Of the r word, regulation.
Now, regulation often gets a bad name, and
it especially has a bad name among the
kind of people who tend to like Bitcoin.
Regulation is some bureaucrat
who doesn't know my business, or
what I'm trying to do,
coming in and messing things up.
It's a burden, it's stupid,
it's pointless, etc..
Now, those arguments often are correct,
but I want to talk in a little more
detail, in this section, about reasons why
regulation might sometimes be justified.
The argument against regulation is pretty
common, it's pretty well understood,
I'm not going to repeat it here.
And so, you'll hear me talking mostly
about reasons why regulation might be
a good idea.
Because that argument is
not as well understood, and
I want to lay it out here a little bit.
Just to be clear, the fact that I'm
spending most of this section talking
about why regulation might be good,
shouldn't be read as an endorsement of
widespread regulation or as a feeling that
regulation is the greatest thing ever.
It's simply that I want to bring a little
bit more balance to the discussion,
in a community where regulation is
often considered as always bad,
or just stupid by nature.
All right, so, the bottom line argument
in favor of regulation is just this,
that when markets fail and
produce outcomes that are bad and
often agree to be bad by pretty
much everyone in the market.
Then regulation can step in and
try to address the failure.
So the argument for
regulation when there is an argument,
starts with the idea that markets don't
always give you the result that you like.
So let me give you an example of
a way in which the market can fail.
And this is a classic example
called the lemons market,
which originated in
a discussion about used cars.
So, let's talk about a market, in concept.
A market for widgets.
Some kind of good that we want to sell.
And let's say that widgets can
be either low-quality widgets or
high-quality widgets.
A high-quality widget costs
a little bit more to manufacture
than a low-quality widget, but it's much,
much better for the consumer who buys it.
Consumers like high-quality widgets much,
much better.
Now an efficient market, a market that's
operating well, would therefore deliver
mostly high-quality, or I'll write it HQ,
widgets to consumers, why?
Because the price of the high-quality
widget will be just a little bit higher,
but the widget will be so
much better that almost everyone
will buy the high-quality widgets.
And so this is what you'd hope a market
would provide in under certain
assumptions a market will provide that.
Now, let's suppose that customers for
some reason can't tell a high-quality
widget apart from a low-quality widget.
What if they really can't tell
which widgets are good, and
which widgets are not?
Think of a used car from
the classic example.
You're looking at a used
car sitting on the lot.
Well, gee, it looks pretty good.
But you can't really tell if it's
going to break down tomorrow or
if it's going to run for a long time.
The dealer probably
knows if its a lemon but
you as the customer can't
tell the difference.
So you can't tell high-quality
from low-quality.
So if you think about what happens,
where incentives drive people in this
kind of lemons market,
you can see that as a consumer,
you're not willing to pay for
a high-quality widget, why?
Because you can't tell the difference.
And so if the used car dealer says,
sure this one is perfect.
It's not a lemon at all.
Go ahead and buy it.
It's only an extra $100 dollars.
Well it might be that you'd happily
pay $100 for a higher quality car,
but you don't really
know whether that car,
whether that widget
really is high-quality.
So if you really can't tell which widgets
are high-quality versus low-quality,
then you're not willing to pay extra for
the high-quality one.
And if consumers are not willing to
pay extra for a high-quality one,
then producers can't make any extra
money by selling a high-quality widget.
In fact, they lose money by selling a
high-quality widget because they don't get
any price premium.
They'd be better off buying the slightly
cheaper low-quality widget and selling it.
And so the result is, if consumers really
can't tell which widgets are high-quality
and which are low-quality, the market
gets stuck in an equilibrium where only
low-quality widgets are produced, and
consumers are generally unhappy with them.
Now this outcome is worse for
everybody than a properly
functioning market would be.
It's worse for buyers because they have
to make do with low-quality widgets,
when in a more efficient market,
they could have bought
a widget that was much much better for
only a little bit higher price.
It's also worse for producers.
Because the widgets that are on
the market are all lousy,
consumers don't buy very many widgets.
The widget market is relatively small.
And so there's less money to be made
selling widgets than there would be
in a healthy market.
And so both consumers and producers
are worse off in a world where consumers
can't tell the difference between
high-quality and low-quality widgets.
That's a market failure.
It's called an asymmetric
information failure and
the result is a market that's
sometimes called the lemons market.
Okay, so how can we fix this?
Well, there are some market-based
approaches that try to fix
a lemons market.
The first market-based approach
relies on the seller's reputation.
The idea is that if a seller tells
the truth to consumers about which widgets
are high-quality, and
which are low-quality,
then the seller might get a reputation for
telling the truth.
And once they have that reputation, then
maybe they can sell high-quality widgets
for a higher price,
because consumers will believe them.
And therefore,
the market can operate more efficiently.
The problem with this is,
yes, this sometimes works.
