“The Theory of Industrial Organization” was published in 1988, after which its author, Jean Tirole, went on to study businesses with market clout – monopolies, cartels and oligopolies. This month he was awarded the Nobel Prize for economics, which gave him the ultimate legitimacy for his work.
It was great timing for fighters against cartels, monopolies and the other giant companies in Israel’s concentrated market couldn’t have hoped for better timing. Tirole won the prize in the same week that the food giants were protesting that Israel doesn’t lack competition - “there are five big companies,” they said. The Nobel committee sent a message: competition, regulation, cartels and monopolies aren’t a mathematical puzzle — they affect everybody’s quality of living.
Why is it so hard to promote competition through regulation? Because different sectors and market structures require different sorts of regulation, Tirole explains. The markets are too complex for regulators to simply work according to standard models.
Well before him, in 1982, George Stigler won the Nobel for his “captives” theory of regulation: why regulators who are supposed to restrain companies and encourage competition get “captured” by the firms they’re supposed to oversee. Tirole used game theory to upgrade Stigler’s description to the new complexity and tools. Meanwhile, the ones who lose the game are the taxpayers, consumers and investors.
Yet there’s no rule that we have to lose. We lose because the system is built for us to lose. We can intuit it yet not understand how the system works. But we believe we will never beat the system, a highly rational belief, which is what the system is based on.
One definition of economics is “the science of efficient resource allocation.” Economists have been arguing for centuries over how to achieve that. By now most agree that the “market” – that amorphous collection of individuals – leads to more efficient resource allocation than a single concentrated entity (the government) does.
Yet in recent years, mainly after the 2008 meltdown on Wall Street, that paradigm has been questioned. The crises, the yawning inequality, the corruption and growing sense that the game’s been rigged and the system serves the few, not the many have begged questions.
The hand that grabs
Doubters generally belong to one of two camps: ones who feel the market failed and only government can fix it, taking from the haves and giving to the have-nots, providing more services and fiercely regulating the private market.
The second camp blame the market’s failures on government meddling. The ticket in their view is to lower taxes, eliminate most regulation and bureaucracy, free up resources for entrepreneurs and let the market do what it knows best.
Prof. Andre Shleifer of Harvard feels both are wrong. He calls the first camp “the helping hand,” referring to the government helping to correct the market’s distortions; the second hand he calls “the hidden hand” a-la Adam Smith. (We in Israel know a third hand, the “grabbing hand,” consisting of the giant government and bureaucracy that grab much of the taxes for themselves rather than use the money for the people.)
The biggest mistake of the “hidden hand,” says Shleifer, is the assumption that market forces can be left to work alone, resulting in miraculously efficient resource allocation. But unfettered market forces will always seek to dampen competition.
People supporting the free market may not realize that by definition, business wants to prevent competition and get handouts from the state, and the bigger the business, the better it can do all that. Capitalists are enemies of capitalism.
The free market has plenty of ills – asymmetry of information, for one: the big players have it, the little man doesn’t.
Public relations and lobbying are one of the biggest growth industries in the last century, all operating in the “free market,” but their real job is often to hide information, disrupt the signals in the market, for their clients. In an increasingly complicated world people tend to rely on third parties to broker reality and tell them what’s good and what’s bad but they are not necessarily serving the cause of efficient, transparent markets.
As for the “helping hand” camp, their basic mistake is to assume that politicians who appoint the clerks, regulators and managers in government are serving the public, not themselves or their cronies who can reassure their reelection. This camp also ignores the tendency of large organizations, certainly the ones relying on tax money, to accrue the flab, red tape and inefficiency so familiar to every Israeli.
I make an unoriginal claim: in Utopia, both camps would be right and in the real world, both are wrong.
In “The Logic Of Collective Action,” Prof. Mancur Olson explains why every Western democracy develops powerful interest groups over time that organize the rules of the game in the economy, regulation, and laws for their own greater good. Like Anthony Downes before him, Olson explains that the unorganized public is a rational ignoramus. It has no incentive and usually no ability to investigate and understand what politicians and regulators do, and figure out if they’re serving him or the interest groups.
