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Sunday, October 12, 2008

Regulation and Competitive Markets

I want to rerun an old post, then add something to it:

Markets Are Not Magic, by Mark Thoma: To listen to some commentators is to believe that markets are the solution to all of our problems. Health care not working? Bring in the private sector. Need to rebuild a war-torn country? Send in the private contractors. Emergency relief after earthquakes, hurricanes, and tornadoes? Wal-Mart with a contract is the answer.

Whatever the problem, the private sector - markets and their magic - beats government every time. Or so we are told. But this is misplaced faith in markets. There is nothing special about markets per se - they can perform very badly in some circumstances. It is competitive markets that are magic (though even then we have to remember that markets have no concern whatsoever with equity, only efficiency, and sometimes equity can be an overriding concern).

In order to work their magical efficiency, markets need very special conditions to be present. There must be full information available to all participants. Product quality, locations and prices of alternative suppliers, every relevant piece of information must be known. Not quite sure if the wine is good or not? That's an information problem. Not sure if the used car has problems? Don't know where any gas stations are except the ones beside the freeway in a strange town? No way to be sure if consultants are worth the amount they are being paid? Information problems are common and they can cause substantial departures from the perfectly competitive, ideal outcome.

There also must be numerous buyers and sellers, enough so that no single buyer or seller's decisions can affect the market price. For example, if a firm can affect the market price by threatening to limit supply, the market does not satisfy this condition. If, as some claim, CEOs are in such short supply that they can individually negotiate their compensation, then the market is not producing an efficient outcome. Whenever there are a small number of participants on either side of the market - suppliers or demanders - this is potentially problematic.

In order for markets to work their magic, the product must be homogeneous. That is, the product or input to production sold by all firms in the market must be perfectly substitutable so that as far as the buyer is concerned, one is as good as the other. If some buyers favor one brand over another, if CEOs are perceived to have different and unique talents, if government favors one contractor over another due to political contributions, this condition does not hold. In many cases the variety may be worth the inefficiency, not many of us would want just one style and color of shirt to be available in stores, but the inefficiency is there nonetheless.

In order for markets to work their magic there must be free entry and exit. Most people understand free entry, but free exit is sometimes less evident, so let me try to give an example. Starting a blog on Blogger or TypePad is easy. Entry is a snap and you can be up and running in no time at all. It's easy to join the competition and start supplying posts. But suppose that later you decide you want to switch, say, from TypePad to Blogger. That is not so easy. There is no way, at least no simple and convenient way, to export all of your old posts from TypePad and import them into Blogger, a significant barrier to exit if a large number of posts must be moved. Whenever barriers exist in markets that prevent free movement into and out of the marketplace or between firms within a market (on either side - there are sometimes barriers to purchasing as well), markets will underperform.

The list goes on and on. In order for markets to work their magic, there can be no externalities, no public goods, no false market signals, no moral hazard, no principal agent problems, and, importantly, property rights must be well-defined (and I probably missed a few). In general, the incentives that the market provides must be consistent with perfect competition, or nearly so in practical applications. When the incentives present in the marketplace are inconsistent with a competitive outcome, there is no reason to expect the private sector to be efficient.

Markets don't work just because we get out of the way. When government contracts are moved to the private sector without ensuring the proper incentives are in place, there will be problems - waste, inefficiency, higher prices than needed, etc. There is nothing special about markets that guarantees that managers or owners of companies will have an incentive to use public funds in a way that maximizes the public rather than their own personal interests. It is only when market incentives direct choices to coincide with the public interest that the two sets of interests are aligned.

If there is no competition, or insufficient competition in the provision of government services by private sector firms, there is no reason to expect the market to deliver an efficient outcome, an outcome free of waste and inefficiency. Why would we think that giving a private sector firm a monopoly in the provision of a public service would yield an efficient outcome? If the projects are of sufficient scale, or require specialized knowledge so that only one or a few private sector firms are large enough or specialized enough to do the job, why would we expect an ideal outcome just because the private sector is involved? If cronyism limits the participants in the marketplace, why would we expect an outcome that maximizes the public interest?

