It’s said that one man’s trash is another man’s treasure. In the same way, one man’s market imperfection is another man’s market opportunity. Imperfections in markets don’t prevent markets from operating – they are a driving force of the market process. As Hayek once said, in the standard economics model of “perfect competition,” there is no actual competition!
A commonly cited market imperfection is “imperfect information.” Lack of information is indeed a problem, but companies and consumers both have incentives to find ways to solve this problem. One way to achieve this is through branding. Suppose you’re on a road trip and need to make a quick stop to eat. You have two options – a local burger joint called Billy’s Burgers, or a McDonalds. You know nothing about the former restaurant – it could be a hidden gem, or it could leave you chained to your toilet for the next three days. You’re just passing through town, so you’re not going to be a repeat customer; this is a one-time transaction. You might not want to take the risk that Billy’s might turn out to be a dud. Meanwhile, with McDonalds, you know exactly what you’re going to get. It’s going to be basically the same as every other McDonalds you’ve ever tried. The same is true for other major chain restaurants. The brand name communicates valuable information to the consumer, alleviating the problem of imperfect information.
But times have changed. We don’t need to rely so much on branding to supplement our information. Nowadays, everyone knows about Yelp, Google reviews, and other similar review aggregators. If you were to take that road trip now, you could just pull up the Yelp reviews for Billy’s Burgers. You’d see the results of hundreds, if not thousands, of others who have been through that town. You’d be able to see the full menu, along with pictures posted by both the restaurant and the customers. Suddenly, your ability to choose between McDonalds and Billy’s can be much more informed.
In fact, a working paper from the Harvard Business School looked into the effect of Yelp on the restaurant industry. The author, Michael Luca, found that a rating increase of one star on Yelp leads to an increase in revenue between 5% to 9% – but that this impact was limited to independent restaurants. Chain restaurants saw no significant effects from Yelp reviews. This makes intuitive sense – I’ve often consulted Yelp and similar apps when deciding about an independent restaurant or a food truck. It’s never even occurred to me to look at Yelp to find a rating for any given Chipotle or Applebee’s. Why would I? I already know what to expect from those places. And I’ve also found that because of Yelp, I’m far more likely to seek out and eat at independent or specialty restaurants instead of chains, because Yelp has made it so much easier to find the gems among the grit.
What to make of all of this? I think there are three takeaways.
Markets are not about reaching and maintaining an equilibrium, free from frictions or imperfections. Markets are an ever-ongoing process, working in response to those frictions and imperfections.
The solution used yesterday may not be the same as the solution used today. Where branding was once key to imperfect information, crowdsourcing has now emerged as a valuable tool as well. Tomorrow’s might introduce a new solution which is totally different – the process will continue to evolve, in ways that aren’t always apparent right now.
Because the process always evolves, there is no fixed, “correct” answer to how to handle market imperfections over time. This should make us extremely reluctant to use regulation. Once you do, you’ve said a single institution (the state) must create a one-size-fits-all solution for everyone. Once implemented, a political solution will inevitably create some winners and losers, which itself inevitably creates interest groups out of the winners who have reason to maintain this new status quo. If a better solution emerges, markets could smoothly transition to it, as we’ve seen with branding giving way to crowdsourcing. But political structures force you to battle with special interest groups and entrenched interests before you can gain new options. This can leave a suboptimal solution in place long after it stops being useful – if it ever was useful to begin with.
Kevin Corcoran is a Marine Corps veteran and a consultant in healthcare economics and analytics and holds a Bachelor of Science in Economics from George Mason University.
READER COMMENTS
Matthias
Sep 7 2022 at 8:20pm
I broadly agree.
However not all regulations are the same. Some allow for much more flexibility than others.
Look at the famous German purity law for beer. You could decry it as a one-size-fits-all regulation that restricts beer to be made of only a few approved ingredients. (Plus lots of grandfathered exceptions, because this is Germany.)
But: the Reinheitsgebot isn’t actually quite so bad. You can still brew whatever you like, you just aren’t allowed to call it Bier.