But sometimes it doesn't,
depending on the precise assumptions
you make about the market.
But if you think about it, this is not
going to work as well as a market where
consumers can really tell the difference.
Because for one thing,
it takes a while for
a producer to build up a good reputation.
In order to build up a good reputation,
they have to sell high-quality
widgets at low prices for
a while until consumers learn that
that seller is telling the truth.
And that makes it harder for
an honest seller to get into the market.
The other problem that can occur, is that
that seller, even if they've been honest
up to now, if for one reason or
another their sales are shrinking or
they think they want to get out of the
market, their incentive is to massively
cheat people all at once and
then leave the market.
Rather than continue to be honest and
then leave the market.
And so in the beginning,
of a seller's presence in the market and
at the end of a seller's presence in
the market, reputation tends not to work.
This sort of reputation based approach
also tends not to work in businesses where
consumers don't do repeat
business with the same entity or
where the product category is very new.
And so there hasn't been enough time for
sellers to build up a reputation,
like say in a high tech market
like say Bitcoin exchanges.
The other market based
approach is warranties.
That's the idea that a seller could
provide a warranty to a buyer that says,
if this thing turns out to be low-quality,
if it doesn't work well for
you, I'll give you a new one,
I'll pay you back or something like that.
And that can work up to a point as well
but there's also a problem as well.
That this warranty is just
another kind of product,
which could also come in high-quality and
low-quality versions.
A low-quality warranty is one where the
seller doesn't really come through when
you come back with a broken product.
They don't really replace it,
they don't really give you your money,
they make you jump through
all kinds of hoops.
And so this is not a panacea either.
So, if you have a lemons market which
has developed, and if these market based
approaches don't work for the particular
market that you're dealing with,
then regulation might be able to help.
And there are three ways in which
regulation might be able to address
a lemons market.
First, regulation could require
disclosure, they could require say,
that all widgets be labeled as
high-quality or low-quality and
then have penalties on the firms for
lying.
That gives consumers the information
that they were missing.
A second approach to regulation is to
have quality standards, is to require
that no widget can be sold unless it
meets some standard of quality testing.
And have that standard set so that only
high-quality widgets can pass the test.
That way you have a market that's
all one kind of widget, but
at least it's high-quality widgets.
Assuming that the regulation
works as intended.
Or you could have required warranties, so
that all sellers have to issue warranties,
and then enforce the operation
of those warranties, so
that sellers are really held to
the promises that they make.
So, all of these are forms of regulation,
which obviously could fail,
which might not work as a tenant,
which might be miswritten, or misapplied.
They might be burdensome on sellers,
and so on,
but there's at least the possibility
that regulation of this type
might help to address the market failure,
due to a lemons market.
So this is one example of how regulation
can be an efficient thing to do
if it's done well when there's
a certain kind of problem.
Namely, the inability of consumers to tell
the difference between a high-quality and
a low-quality product offering.
And so people who talk about Bitcoin
exchanges for example, and argue for
regulation of them, sometimes point to
them as an example of lemons market.
Another example of a market failure, or
a place where the market doesn't operate
the way that you would like it to in order
to serve consumers, is price fixing.
Price fixing simply is a case where
different people are selling a product in
a market, and they just agree with each
other that we're going to raise prices.
Or we're not going to lower prices.
Related to price fixing is
an agreement not to compete,
where companies that would otherwise
go into competition with each other,
agree not to compete with each other.
For example, if there were two bakeries
in town, they might agree that
one of them will only sell muffins and
the other will only sell bagels.
And that way, there's less competition
between them than there would be,
if they both sold muffins and bagels.
As a result of the reduced competition,
presumably prices go up, and
the merchants are able to foil
the operation of the market.
Because after all, the reason that
the market protects consumers well in its
normal operation,
is through the vehicle of competition.
That sellers have to compete in order to
offer the best goods at the best price to
consumers, and if they don't compete in
that way, then they won't get business.
So an agreement to fix prices or an
agreement not to compete circumvents that
competition and prevents competition
from operating in the market.
So another way that the market can fail,
is when people take steps
that prevent competition.
These kinds of agreements,
either an agreement to raise prices or
an agreement not to compete,
these are illegal in most jurisdictions.
This is part of anti-trust law or
competition law.
In general, antitrust or
competition law is aimed to prevent
cases where the markets gets
stuck in a situation where there
isn't enough competition
to protect consumers.
Or cases where somebody acts in
a deliberate way to try to prevent
someone from competing them.
Acting in a way other than, simply
offering good products and good prices.
Antitrust law is very complicated.
I've given you sort of a sketch of it but
this is another instance where we know
that there are failures that can occur and
where the law will step in to prevent,
in the easy cases, things like price
fixing or agreement not to compete.
But in more difficult cases, even some
attempts to reduce competition in
the market, through say mergers or
other kinds of activity.
Another example where
regulation might be helpful.