points for eloquence, yet there was nothing particularly offensive about the substance of his remarks. We have known for a long time that unfettered markets do not deliver the social good. So, why is there such a huge backlash from the city and the media.

Through the history, unfettered markets have delivered the society to disastrous consequences. Slavery being the best known example. We associate prosperity with a government that has a strong fiscal capacity (ability to tax and spend) and an ability to deliver market supporting public goods, i.e., regulate the markets effectively so that they deliver the social goods. (Besley and Ghatak, 2001, 2003)

There seemed to have been a surprising back lash at what Mr. Cable said. What surprised me was how organised and orchestrated it seemed. Mr. Cable’s tone was certainly irreverent and emotional. After all, why bring the words murky, greed and capitalism into it. But to understand the precise reason for the backlash, we have to think of the role regulation plays in maintaining market competition in the services industry.

Regulating the services sector (banking, law industry etc.) is not easy. The services sector produces an output that has significant information problems associated with it, i.e., the consumers are not able to assess the quality of the good before buying it. The information problems are circumvented by the service producers developing reputations for producing reliable services. Cost of acquiring reputation is often steep in these industries. This makes entry into these markets become extremely costly and the industry naturally gravitates towards a monopolistic competition environment.

In a monopolistic competition environment, the firms pays an upfront fixed cost to the enter the market before it can start producing in the market. The fixed cost could be the cost of setting up the factory, the cost of acquiring the correct permits, cost of researching and developing a particular product or the cost of acquiring a reputation for reliability. The size or the volume of the markets and the fixed cost of entering the market together give you the number of firms that the market would be able to support.

In the services sector, given the problem of reliability, the up front fixed cost is often the cost of acquiring the reputation. An entrant that does not have sufficiently deep pockets would not able to enter such a market. See Banerjee and Duflo for an excellent study on the software sector in India and specific cost of developing reputation in this sector. (A. Banerjee and E. Duflo, 2000)

Does monopolistic competition deliver the social good for the society? The answer is a definite yes. There are a lot of sectors that have monopolistic competition and deliver the social good.

But, there is another level of complication here. What is the relationship between regulation and cost of acquiring the reputation. Regulation reduces the cost of acquiring reputation. If the firm meets the regulatory requirements, the consumer does not have to worry about the reliability of the firm.

If the regulation is sufficiently stringent, the significance of regulation decreases driving down the cost of entry. As the fixed cost of entry decreases, there are more players in the market and price of output decreases as a direct result of a lower initial fixed cost that needs to be recovered by the firms. With monopolistic competition per se, the firms are not really able to charge any kinds of rents. The price of the output is sufficiently higher than the variable cost so that it allow the firm to recover the initial fixed cost.

When does monopolistic competition become bad for the society? Essentially, this happens when the firms in the economy are able to collude with each other and influence the regulation that effects that sector. Think of the political economy of regulation. If the market incumbents are able to influence the regulation, what kind of regulation would they like. They would like to drive up the potential cost of entry into the market. This would ensure that only the collusive incumbents remain in the market. If the set of incumbents are stable, their ability to collectively influence the policy becomes greater over time, leading to a vicious circle.

The are many ways to drive up the fixed cost of entry. You could burden the firms that are entering the market with all kinds of regulation that put the new entrants to a disadvantage compared to the incumbents. The most extreme case of this was the “license raj” in India till the mid 80s. The firms had to obtain a license to produce. The regulators (bureaucrats and politicians) would compare the payoffs from the new entrants and incumbents before deciding on the license. Over time as the incumbents grew strong, the new entrants found it difficult to outbid the incumbents and the entry virtually stopped in the market. The oft quoted example of this is the car industry in India, where for decades there were only two players in the market. The market over time grew so lucrative that the government itself entered into the market as the third player in the early 80s.

Of course, if the quality of particular output is not obvious from the start, only firms with reputation for reliability would be able to operate in that market. In that case, lowering the regulation may prove of beneficial as it increase the need for reputation and increases the fixed cost of entry into the market. Thus, counter-intuitively, in these markets, the incumbents could argue for lower regulation.

Ironically, by singing praises of free markets, the services sector has limited the number of players in the market and ensured lack of effective ex post competition. This has been a two-pronged strategy. The first strategy has been to influence the regulators directly and convince them that there is no need for regulation. The second strategy is to build a narrative for the society through an extensive media campaign. In both cases, these market fundamentalist are using the using the free market slogan to effectively reduce the competition in the market.

Vince Cable’s observations were not off the mark. He of course underestimated the ability of the service sector incumbents to use the media to discredit anything that deviates from the narrative. It is indeed puzzling that four decades on after Akerlof’s lemon’s paper, we as society still think that free markets work and anybody who interferes with it is evil. (Akerlof, 1970)

As a society, collectively empowering our regulators to deliver the social good is extremely important. We often talk of regulators that are influenced. The bigger problems is that the society can collectively be influenced by vested interests to think that unfettered markets are always good for us. It is thus extremely important for the social scientists to challenge the free market slogan and explain the precise caveats the markets come with.

References:
A. Banerjee and E. Duflo (2000). Reputation effects and the limits of contracting: A study of the indian software industry. Quarterly Journal of Economics, 115(3):989–1017.

T. Besley and M. Ghatak (2003). Public goods and economic development. Prepared for Policies for Poverty Alleviation (ed.) Abhijit Banerjee, Roland Benabou, and Dilip Mookherjee.

T. Besley and M. Ghatak (2001). Government versus private ownership of public goods*. Quarterly Journal of Economics, 116(4):1343–1372.

G. Akerlof (1970). The market for” lemons”: Quality uncertainty and the market mechanism. The quarterly journal of economics, pages 488–500.

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