Markets are actually pretty good at routing around unwanted regulation as well. Like selling milk from non-pasteurised milk as ‘for external application only’.
Walter Boggs
Sep 8 2022 at 11:10am
If people need to route around the regulation, the regulation is harmful and should be eliminated. We want regulations to serve people, not the other way round.
MarkW
Sep 8 2022 at 8:15am
It’s never even occurred to me to look at Yelp to find a rating for any given Chipotle or Applebee’s.
But you probably should. We don’t eat at those kinds of restaurants, but we definitely do check reviews for chain hotels — some are much better (newer, cleaner, better managed) than others in the same chain. I assume the same is probably true of Applebee’s. It occurs to me that you could rate chains based on average rating and also variability — I assume chains vary in how much consistency they actually provide. I wonder if anybody has done this?
But that’s a side note. This seems exactly right (and is a point that market critics never seem able to grasp):
Markets are not about reaching and maintaining an equilibrium, free from frictions or imperfections. Markets are an ever-ongoing process, working in response to those frictions and imperfections.
vince
Sep 8 2022 at 3:15pm
“Markets are not about reaching and maintaining an equilibrium, free from frictions or imperfections. Markets are an ever-ongoing process, working in response to those frictions and imperfections.”
And the capitalist tries to impose frictions and imperfections. An example is regulatory capture.
Jon Murphy
Sep 8 2022 at 5:39pm
True but trivial. Any individual may try to impose frictions and imperfections: the capitalist, the socialist, the pragmatist, any “ist.” So, the question is not about who imposes but how to discourage it.
“People of the same trade seldom meet together, even for merriment and
diversion, but the conversation ends in a conspiracy against the publick, or
in some contrivance to raise prices. It is impossible indeed to prevent such
meetings, by any law which either could be executed, or would be consistent
with liberty and justice. But though the law cannot hinder people of
the same trade from sometimes assembling together, it ought to do nothing
to facilitate such assemblies; much less to render them necessary.”
vince
Sep 8 2022 at 11:09pm
Regulatory capture is trivial?
“So, the question is not about who imposes but how to discourage it.”
That’s the question. Where is the search for answers? It’s as if the searchers are captured too.
Jon Murphy
Sep 9 2022 at 5:46am
No.
That’s a very deep and old literature going back to Adam Smith (as from the quote I posted). If you’re looking for good places to start, I can help.
MarkW
Sep 9 2022 at 7:28am
One of the first things to consider, in your search for understanding, is that ‘regulatory capture’ can often be more accurately described as ‘regulatory shakedown’:
As the Microsoft example suggests, the Washington culture of influence peddling is not entirely, or even primarily, the fault of the corporations that hire the lobbyists and pay the bills. It’s a vast protection racket, practiced by politicians and political operatives of both parties. Nice little software company you’ve got here. Too bad if we have to regulate it or if Big Government programs force us to raise its taxes. Your archrival just wrote a big check to the Washington Bureaucrats Benevolent Society. Are you sure you wouldn’t like to do the same?
Here’s a story I’ve told before but without the name. Lanny Davis was special counsel to the president in the Clinton administration and a personal friend of the Clintons. He called me shortly after I got to Microsoft to say how sorry he was that we’d missed each other as I was leaving Washington and how much he hoped to stay in touch. Oh yes, and he felt terrible about all the bad publicity and unfair government harassment my boss, Bill Gates, was getting. He would love to give him some help and advice. Could I put the two of them together? The answer, of course, was that I couldn’t. But the odd thing was that, at that point, I had never even met Lanny Davis.
https://www.politico.com/story/2011/04/how-microsoft-learned-abcs-of-dc-052483
vince
Sep 9 2022 at 12:28pm
Jon: If regulatory capture is taken as a given, then the deep literature either hasn’t found a solution or something prevents implementation.
MarkW: Regulatory shakedown puts the blame on money in politics. What’s exasperating is that everyone agrees it’s a problem, but no one does anything about it. Term limits? Greater restrictions on lobbying? More transparency and investigative reporting? Publicly funded elections? End Citizens United? And so much more …
Jon Murphy
Sep 9 2022 at 1:31pm
Who said it’s taken as a given? Not I nor anyone I know who has researched rent seeking and regulatory capture.