Olson also showed, as did economists before him, that the general public has neither the means nor the incentive to organize against the interest groups.
The average Israeli now grasps that the tycoons, monopolies and powerful unions usually have more power than the consumers or taxpayers off whom they live. They see how money influences politics and internal party elections and understand the advantage of size. But they still don’t see that this phenomenon – interest groups taking over politics, setting the rules of the game and therefore influencing the allocation of resources – isn’t an Israeli thing; it’s an indication that we’re a banana republic. Sometimes it doesn’t necessarily reflect corruption: It’s a natural result of the structure of democracy.
Some democracies are completely captive to interest groups; some are constructed to serve the general public or a greater economic good. The United States is famously the leading democracy in the world but all agree it is today significantly captive to the big interest groups.
The supervisor’s inherent inferiority
Interest groups in both the public and private sectors almost always win because of the regulator’s constraints. There are structural failures. Here are some of the things we learned from monitoring economic regulation in Israel:
1. Information: To regulate a market and set rules, prevent cartels, protect consumers and encourage competition, the regulator must thoroughly understand the markets and how they work. The problem is that most of the information on the markets is in the hands of the interest groups that are under supervision. The regulator may demand all information under law but his knowledge and understanding of the market, mainly markets that move swiftly, will always be inferior to that of the supervisee, the interest groups. If there is a change in the market that serves the supervisee’s claims, he will present it to the regulator; if the change is not in his favor, he won’t. The regulator needs to be aware of this and keep track of the markets and of changes. But he’s extremely unlikely to be more aware of them than the interest group.
2. Complexity and expertise: The markets are becoming increasingly complex and the regulator will always be in an inferior position to the interest groups, which usually have a tremendous incentive to study the markets and present things in their favor.
Regarding expertise, progress and technology lead to growing need for expertise, but this can be a double-edged sword. The greater the regulator is in a narrower field, the greater his incentive to work in the market he’s supervising in the future. The greater his expertise, the more the regulator finds himself living in the professional and academic world of the supervisees, and sharing their point of view. Thus his very expertise may lead him to become ideologically captive by the interest groups.
3. There is no “other party”: Many err in thinking that “market forces” – meaning competition between players in the market and the interest groups – will mean that each presents his position to the regulator and legislator, and a compromise is reached that serves the greater good. Not so. The players appearing before the regulator, with lobbyists and information, always serve their own interests, never that of the disorganized public.
In the battle between food suppliers and retail chains, neither represented the good of shoppers. In the battle between the banks and insurance companies over who would market pension vehicles to the public and who would control the provident funds, the little saver was unrepresented. Sometimes they purport to serve the man in the street but it’s a very lacking representation at best.
4. The public’s ignorance: The more complex the sector, the less the public can understand what the regulator is doing. The regulator learns that the interest groups hurt by his decisions, like opening the market to competition, will be more vengeful and vocal, and will invest resources in ruining his good name and chances of a future job. On the other hand the disorganized public that would benefit from the regulator’s decisions will usually demonstrate utter apathy to his work.
The press, which could and should inform the public and help it understand the complexities, has a double problem. Like the regulators, it is fed data and analyses of the interest groups and is often captive to the same groups.
5. Consistency: Regulatory decisions on the rules of the game are critical to all players –the workers, the managers and the owners (if it’s private). Therefore, interest groups will invest an enormous portion of their resources in influencing regulation, and will stay on their toes over the years. But the regulator has multiple, morphing clients; his manpower is constantly changing; so his ability to stay on top of the market is less than that of his supervisee. As a public servant the regulator is more sensitive to his good name and will steer clear of mistakes; but being human, mistakes will happen, which the interest groups will highlight in order to hurt his good name and “prove” the damage that regulators do. A regulator fearful for his good name may compromise in order to spare himself attack by the interest groups.
