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Competition Can Improve on Apparent Market Failure

When products create no externalities, like pollution, and markets have perfect information and are relatively unconcentrated, competition, not direction or regulation from government, is clearly the best route to human welfare. But it does not follow that when production creates externalities, or information is imperfect, or markets are concentrated that centralized regulation is the best response. Government regulation can make things worse. Bureaucrats may lack information to improve on the failures of market even if they were wholly benevolent, because decentralized processes, like markets, are usually best at providing the self-correcting mechanisms that produce good information. And bureaucrats cannot always be depended upon to act in the public interest. Their regulatory decisions may be deranged by their own interests, including their own interests in creating a larger bureaucracy or providing better outside options for themselves when the leave government.

Thus, it is always important to remember that competition can often prove better than regulation even when markets are imperfect. Take the example of protecting consumers against low quality goods. Observers have sometimes argued that government regulation of quality is necessary when quality is difficult to evaluate, because consumers may be misled and not be able to get recompense. It is noted correctly that breach of warranty suits are often impractical or too expensive. But markets then can create other mechanisms to protect consumers. For instance,  companies spend a lot of money advertising their products and themselves. By creating these assets, they give consumers better assurance of quality. If the consumers do not get it, they can badmouth the product. Competition through advertising makes the companies hostage to consumers without any government intervention.

Or think of ride-sharing companies today and the protection of public safety. These companies provide a continuous rating system of drivers. I know I would trust a driver who had been rated well scores of times in the last few months more than one who has passed some bureaucratic test years ago. Thus, even if regulation for a particular public good was once necessary, it always needs to be evaluated against the new competitive alternatives that technology offers.

Competition can also improve the regulatory system itself. Instead of making the nation the locus of regulation, we can choose to rely on the states. This decentralization creates competition between regulatory authorities. Now it is sometimes said that inter-jurisdictional competition leads to a race to the bottom, but that is often not the case. Most scholars of corporate law believe that competition in the regulation of the corporate form has led to a race to the top. To cite one example, Delaware is the home of most corporations because it has the most efficient corporate law. Even in the case of pollution, states and localities have very good incentives to regulate to provide clean waterways and other pollution-free amenities to attract businesses and people.

The point here is not argue that centralized regulation is never necessary, but to provide a reminder that even when markets are imperfect, competitive processes can complement and sometimes outperform regulation. It follows that government should create institutions and norms that help bureaucrats make the right trade-off between competition and regulation because left to their own devices they will too often prefer regulation because of their own bureaucratic and ideological interests.

Reader Discussion

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on January 30, 2018 at 09:15:46 am

There are rarely no externalities, and information is never perfect. These are false tests that people who do not understand or believe in markets assert are essential for markets to work. When these are absent, such people assert that government intervention is necessary--as if government intervention does not create its own (and often perverse) externalities and government ever has perfect information ( government information is commonly inferior to the information available in the market place). Markets have shown themselves--when allowed--to adjust very well to externalities and lack of information, normally building that all into supply, demand, and price. As the author points out, competition is the disciplinarian.

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Wayne Abernathy
on January 30, 2018 at 13:37:24 pm

Happy to see that McGinnis recognizes the various *internalities* consequent upon governmental regulation and that these internalitites arise from both institutional and personal motivations / incentives.

One wonders will economists ever begin a study of internalities comparable to what they have done on externalitites?

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gabe
on January 30, 2018 at 23:44:58 pm

Thus, it is always important to remember that competition can often prove better than regulation even when markets are imperfect.

Competition and regulation are not alternatives for each other. Competition, collaboration and government regulation serve different purposes. I would not leave it to competition to replace the FDA or the FAA.

Competition and collaboration are optimizing mechanisms, but they are not interchangeable. Competition optimizes processes whereas collaboration optimizes resources. Both have their role. Free market conservatives may argue that optimizing processes often optimizes resources, but that is a discussion for another time.

Competition and collaboration are concerned with optimization. Regulation is (or should be) concerned with general welfare. Optimization relates to the maximum possible, regulation to the minimum acceptable. They serve different purposes and are essential in different ways. Successful societies seek out that elusive balance between competition, collaboration and regulation, and flourishing societies come close to finding it, but of course, being human, never quite get it exactly right.

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z9z99
on January 31, 2018 at 09:32:06 am

"... never quite get it exactly right"; but of course, being [bureaucrats and ideologues] even the realization of repeated failure does not dampen their Icarus like pursuit of that bright shining utopia on the hill.

Great take on competition / collaboration and regulation and their optimal interplay.

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gabe
on January 31, 2018 at 11:25:21 am

Gabe,

There are some meta issues there. For instance, federalism should allow competition among states to optimize or improve regulation. Bureaucracy has no efficient optimizing mechanism, particularly one that seeks optimal outcomes among multiple outputs. This is why the two single payer healthcare systems in the United States, the VA and Indian Health Service are chronically plagued with quality issues. Competition achieves its goal when it produces the best possible; regulation achieves its goal when it defines good enough.

There is a another meta issue as well; in a bureaucracy there is competition, but it is competition between the purposes of the bureaucracy and the interests of the bureaucrats. Sometimes these are the same and certainly some bureaucrats are better than others, but bureaucracy contains no significant mechanism for discouraging exploitation of bureaucratic prerogatives. Venezuela is the result.

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z9z99

Law & Liberty welcomes civil and lively discussion of its articles. Abusive comments will not be tolerated. We reserve the right to delete comments - or ban users - without notification or explanation.