Again, if you actually want to look at regulatory capture and understand it, I can help. I’m not saying you need to do a deep research dive. There are many good summaries out there (like the quote from Adam Smith I posed originally).
vince
Sep 9 2022 at 3:56pm
“Who said it’s taken as a given?”
No one. I said IF it is. Are you saying it doesn’t exist? Or it’s unimportant?
“Not I nor anyone I know who has researched rent seeking and regulatory capture.”
Ahh, there is the problem. It seems like this is the kind of issue that would, or should, engage economists who work in public policy.
For just one real world example, one can google Certificate of Need.
Jon Murphy
Sep 9 2022 at 4:43pm
I no longer understand what you are talking about. I thought I did, but you keep changing topics. There is very deep literature on regulatory capture, including CON (in fact, I just had a phone call today with a top CON scholar).
I don’t understand what your point is.
vince
Sep 9 2022 at 5:59pm
On the topic of regulatory capture, you said it was trivial and wrote: “the question is not about who imposes but how to discourage it.” And “Who said it’s taken as a given? Not I nor anyone I know who has researched rent seeking and regulatory capture.” And: “There is very deep literature on regulatory capture, including CON”.
I assume the literature opposes CON. If so, why has the literature failed to end CON?
Jon Murphy
Sep 9 2022 at 7:12pm
No, I said your statement that capitalists engage in regulatory capture is trivial. It’s like saying “capitalists drink water.” Of course they do. Everyone does. It’s a trivial statement to single them out. Capitalists respond to incentives just like everyone else.
Two things here:
First: you’re confusing the normative with the positive. Economics is a positive science. The goal of any scientific literature is not to “oppose” or “support” anything. It’s to study the phenomenon. Just like there are researchers who support minimum wage and those who oppose minimum wage, there are those who support regulatory capture and those who oppose regulatory capture as normative matters. We have a very deep understanding about the different incentives that lead regulatory capture behavior (in fact, just last week I lectured on it in my MBA course).
Second: to understand a phenomenon does not mean to conquer it. It would be like saying “If physicists can understand gravity, how come air planes still crash?”
“There are more things in Heaven and Earth, Horatio, than are dreamt of in your philosophy” -Hamlet
vince
Sep 10 2022 at 11:15am
“We have a very deep understanding about the different incentives that lead regulatory capture behavior.”
Now, that’s an example of triviality.
We can agree to disagree on the following statements. IMO, they are either incomplete or are half truths:
1. Economics is a positive science.
2. The goal of any scientific literature is not to “oppose” or “support” anything. It’s to study the phenomenon.
I would like to see any references you have concluding that CON is beneficial in any way.
Jon Murphy
Sep 10 2022 at 1:18pm
Fortunately, much of the world disagrees with that statement (take, for example, James Buchanan’s 1986 Nobel Prize). I think the world has been made far better with the study of regulatory behavior and capture.
You seem to be too glibly dismissive of regulatory capture. It’s an important thing to understand, especially the incentives that lead to it (indeed, I’d argue that saying a given literature’s job is to advocate for/against policies will lead to regulatory capture, or at least rent seeking. Events of the past 2 years bore that out).
I don’t know of anything off the top of my head given CON isn’t something I am actively working in. But I am sure if you do a Google search, you can find something.
diz
Sep 9 2022 at 1:00pm
“The author, Michael Luca, found that a rating increase of one star on Yelp leads to an increase in revenue between 5% to 9%”
“Leads to” appears to attribute causation — as opposed to something like “is associated with”. I would guess both “Yelp reviews” and “Restaurant revenues” are correlated with the quality of experience a restaurant offers. Didn’t look through to the underlying study but it seems like it would be difficult to isolate the effect of “Yelp reviews”. I don’t doubt good Yelp reviews increase revenue, but I’d bet that the effect is secondary to being a good restaurant in general. The vast majority of restaurants I go to I have (or someone I’m going with has) been to before. Rarely pick one based on Yelp reviews.
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