Government regulation and market failures: Microsoft and IBM case studies

Role of Government

Government economic regulation occurs when: (1) undesirable market structures exist (i.e., fewness of firms); (2) there is a desire to control or dilute large power blocks in the economy (e.g., the strategic position of utility companies). (3) the market or other conduct of a firm is judged to be socially undesirable (e.g., unfair pricing policies); (4) there is a perceived need to conserve and efficiently use a natural resource; and (5) significant negative economic externalities (e.g., pollution) are associated with a firm's activities. Government social regulation focuses on firms' impacts on people as employees, consumers and citizens. The primary reason for economic and social regulation is to correct perceived or actual market failures.

Increasingly, people are saying that government regulation doesn't appear to be working. Some of the more cynical have developed villain theories or power theories that hold that powerful groups can solve problems, but they simply don't want to because the solution would not be to their advantage. Others believe in the conflicting objectives theory that states that issues and complex and have competing objectives that make it difficult to design effective solutions. However, the findings of this paper are than government regulations are failing because trying to alter market dynamics doesn't work. True, the dynamics of the market created the market failure, but the dynamics of the market will eventually resolve it as well if only given a chance.

2.0 Market Structure, Power and Conduct

Proponents of government regulation argue that the government has a responsibility to ensure that no one company controls an industry to the point where the market is not competitive. Monopolies can cease innovation and force people to pay exorbitant prices for its products. However, monopolies don't necessarily thrive because of unfair business practices. In 1994, the government accused Microsoft of using its more than seventy percent share of the personal operating systems market to prevent competition. However, what the case revealed was that Microsoft dominated the industry because of its innovation, solid marketing and successful products offered to the market at very affordable prices, exactly those factors that monopolies are supposed to impede. In January of 1969, the United States Department of Justice filed an antitrust suit against IBM to break it up into smaller, competitive companies because it controlled almost 70% of the computer market at that time. In 1982, the case against IBM was ruled to be "without merit." Even so, IBM did not continue its market dominance as advocators of government regulation for this company had asserted that it would. Instead, the company began to falter after a series of product failures. As a result, many companies gained market share against IBM with some even over taking it. These Microsoft and IBM examples illustrate how true market forces compel monopolies to act in the interest of the consumer and that government regulation isn't really necessary to accomplish this.

The prices of goods and services shall be set in accordance with domestic supply and demand with the consumer as the ultimate regulator because government regulation of prices eliminates price competition. The economic effect of regulating prices is to fix marginal revenue for the sale of a product at the regulated price. Thus, the seller has to adjust its marginal costs so that they equal the marginal revenue. If the size of the operation at that level of cost is anything other than the most efficient size in the long run, there will be inefficient allocation of resources, resulting in over-investment in some industries and over-investment in others. Of course, this waste in bad for the consumer, the very person the price control was intended to help.

3.0 Negative Economic Externalities

One form of market failure, a negative externality, arises when the actions one party result in a benefit or cost accruing to some external party that did not consent to the impact. Examples of negative externalities might be a manufacturer that irresponsibly releases pollution or consumes scarce natural resources. Market failure results because the manufacturer bears no costs for its actions; instead, costs are imposed on downstream parties that did not cause them. Advocates of government regulation believe that it can correct this type of market failure by imposing standards or fees to force firms to internalize some of these social costs. but, the United States environmental regulatory system that was set up in the 1970s has offered the regulated community little flexibility in how best to achieve environmental performance goals and has focused on solutions that have provided little incentive to the regulated businesses to move beyond compliance.

A better approach to government regulation for dealing with negative externalities is to approach this type of market failure from an information asymmetry perspective. Information asymmetry refers to variations across persons in the amount and quality of information about the characteristics of a good. There is ample evidence to suggest that there is a positive link between environmental and financial performance:

Boston nonprofit, Alliance for Environmental Innovation, reviewed 70 research studies in 1998, all of which found a positive relationship between environmental and financial performance. Companies that outperform their peers environmentally were also found to perform better on the stock market by as much as two percent.

The Storebrand Scudder Environmental Value Fund, launched in 1996, uses nine ecoefficiency criteria to select firms that rank in the top third in environmental performance within their industry sector. The fund grew 51% between 1996 and 1998, and outperformed the comparable Morgan Stanley international World Index by eight percent over the same period.

1996 study by ICF Kaiser Consulting Group that looked at 327 S&P 500 firms found that companies could push up their stock price by as much as five percent by improving their environmental performance.

Given that firms are and should be driven by motivations for profit, the above data suggests that the government would be well served to collect and disseminate corporate environmental performance information to correct negative externalities which are really a problem of information asymmetry. In this way companies will look at their own operations and decide what measures will help them meet their goals rather than having to follow one-size-fits-all government regulations.

5.0 General Regulatory Issues

Along with government regulation comes inefficient and costly bureaucracy because government is not faced with market forces that make private businesses perform well. Those in favor of government regulation say that the system can be fixed, but as Ludwig von Mises explains,

It is a widespread illusion that the efficiency of government bureaus could be improved by management engineers and their methods of scientific management.... What they call deficiencies and faults of the management of administrative agencies are necessary properties. A bureau is not a profit-seeking enterprise; it cannot make use of any economic calculation.... It is out of the question to improve its management by reshaping it according to the pattern of private business. "

Also, according to Ludwig von Mises, "All such deficiencies are inherent in the performance of services which cannot be checked by money statements of profit and loss." Government regulation is also inefficient because it doesn't actually create value.

All it is really accomplishes is forcibly transferring wealth from one party to another.

These transfers can actually create new market failures by forming barriers to market entry, and creating unfair competitive advantages through subsidies, tariffs, tax-breaks and regulations that favor one party over another.

Fundamental to the notion of government regulation is that its purpose is to eliminate unfairness in competition. However, powerful businesses have huge influences on policy making in the United States that make this an ideal rather than a reality. They hire lobbyists, create ad campaigns, and court politicians to gain influence. Companies compete for bureaucratic power just as much as they do for market power.

Because of the advantages government regulation can offer, firms try to out-regulate each other rather than to just out-compete each other in the market. Government regulation has invited businesses to become involved in government and the best way to put an end to this is to get government out of business.

6.0 Conclusion

Government regulation isn't working, but it's not because of evil people or because issues are too complex and having too many competing objectives to resolve. Adam Smith was right when he coined the metaphor of the invisible hand to illustrate how those who seek wealth by following their individual self-interest, inadvertently stimulate the economy and assist society as a whole. Markety dyanamics, by their very nature, are more efficient because all factors possible are considered and because the consumer is the better regulator as the laws of supply and demand eventually take hold. In the interim, there are market failures, but government regulation doesn't fix them.