When restricting competition is good

Can restricting competition and creating rents be efficient? No, according to first-best economics. But in the presence of asymmetric information about product quality, rents can be a useful disciplining device to keep firms honest: cheat your customers and reduce your quality and you lose a future stream of rents if your transgression ever comes to light. This is in contrast to perfect competition, under which no-one would have the incentive to maintain quality: if you are discovered, you simply go and do something else, at no loss to your bottom line. 

Sounds like a theorist's construct? Consider how Japan deals with food safety issues in its imports from China: 

Under the system, a number of Chinese companies receive licenses from the government there allowing them to export to Japan on the condition that they maintain Japanese standards. Currently, 45 Chinese companies are licensed to produce spinach for sale in Japan. The Chinese producers must grow all their spinach on their own plots and not buy any from other producers. This greatly reduces the chance of dangerous pesticides getting into shipments, Japanese officials say.

While China has licensed exporters before, this system is more stringent, Japanese and American officials say, in part because the health ministry helps to enforce it by allowing in products only from licensed companies. By contrast, the United States, with its free-market approach, allows importers to disregard China’s licensing system.

Japanese officials acknowledge that their system limits competition, allowing Chinese producers to charge the Japanese consumer higher prices. But they say that this profit incentive also keeps the Chinese companies adhering to Japanese standards — lest they lose their licenses. Tokyo also requires Japanese importers to test every shipment of spinach for banned pesticides and other chemicals.

Read the last paragraph again. It is a perfect illustration of the theoretical principle at work. A second-best world requires second-best solutions.

Comments

[jerry]

Is this different from what the label/brand of "fair trade coffee", "dolphin safe tuna", "no rBST milk" attempt to do?

Could the Japanese licensing run afoul of WTO?

[Dani Rodrik]

jerry --

Very different indeed. In your examples, no government licensing or mandate is involved. Everyone is free whether to consume dolphin-free or not. In the Japanese spinach case, the spinach does not come in the country unless the Chinese government licenses it.

[jsalvati]

I feel like the last sentence is a bit of rhetorical spin, a way of implying that second best solutions are always best, without actually saying it. Perhaps it would be better to say "A second best world often requires second best solutions."

[jerry]

Thanks, I was considering the government mandate, but I couldn't remember if dolphin-safe tuna was mandatory or not these days.

Apart from the government licensing, it seems similar in other ways. Provide a trusted and restricted brand designating an added value with the result being extra profit.

I hope we figure out ways to make trade safer and soon. My suggestion is to take free trade lobbyists and their economic advisors and make them taste imported food, pet food, and toys. This would seem to have the benefit of allowing a free market to operate (while potentially reducing opposition to fair trade practices.)

[jerry]

One more thing if you have time, it's been years since I was in an economics class.

Could the Japanese licensing scheme run afoul of WTO?

[Dani Rodrik]

jerry --

The scheme is run by the Chinese as an export licensing scheme, which is not prohibited by the WTO. If it were an import licensing scheme run by the Japanese, it would certainly run afoul of WTO rules. And no, you would never have learned this in an economics course.

[jerry]

Interesting. Thank you!

[conundrum]

The example is a great illustration of second-best economics at work. But why do we need the Chinese government to make this arrangement work? Ultimately, it's the Japanese consumer who wants high-quality spinach. If so, we should expect brands to emerge that promise and deliver exactly that. The difference to the Chinese licensing scheme it that the market then sets the price premium on high-quality spinach as opposed to the Chinese government. Wouldn't that give you the same outcome but without the kind of corruption and favoritism that often accompanies government licenses? And how does the Chinese government know the efficient level of rents to make this work?

[Zhihong]

Hi Dani , I am a Chinese , and thank you for this very interesting story.

My question is that, if export restriction is good at least in the spinach case, why other countries e.g. U.S. do not follow China and restrict their agriculture export to Japan as well ? How special is China in this example ?

A related and more generial question is what is the condition, apart from the "asymmetric information of quality", under which the "restricting competition is good" argument to be working ?

Thanks for your time.

[aaron schiff]

It's an interesting point, but I'm not sure if this is the optimal policy. It doesn't give consumers who want to make a price/quality tradeoff the ability to do so. Of course no one wants to get poisoned by their spinach. But a single import quality standard might be too high for many people.

