Thursday, March 1, 2012

Regulations in the services sector

Econ 101 teaches us that restrictive regulations distort the market and creates conditions for rent-seeking. Such regulations act as entry barriers that stifle competition and confers undue benefits on the existing producers or suppliers or owners at the cost of their prospective competitors and other consumers.

Accordingly, labour market qualification norms in service sector or product standards in manufacturing and agriculture can act to screen out potential competitors. Zoning regulations place restrictions on new residential and commercial developments, thereby keeping real estate prices artificially high. Similarly, excessive and extended copyright protection are an effective legal monopoly, transferring money from consumers to the original developers. In all these cases, apart from keeping out competitors, the regulations help the incumbents earn a premium, an economic rent, at the cost of their consumers.

The FT chronicles restrictions on taxicab permits in Milwaukee, Wisconsin, that promotes rent seeking,

It would cost $150,000, over and above the price of the vehicle itself, to buy from its existing owner one of only 321 cab licences in issue by the city... Licences are so expensive because the limit on competition makes each of Milwaukee’s taxis unusually profitable: their extra earnings are an example of an “economic rent”. These are reflected in the literal rent of up to $1,000 a week that a driver must pay for a fuelled and licensed cab...

The Milwaukee cab licences are together worth $48m – and since 1991 more than half of them have migrated to companies owned by one family: the Sanfelippos. Even at their own more modest price estimate of $80,000 their permits are worth as much as $13m.

The NYT writes about Germany's "dual economy", especially in its service sector,

On one side, we have this very dynamic, innovative, competitive and refreshingly unsubsidized export sector. On the other side, there is a much less glamorous services sector which depends on barriers to entry, subsidies and not developing and reaching out for new activities... This economy is overregulated, intended to insulate insiders from competition and deeply resistant to change... German economy features some of the same flaws... including protected professions and zoning laws that favor existing businesses over new ones...

For example, two years after a promised deregulation of domestic transportation, intercity long-distance bus service is still effectively prohibited in Germany. The decades-old ban shielded the government-owned rail company, Deutsche Bahn... years of training are still required to qualify as a house painter, chimney sweep or bicycle mechanic, to name a few examples... restrictions on advertising and fees limit competition among architects, lawyers and engineers.

In contrast to these strongly regulated service sector markets, India appears like a Chicago economists' dream. Service sector is virtually unregulated, even in the organized economy, and most of these professions have virtually no entry barriers. Ever heard of standardization or courses to become a barber, painter, plumber, or electrician? The only facade of regulation is maybe a vocational skill diploma or a driving license. For sure, it has kept prices down and people move in and out of these occupations without any hinderances. However quality has suffered.

But the market for each of these services has been getting increasingly differentiated. Those equipped with some professional training or certification command a higher premium by signalling their expertise and the assurance of better quality of service delivery. Incidentally, in all these services, market differentiation has followed the emergence of organized service delivery. In other words, as these markets move away from freelance individual-run service delivery towards organized firm-based service delivery, standardization and certification becomes important screening and signalling mechanisms and entry barriers emerge.

The challenge is to find the right mix of standardization. On the one hand, the entry barriers should not be so prohibitive as to stifle competition and constrain job creation. On the other hand, there should be some appropriate level of screening that ensures quality is not significantly compromised. A two-tier market, like in India, in the organized and unorganized sectors respectively, for each of these services, may in someways be a satisfactory compromise.

Update 1 (17/6/20120

Nice report in the Times about how stringent licensing requirements impose occupational entry barriers. It writes that in 1950, fewer than 5 percent of Americans worked in jobs that required licenses, whereas today, it’s roughly 30 percent and growing. It has this nice illustration of Mancur Olson's famous collective action problem,
This is the pattern that creates regulatory capture — the people with the biggest stake in any regulation are usually the ones who are being regulated. When there’s a public hearing on, say, implementing new rules for trading derivatives, most of the people who show up are the people who trade derivatives. And these people, who generally know the most about trading derivatives, can use their expertise to try to create rules that benefit themselves. In the high-school-­civics model, the insiders would be countered by smart, well-informed opponents who could argue for the public interest. But real life has nothing to do with high-school civics.


HK said...

Between professional training and certification which one is better in your opinion? Is certification better suited for India? It seems so at least for the IT sector: more people from diverse backgrounds have entered the IT services industry through Microsoft or Cisco certifications.

Getting a certification is largely dependent on self-selection and ability, and the number of certificates that can be issued is flexible, so rent-seeking seems unlikely. At least at first sight, the market seems quite efficient.

Anonymous said...

Even without standardization, there do exist checks on service quality. The better skilled (not necessarily better certified) workers enjoy a premium by way of word-of-mouth reputation. They are harder to find for the consumers - possibly because they don't advertise online, nor do they associate themselves with brick-and-mortar service agencies - but they (I presume) are never short of business and remain gainfully employed. The less-skilled often enter as apprentices and enhance their skills by working under supervision.

Besides standardization of service quality, what could be other reasons to organize? Is the unorganized sector (or as some like to call it, differently organized sector) inferior, by definition? Just thinking aloud...