We see that time and again every time a reform looms that would be good for the public and bad for the interest groups. Suddenly a campaign starts in certain media against it, highlighting less significant side effects and ignoring its benefit. For instance, instead of pointing out the 90% drop that reform brought to the price of cellular communications, interested parties (mainly ones hoping to stymie future reforms) choose to dwell on layoffs in the industry, not the 5 billion shekels ($1.3 billion) that the people of Israel save each year on their mobile phone bills.
6. Tall tales: Regulators who want to change the rules of the game will often find that the public seems to share the interest groups’ views. That is because the groups create artificial narratives that explain why the regulator’s moves to introduce competition are bad for the people.
The interest groups have three effective narratives to block change. The first is “job losses,” which ignores the fact that far more people will benefit from the reform.
The second is “safety”: New players will compromise public safety, ignoring that they can be just as safe, and it isn’t clear that the present market structure actually maximizes safety. In the technological age, “safety” has a twin argument, “privacy,” and again efforts to encourage competition by providing information and transparency are blocked on the grounds of protecting the consumers’ “privacy.” We saw that in September when the taxi service Uber was barred from opening shop in Israel. The taxi lobby and Transport Ministry threatened that the new competitor would compromise safety; they didn’t discuss how to let in new players that would be safe too.
The third narrative is “it’s never been tried before” or the twin argument, that prior attempts at reform failed.
The battle over narrative perceptions is a true battle over democracy that requires resources and expertise to win.
7. Most regulators are appointed by politicians, who in turn usually rely on the interest groups for reelection: tycoons give donations and control the media or are tied to the owners of media, big unions that have clout in party primaries and elections, and are rewarded by preservation of the status quo.
Therefore, the incentive of regulators or bureaucrats to hurt wasteful, corrupt or monopolistic interest groups is usually not high. They don’t want to make powerful enemies that could hurt the politicians that appointed them. The public meanwhile demonstrates apathy and sometimes buys the interest groups’ narrative and actually resents the meddling regulator.
Whether we’re in the free market camp or the government hand camp, we see that both have players with selfish agendas: companies operating in the free market or politicians serving their own interests.
In both models we need laws and regulation that serves the greater good, not the interest groups. But the regulator is unlikely to do so, which is why we usually lose. That is, ostensibly, the natural order of things.
So far I have tried to drive home the message that regulation is crucial to the free market and inevitable, but is nearly always taken captive by interest groups. Freeing it from captivity by politicians and interest groups and making it simple and effective are possibly the most important mission in democracy today. The decision by the Nobel Prize committee may reflect that estimation.
Must we always lose? No. The cases of the cellular market and Business Concentration Law demonstrate that in some markets, moves can be made against the interest groups for the sake of the public. These reforms are an example of another kind of regulation and political work. The problem is that the interest groups learn quickly from these test cases, learn the new language and will create new narratives for the next round.
Stigler, Olson, Downes and others had one small mistake: Rationally you should have spent the last minutes engaging in your personal pursuits, not trying to learn something for the greater good, but you did. Maybe it was intellectual curiosity or the realization that if you don’t act irrationally, for the greater good, nobody will do it for you.
It isn’t impossible for public pressure to drive economic policy that serves the public more than it does the interest groups. The welfare state arose after World War II, with education, health care and social networks. Civil rights movements also sprouted against powerful interest groups, thanks to public pressure always rising from the bottom, the margins, from courageous academics, finally joined by politicians.
If to be optimistic for a second, following the Nobel award that legitimized the war on the conglomerates, one can argue that Downes, Olson and their colleagues didn’t consider our case, of the Israeli public achieving a relatively high degree of taking an interest, caring and wanting to have influence when it realizes that it’s being screwed. Israelis think they can change reality. And that is why you devoted time to reading this column rather than engaging in your own pursuits. If there are a few hundred thousand more that understand this language, maybe the reality in Israel will change.