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Regulators Are Not Heroes

Adam C. Smith
Stewart Dompe

Amazon is suing thousands of “fake” reviewers, who, for a fee, have posted positive reviews for various products. These pseudo reviews violate the spirit — and possibly the functionality — of Amazon’s largely self-governed rating system. Customers rely on reviews to guide their own choices, and a wave of sponsored reviews can mislead them into choosing inferior products.

A similar theme plays out in George Akerlof and Robert Shiller’s newest behavioral economics-cum-self-help book, Phishing for Phools. The authors, both Nobel laureates, claim that an unregulated market leads to massive amounts of manipulation and deception. Just how much remains unspecified, but the general thrust of the argument is that regulatory heroes are needed to rein in villainous dealers.

Heroic Regulators?

It is no surprise then that the authors favor heroic efforts of an older progressive sort, such as the works of Alice Lakey or her modern-day counterpart Elizabeth Warren. Their work, respectively, led to the establishment of the Food and Drug Administration and the Consumer Financial Protection Bureau. These progressives are seen as heroic for taking “action not selfishly but for the public good.” The trouble with such heroes, however, is that they invariably focus not on educating consumers so that they may make better choices but on corralling the cat herd of bureaucrats and politicians into ever-expanding spheres of regulation.

While it is true that consumer regulation can provide focal points that help buyers and sellers interact — in fact, Amazon appealed to just that in its lawsuit — this truth nevertheless misses the pivotal point (and an awkward one for Akerlof and Shiller) that it is Amazon that is working to resolve the problem, not government regulators.

Make no mistake. Akerlof’s classic paper on the quality of goods in a world of imperfect information clearly outlines a problem that markets must address, but it is a problem for both consumers and the market platforms on which they participate. Those platforms have a natural incentive to promote the information consumers need in order to make more informed decisions. The incentives faced by regulators are less well aligned with consumers’ interests. (But advocates of regulation rarely ask what incentives drive government regulators.)

There is another aspect of Akerlof’s model that is telling in this regard: in equilibrium, the so-called “lemons market” should unravel as more and more consumers become frustrated with ever-decreasing levels of quality. Thus, the market platform should topple over. The trouble with this theoretical outcome is that it again fails to account for the empirical observation that it is markets that are solving market problems.

Find a Portuguese translation of this article here.

Akerlof’s co-recipient of the 2001 Nobel Prize, Michael Spence, would have no trouble with this observation. Spence noted that it is far more interesting to compare the outcomes in the market to what is possible in a world of incomplete information, not to what is found where no imperfection exists by assumption. Spence explained in his Nobel address that when facing a world of imperfect information, the asymmetry between buyer and seller “cannot be simply removed by a wave of the pen.”

Compared to What?

Even when we acknowledge that individuals may be limited in their analytical and decision-making capabilities, we must ask ourselves, “Compared to what?” As noted elsewhere in these pages, every flaw in consumers is worse in voters. Furthermore, the immediate call for greater government regulation ignores the ongoing knowledge problem: acquiring information is limited by the abilities of normal people (after all, we can’t all be heroes). Knowing which transactions to avoid is valuable information, but that knowledge must first be discovered to be shared. If this information is not readily attainable, then it is unclear how regulators will know what market processes to target, much less how to improve on them.

And if the information does exist, then there is an opportunity for entrepreneurial action to gather this information and sell it to consumers. Put another way, market failures that cause individuals to make poor decisions are themselves profit opportunities for entrepreneurs to help people make better decisions.

In a world of uncertainty, ensuring quality can be a powerful competitive advantage. Amazon wants you, the customer, to use its search and recommendation system to buy new products, products that you cannot physically touch and inspect. The review system is one method of overcoming this informational asymmetry. When the integrity of the review system is challenged, Amazon is faced with the prospect of a lower volume of transactions and therefore lower profits.

Private Heroes

This is why Amazon is acting to curtail its rogue members. Retailers can only justify high prices when they can guarantee quality. Amazon’s feedback system constitutes a significant informational subsidy to its users, and the company is willing to create this information (or have it created by users) because it leads to a higher volume of trade and the accompanying consumer benefits that Amazon brings to book readers worldwide.

What Akerlof and Shiller miss is that creating and maintaining a viable platform for trade opportunities is enormously expensive. Having customers exit the door to never return — or perhaps write negative Yelp reviews — causes instability to the market that can be fatal if left unattended.

Rather than focusing on the failure of consumers, the original sin of our humanity, we should instead notice how information entrepreneurs are enabling us to make better choices. The information revolution led by these innovators has changed the world with the costs of distribution lower than ever. These may not be the welfarist heroes of Akerlof and Shiller’s fantasy world but market troubleshooters of the one we actually occupy.

Public-spirited regulators may be the heroes we want, but they are not the heroes we need.

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