Monday, February 29, 2016

Another Look At "Too Big To Fail"

NOTE: I am copying sixteen essays from my old blog ("Random Notes") to this blog. Some are cited in other essays, but most are simply essays that struck me as interesting while I was going through my search for essays to fix broken links.

I wrote about the many logical issue with calling banks (or anything else) "too big to fail" in my post "A Very Quick Banking Question". However, in replying to a comment to that post, it occurred to me that there is something strange in the way the government handles businesses, especially in fields which it heavily regulates. While claiming to "favor competition", to detest monopoly, cartel and "oligopoly", and wishing to "favor small business", the government, through its regulatory processes, actually favors not only cartels and oligopolies, but also ever larger firms. Which is quite bizarre when one considers that the government not only regularly criticizes firms for being "too big", but even prosecutes them for "controlling too much of the market", a situation its own policies make almost unavoidable.

Before I go on, let me make a few points clear. They are not directly relevant, but I don't want anyone to misunderstand my position. The idea that there is something inherently better about small firms rather than large is the government's not my own. I discussed this more fully in "Small Business Fetish", but allow me to make my case briefly. The optimal size of firm is not carved in stone. Even within the same industry, with similar circumstances, sometimes large firms may be better suited, sometimes smaller. Ther eis nothing inherently good about "small business"> Yes, they create many jobs, but partly that is because so many open up and fold, puffing up the numbers, and partly because, inevitably, small firms always farm outnumber large. It does not mean small firms have an inherently strong job creation ability. In reality, small or large, the best firm is the one which produces best at lowest cost and responds to changes most swiftly and accurately, and those traits do not correlate with size. So I do not agree that large firms are harmful.  (In some ways, I think the fear of "big business" is part of populist rhetoric. See "Fear of the "Big"" and "Beware Populist Deception".)

Nor do I believe there is anything inherently beneficial about having a specific number of firms in a given market. Though the government and many economists argue otherwise, I would argue a market can be perfectly efficient with one, or just a handful, of firms controlling it, though it is remarkably unlikely such a situation would arise in a free market. In a free market, in general, there would be a proliferation of small, competitive firms. However, it is possible that an extremely adept competitor could become very large, even so large as to control the market. However, it would be irrelevant in terms of "monopoly", as that firm would have to maintain the same prices and efficiency as if competing with other firms, otherwise new competitors would arise to compete. In other words, a competitve "monopoly" would produce the same results (or slightly better) than a number of competing firms. And, for that reason, I do not share the fear that a market may have "too few" firms competing.

Having established all those facts, let us return to the point of this post, the many ways in which the government encourages the very things it claims to abhor. 

First, and most damaging, by regulating industries the government creates barriers to entry. These can take a number of forms, be it regulations concerning entry, inspection requirements, reporting requirements, bond or deposits, or other methods to protect consumers which still serve to keep out competitors.

The primary practical result of these restrictions is to keep newcomers from entering the market. This can be done in several ways. First, by increasing the entry cost, which makes entry cost unattractive relative to other ventures. Second, by imposing many new and confusing rules, requiring newcomers to endure a long elarning curve, making it take much longer before a competitor can effectively function in the market. And, finally, by creating arbitrary entry requirements, such as approval by a board or individual, which can prevent a company from entering for no obvious reason. In fact, that last is the most dangerous, as often one has to make considerable investment before even applying for approval, meaning one could easily lose a fortune, unless he has the assurances of a regulator or someone with political clout. That risk alone often keeps newcomers from even considering entering the field, leaving the market to established firms and a few new entries with political clout.

This has a secondary effect of dampening competition, as there is little reason to compete. With a fixed pool divided between an established se tof firms, the only possible outcome of competition would be to steal business from rivals. However, as that may upset a regulator, or a political patron, and since regulators have undue influence over the fates of such industries, it is usually seen as best to simple carry on business as usual, each holding his share of the market,  making few changes as there is no reason. In a private market such behavior would be impossible, even with such a cartel, as there is the threat of new competitors entering the market, but in a closed regulated market, there are no such potential competitors. You can count upon the playing field having the same individuals for the foreseeable future.

And since the market is so hard to enter, when a firm begins to fail, it is almost impossible for an outsider to buy it. So, as a result, failing firms are almost always bought up by their competitors, resulting in a concentration of the market into a handful of firms. Yes, we do get the occasional new firm, but the failures are a bit more common, and so, over time, the market not only remains closed, but also tends to be reduced to a small number of businesses.

And that is what makes these regulations so ironic. The government claims to want small competitive firms, responsive to consumers, with none having too much influence or too large a market share. And yet, through their actions trying to protect consumers, they end up creating cartels which bar entry by new firms, and eventually end up concentrating the entire market into a small number of very large firms.

More ironic still is the fact that by simply eliminating regulations and barriers to entry the market would likely be filled by a large number of small firms, much more responsive to consumers. Now, such firms would end up going bankrupt much more often, as that is the nature of a competitive market ("An Analogy From Past Inflation", "Environmentalism For The Economy?", "Why"Negative" Economic Indicators Are A Good Thing", "Bad Economics Part 11"), but we need to overcome our fear of bankruptcy. Once we accept that business failure is natural, and competition protects consumers better than government, we will find that a lack of regulation is a much better defense than all the regulations in the world.

Originally posted in Random Notes on  2010/03/01.

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