Firm Survival and Regulatory Challenges in the Industrial State
Survival in market is no doubt an anxiety-inducing occupant of a business owner’s mind. Here I discuss a simple but general solution for a firm to harness market power and insure itself against the threat of economic circumstance in the industrial state. The solution is for the firm to ramp up fixed costs, establish a ‘brand’, and consequently separate itself from the market. This solution we shall refer to as ‘scaling’, and the businesses that scale successfully we shall refer to as ‘separating markets’. These markets not only present less of a challenge to the regulatory state, but, in the very fact of separation, they also solve some of the informational problems that would have otherwise rendered these markets less than efficient. We will then contrast separating markets to businesses that produce generic goods. The market for a generic good is, in essence, a pool of the businesses that produce it. Hence, we refer to these businesses as ‘pooling markets’. Competition in pooling markets, paradoxically, risks business survival and descends these markets into a state of rampant failure.
Oligopolies and monopolistic competitors as separating markets
Any study of economic principles begins with a fixation on competitive markets in which survives only the most efficient, market-led producers. The all-important parameter of price is a given to all firms. No firm can afford to fall behind, and even the most efficient firm counts, everyday, on favourable conditions of market demand tomorrow. Economic security is hardly a notion. Yet, competition has eroded away even in markets that are seemingly competitive. The reason for this is as follows: even when important parameters are out of the firm’s sphere of control, business savings and wealth accrued over time mean that fixed costs can be artificially ramped up and the quality of the firm’s goods and services may be improved. A marginal increase in price is sufficient to more than offset the newly incurred fixed costs over time. We shall interpret this as the general scheme under which a competitive business is able to extract profits. The chemist becomes a giant pharmaceutical by investing its intellectual efforts and time to warrant a patent and enjoy the profits made possible by it. The barbershop splurges on opulent decorations whose costs do not come as a function of the number of customers it serves, and therefore is able to spread these costs across customers over time.
Even though scaled economies are able to ramp up profits by way of fixed costs and a bit of patience, they are nevertheless exposed to the risk of non-recessionary contractions in demand. Fashion fall out of taste to considerable degrees and at considerable speeds. It would be especially tragic were it to happen before the expiration of patents from which arose the chances of profits. But with the scaled economy’s newfound cash in hand, demand is contrived and sustained by two initiatives: marginal innovation and marketing. Year on year, salesmanship serves to overblow the extent of this marginal innovation and convince the mass that some new iteration is an ever-so-necessary production. A car manufacturer needs only to supersize the dashboard screen, or redesign the rims and headlights, in order to sustain demand year on year. Trends are kept afloat by the annual excitement of a new release, made possible to the firm by the devices of marginal innovation and marketing. In the short-run, scaling, marginal innovation and marketing suffice to establish the firm as ‘branded’, or reputable. The brand, or reputation, separates the firm from the market as a whole. It goes without saying that an opulently decorated barbershop is known for its relative opulence in the midst of all other barbershops within its vicinity. A Volkswagen is appreciably distinguishable from a Chevrolet even to the least trained eye. Reputation makes the firm a market itself, and these markets are known in principle as ‘oligopolies’ or ‘monopolistic competitors’, depending on the extent of scaling and the harshness of its marketing campaigns. We refer collectively to these oligopolies and monopolistic competitors as ‘separating markets’.
In the long-run, and especially so within concentrated industries, marginal innovation is insufficient to ensure the long-run survival of firms. Increases in fixed costs over time stave off potential competitors, and the presence of only a few firms means that auditing by the regulatory state is relatively easy. Not only that, but separating economies, even as it has wielded recognition and market power, has turned itself into a signalling institution. A car manufacturer fitting defeat devices inside the exhaust system of its cars (an illegal and wholly substandard practice) can expect not only to be caught in the act by the regulatory state, but also by its pool of consumers. If Volkswagen fits defeat devices in its cars, then only the company incurs the regulatory fines, only its management is subject to public angst, and only its showrooms see the number of its visitors dwindle to new lows. On the other side of the market, its competitors receive more than just a nod of trust. It follows that the firm’s best response, to the economic circumstance I have thereby described, is compliance to standards and law.
In principle, what I have described above is a phenomenon in the kind of a reputation game. When a firm has accrued sufficient market power, it automatically also accrues a signal. This signal puts the reputation of the firm at stake. When consumers can pick out the produce of a firm from that of another’s, as is the case amongst separating markets, the firm can only best-respond by seeking to preserve it. Surprisingly, market power paves the way for tolerably efficient outcomes. It solves, to an appreciable extent, asymmetries in information, which, in the new industrial state, is an ever-so-endemic problem. The same cannot be said of pooling markets, an issue to which we now turn our attention.