There is nothing inherent in markets that guarantees a desirable outcome. A market can be a monopoly, a market can be perfectly competitive, a market can be lots of things. Markets with bad incentives produce bad outcomes, markets with good incentives do better.

I believe in markets as much as anyone. But the expression "free markets" is often misinterpreted to mean that unregulated markets are all that is required for markets to work their wonders and achieve efficient outcomes. But unregulated is not enough, there are many, many other conditions that must be present. Deregulation or privatization may even move the outcome further from the ideal competitive benchmark rather than closer to it, it depends upon the type of regulation and the characteristics of the market in question.

When competitive conditions are not met but can be regulated, the regulations should be put in place and the private sector left to do its thing (e.g.  mandating that sellers disclose problems with a house to prevent asymmetric information or mandating that government funded projects be subject to competitive bidding and monitoring to ensure contract terms are met). There's no reason for government to do anything except ensure that the incentives to motivate competitive behavior are in place and enforced.

But rampant privatization based upon some misguided notion that markets are always best, privatization that does not proceed by first ensuring that market incentives are consistent with the public interest, doesn't do us any good. There are lots of free market advocates out there and I am with them so long as we understand that free does not mean the absence of government intervention, regulation, or oversight. Free means that the conditions for perfect competition are approximated as much as possible and sometimes that means the presence - rather than the absence - of government is required.

As we are seeing now, sometimes markets can fail catastrophically, but that doesn't mean that all markets fail, or that we should lose faith in the ability of markets to allocate goods and services. Most markets work pretty well. Every day, somehow, the needs of hundreds of millions of people are met through our market system. For the most part, when you go to the marketplace, you can find what you want -- somehow, the market anticipates your needs and has the goods and services ready and waiting when you walk through the door of a store. You won't always find what you are looking for, stores can stock out, oversupply, not have what you want, and so on, but most of the time you do find what you are looking for, or don't have to wait long to get it. When you think about it, it's actually pretty amazing that we are able to coordinate so many diverse actions of so many individuals into an economic system that does a pretty good job of providing for our needs, responding to changes in our tastes, providing incentives for technological advancement, and so on.

So I don't think the lesson of this crisis is that markets don't work. I think the lesson is that markets don't always work, that we need to be vigilant in our oversight of markets to make sure they really do satisfy, as much as possible, the competitive ideals that are necessary for markets to perform well.

I believe that markets do have lots to offer, and I hope we don't lose faith in the market system. But I do not believe that a competitive marketplace necessarily evolves on its own if we simply get the government out of the way. What market share did some of these financial firms have? Why were they allowed to get too big and too interconnected to fail? Why didn't we ask more questions about the ability of ratings agencies operating as a duopoly and paid by the firms whose securities they are rating to solve asymmetric information problems? Shouldn't we have paid more attention to other market failures such as moral hazard and adverse selection issues that seem to plague all types of insurance markets, including those in financial markets? Why didn't agency problems, a common market failure, receive more notice and attention? And so on, and so on. Government oversight is needed to produce and maintain a competitive marketplace, competitive markets don't just happen through self-correction, and in a broad sense the failure to ensure that these conditions were satisfied, and when they couldn't be satisfied to ensure that the markets were subjected to strict oversight to prevent exploitation of market power, systemic breakdown, etc., is one reason we are in the mess we are in.

There's a difference between government imposing conditions on markets that cause distortions, and oversight that maintains a stable and competitive marketplace. Allowing markets to regulate themselves hasn't worked, a competitive market is not an inevitable outcome of government turning its back and saying do whatever you want, and it's time for regulators to reassert the power they have to regulate markets in the public interest. If we fail in our oversight of markets, if we let markets take on non-competitive and unstable structures, then we shouldn't be surprised when markets fail us in return.

    Posted by on Sunday, October 12, 2008 at 11:34 PM in Economics, Market Failure, Regulation | Permalink  TrackBack (0)  Comments (43)


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