So , what questions should we ask in order to make an appropriate economic assessment ? First , identify the market failure ( e . g . few firms or disproportionate market shares , high transaction cost or information asymmetry ). Second , understand what is causing this market failure ( e . g . a changing macroeconomic environment , patents or ineffective / inefficient policy ). Next , is this failure just an intertemporal shock ? ( i . e ., is it sustainable in the long run or is it only perceived in the short run ?). It is then that we can establish if the correct course of action is more regulation , less regulation or even doing nothing at all .
Let ’ s go back to our previous example . If the only market failure is product heterogeneity , we know by Hotelling ’ s law that other companies would try to replicate that product . In that case , no intervention would be necessary as new firms would enter the market seeking higher profits , and competition would bring prices down towards marginal cost . However , it would be a very different circumstance if heterogeneity of products would be combined with other market failures such as barriers to entry and high transaction costs . Under this scenario , new firms would not be able to enter and compete against the incumbent firms . Furthermore , theoretically , some incumbent may not be able to develop similar products if an extensive due diligence or an accreditation / registration process is not suitably amortized in their cost structure . This is what economists would call a first mover ’ s advantage . Therefore , it seems as some market failures , as it is the case for barriers to entry and transaction costs , could be mitigated or even eliminated by deregulation . Reducing barriers to entry such as reducing inefficient taxes / laws or reducing transaction costs by eliminating unproductive bureaucratic could promote competition .
Although it is now tempting to conclude deregulation and laissez-faire economics will always be the correct response , the doctor could be prescribing acetaminophen to a patient with liver problems . What happens in a market with few firms ? Having a few big firms playing could lead to cartels and collusions or having one dominant firm would lead to monopolistic prices . Again , ask the patients all the questions . Once we have identified the market failure as having one or few firms controlling the market , ask : what is causing this scenario ? Is this condition the result of a macroeconomic external shock and only the efficient firms survived or one of the firms started acquiring and merging horizontally ? The latter might need some further analysis . If one firm is allowed to buy smaller firms without restriction , it would eventually have the means to become a dominant firm or a monopolist deterring a new firm when entering the market . Evidently , this is why most countries have antitrust laws and regulate anticompetitive behavior providing a great example of when regulation is needed .
In conclusion , before implementing a new policy , a policy maker should remember : is water a solid , a liquid or a gas ?
³ An observation that suggests that , in the long run , after playing enough moves , firms would supply similar products after learning what consumers want in a product .
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