Generic goods and failure in pooling markets
Quite a large proportion of the economy is devoted to the production of generic goods. This is especially true in the more impoverished parts of society. The production of meat and offals, fruits and vegetables, electrical appliances and construction materials as generic goods tend to involve those that, by chance or by economic necessity, have not been able to ramp up fixed costs so as to separate themselves from the market. These markets subsequently cater to the poorer masses, to whom the information rent (or the ‘brand premium’) of separating markets is unaffordable. As such, businesses in pooling markets exist in squalor and are rather much poorer than its counterpart. This poverty is interpreted as an explanation for why fruits and vegetables are never advertised: businesses advertise quality that have been brought about by ramping up fixed costs. For businesses in pooling markets, there is little room for fixed costs to play a role, and so, there is simply little to gain from advertising.
The problem in pooling markets is rather serious and chronic. As the firm competes to become the most productively efficient, it begins to adopt the most offensive practices in the industry: the inhumane treatment of cattle, the injection of water into meat, the cutting of cocaine, the use of radioactive substances in cement, the alloy in place of the pure, become standard practices under strategic equilibrium. These arise as a result of, firstly, the simple inability for the regulatory state to effectively conduct audits, and secondly, the negative externalities of ‘cheating in the market’ due to the lack of a signalling mechanism. I elaborate this below.
Recall that separating markets have a real incentive not to cheat. Of course, it is likely that they are discovered. But more importantly, cheating brings about a positive spillover effect on other firms in the market as a whole. In the wake of the Volkswagen scandal, we were able to witness the real fury of consumers, some of whom vowed so diligently never again to purchase a Volkswagen. Its competitors automatically absorb this vacuum of supply. In pooling markets, this is far from true. The existence of a ‘screw up’ messes, in an adverse manner, with the market entire. When only a small proportion of cabbage is found to have been contaminated with harmful insecticides, disdain is directed not towards the handful of farmers that have used it, but rather to the market as a whole, given that it is difficult or impossible to trace cabbage to its farmer. The rest of the farmers, benevolent as they are, bear a significant burden as a result of this contraction in demand. The bad farm shares its melancholy with the benevolent farm. The benevolent farm employs good but costly techniques, and while it cannot signal its benevolence, its profit margins are relatively low. A shock in market demand caused by the handful of bad farms can easily wipe out the benevolent farm’s prospects for business. It follows that the best strategy for businesses in pooling markets is to leverage the lack of a signalling mechanism and employ the most vulgar techniques of production. By way of outright prohibition, the bad producer will cease to exist in the legitimate sector, but so too will the honest producer. From this it follows: if pooling markets were to exist, then it must exist in squalor.
It is worthwhile to take note that what I have just described is not just a simple Akerlof ‘lemons market’. In the markets for used cars and other durable goods, there is a simple solution to information asymmetry. The seller of high quality signals its type by way of warranty. This warranty works simply and sufficiently because durable goods are, simply put, durable, and may be returned to the seller. Signalling is contrived by the physical possibilities of refund and replacement. The same is not true of consumable goods. Moreover, after only a few runs, the owner of a used car can easily pick out the issues that fall short of what the warranty specifies: a damaged door lock or an air-conditioning system that fails its task. On the contrary, the effects of plastic contamination in crabs and other seafood products may simply go unnoticed by the myopic consumer. Only in the long-run may it take a noticeable toll on his health, and even then, that he correctly attributes this effect on his prior consumption is not guaranteed. Finally, even if the consumer attributes his illness to prior consumption, he will sleep, every night, on the question of whether it was the insecticide on his cabbage, or the plastic in his crabs. Subtle differences in the nature of goods make a world of difference in market outcomes.
The Takeaway
The point of this essay is to shed light on an important but often unnoticed trade-off: in practice, as markets become more competitive, signalling mechanisms start to fail, strategies start to become vulgar, and outcomes start to turn inefficient. In theory, this phenomenon muddles the definition and desirability of what we have come to know as ‘productive efficiency’. Nothing in theory reconciles with how businesses in pooling markets squeeze out costs of production and, along with it, the very quality of its products. While the risks of bankruptcy associated with the use of good business practices are real, and signalling is more or less impossible, pooling markets are full of squalor and filth. The poor are themselves poor, while the markets they seek refuge in, harsh and unaccommodating.
The effect is even multiplied. In the new industrial state and as a result of specialisation, countries monopolise over the production of generic goods. There are many rice mills in Cambodia, in much the same way as there are many meat factories in Vietnam. If a few meat factories taint the market, as it should by the rationale of profit maximisation, then, provided that the tainting is sufficiently foul, border control in other countries respond by curbing the general import of meat from the country in which operates the foul player. This is done so at least indirectly: even if border control screens and lets in only good meat, it is much too late. The government, in facilitating this screening mechanism, has warned its people of the hazards associated with meat produced in the particular economy from which it is imported. The rest is behavioural economics.
While separating markets do not produce the right amount at the right price, their techniques of production are tolerable and the quality of its goods, more than sufficient. The practice of economics is therefore not about the concoction of efficiencies everywhere, it is rather about balancing out, in the best possible manner, inefficiencies in markets.
