Published on Let's Talk Development

Too Small to Regulate – A Blog

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Informal industries and markets, with many small producers and suppliers, are generally more difficult to regulate than their organized counterparts, dominated by larger corporations. 

Adulteration of food, for instance, is more common in small, informal outlets than when sold by large, branded firms. It was part of the lore in South Asia that milk bought from small, informal cattle owners would be adulterated with water (which on charitable days may be viewed as traditional technology for converting 4%-fat milk to 2%). A recent study in Barisal District of Bangladesh  found that while small percentages of milk samples had different kinds of adulteration, when it came to added water, 100% of the samples had it. 

When we buy new cars, produced by large companies, we have reasonable confidence that they will meet with regulatory standards of safety. The uncertainty is much greater when we buy used cars from one of a multitude of small traders dealing in used cars. Small informal moneylenders indulge in egregious practices which are relatively less pervasive among larger banks and cooperatives, and not surprisingly efforts are under way in almost all countries to displace the informal lender with more organized banks.

Regulation is a part of the life of a market economy, from the behemoth banks to the seemingly informal farmers’ markets. While the details and extent vary from one nation to another, in all modern economies, restaurants are required to comply with health standards, there are specified hygiene safeguards for hospitals, and factories are expected to adhere to certain environmental standards. 

The reason regulation is needed is that, as Nicholas Kristof argues in one of his recent columns, a firm’s “business case” does not always coincide with what is socially desirable. Many actions have harmful side-effects on bystanders who are not party to the decisions---“negative externalities” in the language of economics. It is not in the interest of the firm, on its own, to pay heed to the negative externalities it inflicts. Regulation, with carefully calibrated penalties, can help bring a firm’s profit-maximizing motive into alignment with society’s overall interests.  

Given this ubiquitous need for regulation, it is important to understand the conditions under which regulation is effective and conditions where it is likely to be violated. In our recent paper, ‘Too Small to Regulate’: we argue that this has little to do with the formality or informality of firms per se, and a lot to do with their size. An industry with a few big firms is likely to be easier and less costly to regulate than a competitive industry with many small firms. 

The reason, in essence, is simple. Consider the milk industry in a developing country and two alternative scenarios. One, in which there are a thousand small, independent cowherds selling to lots of consumers, and another where these thousand sellers are part of one corporation selling a branded product. In the former case, if a seller is found adulterating milk the maximum fine that can be imposed and collected is fairly limited. First, to create a sufficient threat of detection for each of many individuals requires a lot of costly inspection; second, a small cowherd has only a small amount of income that can be taken away by a fine. 

Next consider the scenario with the large corporation. If any one of its outlets is found adulterating milk, the punishment that can be extracted is much greater, namely the profit from all its outlets. Therefore much less inspection suffices to create a threat large enough to deter the corporation. 

A little algebra makes this argument rigorous. For that and other details of the argument we have to direct the reader to our full paper cited above, but it is worth pointing out here that this argument leads to a novel view of the concept of public private partnership (PPP). When economists and policymakers speak of PPPs they usually mean partnerships in production, on how different parts of a large effort to produce a good or a service can be carved out between the private and public sectors.

What is more rarely talked about is how the state’s regulatory function can be parceled and delegated to private corporations. By private corporations we do not here mean private firms created to carry out some government administrative tasks, which is quite common, but private firms engaged in routine production and sales for profit, being made to take on some of the tasks of regulation and administration. 

There is nothing novel in the general idea of incentivizing and making firms do what is good for overall social welfare. This is what a lot of the mechanism design literature is about. But the link between market structure and regulatory efficacy is more novel and certainly has had no play as a policy instrument. What is being argued here is that if we want better compliance with environmental, safety, health and others standard, it is imperative to pay more attention to the link between firm size and enforcement.

This argument is likely to meet with resistance because of the widespread belief that small is beautiful; and the human resistance to admitting diverse views, even when they are non-contradictory—in this case recognizing that small may be beautiful, but large is transparent. 

It should be emphasized that ours is not a general case for large firms. We do not deny that competitive industries keep prices lower for consumers and generate more total economic surplus than monopolistic or oligopolistic firms. What we are arguing is that in today’s world where the regulatory tasks are large and multiplying, it is critical to recognize that large firms are better vehicles for taking over some of these ‘governmental tasks’. This is a trade-off that has to be kept in mind when we design national antitrust and competition policies.

It is also important to disabuse ourselves of the confusion between big firms and inequality. It is true that large firms are often owned by super rich individuals, but that does not have to be so. It is possible to have large organizational structures with well-distributed ownership. That is a debate that we are not going into here, but what needs to be stressed is that the argument for better regulation through large firms must not be equated with a defense of income or wealth inequality.     

Much has been written  recently  on how in the context of banks and investment corporations the doctrine of too big to fail (TBTF) raises troubling questions. So much so that, among the alternative reforms to deal with this problem, the IMF has recently discussed the option of trying to limit the size of such firms. Once again, there is no denying that big firms can be a problem in the light of the potential collateral damage that their failure can cause. All we are arguing is that alongside the recognition of the problem of TBTF, there is a case for being aware of the arguably more ubiquitous problem of TSTR—firms being too small to regulate. 


Kaushik Basu

Former Chief Economist & Senior Vice President of the World Bank

Avinash Dixit

John J. F. Sherrerd ’52 University Professor of Economics Emeritus, Princeton University

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