I also think that Japan's import quality standards are as much about protecting inefficient Japanese producers as they are about protecting consumers. There have been a number of food quality scandals in Japan lately, and casual observation suggests that domestic producers are not subject to the same level of inspections as imports.

[PC]

Dani:
Is it really a rent, or is it the cost of higher quality? If the Chinese govt. extends the license to any producer who meets the quality standards, wouldn't the result be a competitive one?

[derrida derider]

LOL - this is a policy which is far more about protecting Japanese spinach growers than Japanese spinach eaters.

The giveaway is that they're testing every import of spinach for pesticides. If they're willing to endure the cost of that, why do they need any licensing system? Just test every import batch - as well as all the local spinach - whoever it comes from.

[wjd123]

The scheme is run by the Chinese as an export licensing scheme, which is not prohibited by the WTO. If it were an import licensing scheme run by the Japanese, it would certainly run afoul of WTO rules. And no, you would never have learned this in an economics course.--Dani Rodrik

If the scheme results in only licensed spinach entering Japan, wouldn't this be a second best solution because a first best solution would result in no Chinese spinach entering Japan. That's not a distinction between optimal economic theory and second best theory with rents involved but simply what's possible.

If the distinction is made on theoretical grounds it's a distinction being made below the surface in Wonderland. If it's a distinction being made on practical grounds we don't have to go down the rabbit hole to make it.

From this point of view the Mad Hatter is mad because of the rules of the strange world he inhabits.

[Aqdas Afzal (Pakistan)]

I definitely have mental resonance with the second-best approach to economics. However, I have been doing some thinking:

1) How do we justify state activism, especially when the state is not held democratically accountable -- I have in mind militray governments or technocratic setups (Musharraf in Pakistan or Kenan Evren in Turkey) Does the predicted gains from state involvement in economic growth, more or less, trump the concerns of democratically minded citizens -- i.e. citizens who find a constitutive value in political freedoms? This, I believe, is the moral dimension that second-best economist must contend with.

OR,

2)Are we to assume that whenever second-best economists talk about state activism there is an implicit assumption that the "state" as conceptualized by the second-best economits is essentially a democratic entity with elected representatives exercising control over the different executive departments of the administration?

[Darryl]

I spoke a few times with a Mitsukoshi Dept. Store Rep who travelled monthly to inspect the CHN produce... He enthused about the scheme's benefits like:
encouraging safer farming practices amongst locals, more stable, long-term contracts for farmers, greater range for customers, of course; the massive savings over local produce.. In fact he said, the quota exists solely to appease Japanese political Rightists for whom the issue of "Nationally Independent Food Self-Sufficiency" (read; "Rotten Political Boroughs in the Sticks") was a sacred cow...

There's an endless supply of laid-off Department Store warehouse managers to inspect any multiple of food potentially influxing from China. The Depts. want it, we the customers DEF. want it, as do the trucking companies and the CHinese growers. ALas alack - economics has nothing to do with it. Just a handful of corrupt octegenarian Politicians protecting probably a measly few hundred local nanogenarian rice nurturers...

[Bruce Wilder]

"second-best"?

Or, just a world, where control mechanisms matter a lot to outcomes?

Economists often theorize as if allocative efficiency was the only efficiency worth analyzing. What's makes the analysis "first-best" is the assumption that issues of management and control (technical efficieny) are all handled optimally (and magically, since no institutional mechanisms are specified).

Introducing an institutional mechanism of management control is "second-best".

[Bruce Wilder]

I should have added: with institutional control added to the analysis, economists, apparently, feel they have little to say about what would be "optimal" since their primary model of optimality is one in which problems of error and control are assumed away. So, in second-best land we are left rudderless.

I seriously doubt that what the Japanese are doing is, in any practical sense, optimally efficient. Inspecting every single thing is rarely cost-effective.

But, control of error (aka management and institutions) is an inherent aspect of production processes. Assuming away those problems is ridiculous and silly -- just a libertarian fantasy-land where Somalia is an economic paradise. Calling the real world -- the only one we have, where control matters quite a lot, "second-best" seems an odd dodge, when the real work remains figuring out what is best. The first-besters are just assuming away the problem; the second-besters are doing what exactly? Looking on in bemused awe?

[Larry]

A few additional facts would help evaluate the case.

How much does the scheme add to the cost?

Have any producers actually lost their licenses (and should some who haven't?)

Has Japan had any problem with Chinese food quality?

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