Free Our Markets

by Howard Baetjer Jr

  Salons are not the only business enterprises with a financial stake in their stylists’ competence. To return to the case where an injured customer sues a negligent salon for harm she has suffered there, suppose the judge rules in favor of the customer, ordering the salon to pay damages. Who would probably write the check for the damages? Probably not by the salon itself, but the salon’s insurance company. And what is the insurance company’s incentive with respect to the competence of the hairdressers in salons it insures? The more competently and safely the hairdressers work, the lower will be the payments the insurance company has to make to injured parties; therefore, the insurers of hairdressers also have an incentive to require reasonable standards of hairdresser competence and training. Possibly insurance companies would refuse to insure salons that hire hairdressers with no recognized diploma or certification of competence, or charge those salons higher premiums.

  Notice that all the market-regulating factors mentioned here are regulating hairdressing now, alongside the state governments’ licensing requirements. Which is more effective in assuring the public health and safety, not to mention good haircuts? When you go for a haircut, reader, which do you rely on more?

  I believe market forces are so effective that licensing is entirely superfluous in assuring health and safety. The only meaningful effect of hairdresser licensing is to reduce consumer choice and raise prices, as we discussed in the last chapter.

  Let us generalize from the hairdressing thought experiment above: The elements of regulation by market forces that we have identified are:

  Freedom among service and goods providers to enter the market and compete for buyers

  Freedom of buyers to take their business where they will

  Reputation of sellers, and customer experience spread by word-of-mouth

  Tort liability, a legal means by which people can recover damages if they are harmed

  Requirements imposed by insurance companies as conditions of insurance

  Third-party certification of product quality and service competence

  In a free market, these market forces would regulate the provision of virtually every good and service. Like other aspects of the free market, they wouldn’t work perfectly because human beings are imperfect. But they would work well.

  The last element in the list, third-party certification, is important enough to deserve extra treatment.

  The Role of Competitive, Third-Party Certification

  In any business with freedom of entry, competition and reputation by themselves do a great deal to assure customers of the quality of the goods and services they purchase; because when a provider does not perform well, dissatisfied customers leave and the word gets out.

  But that does not and should not satisfy most of us. We want protection from unsafe, defective, or otherwise poor quality goods and services before they go on the market. Unfortunately, many people believe that only government regulation can provide that protection.They make a tragic mistake in this, because in supporting government regulation they open the door to all the abuses of regulatory capture we discussed in the last chapter.There is a superior free-market alternative: voluntary, third-party certification.

  In free and competitive markets, goods and service providers have a strong profit-and-loss incentive to provide assurance of the quality of their products. Their customers want such assurance. Their insurance companies are eager to have it. And the companies themselves are eager to provide it. To do so, they often turn to independent third parties in the business of testing for and certifying quality, safety, or competence as the case may be. Under freedom of exchange, of course, goods and service providers would not be required to secure such certification, but market forces would motivate them to do so. A variety of enterprises would arise that set standards, test for quality, and provide consumers with information.

  In hairdressing, various beauty schools provide certifications of different kinds of competence. Another private-sector incentive for hairdressers to receive training comes from the manufacturers of hair care products. I learned about this from one of my students some years ago. A licensed hairdresser himself, he explained that the makers of certain hair-coloring and styling products will not permit a salon to sell those products unless and until the salon’s employees have been trained in how to instruct customers in their use. Hair care product makers don’t want their reputations damaged by customers’ getting poor results because they misuse the products. Accordingly, salons that want permission to sell these products have a profit-based incentive to insist that their stylists receive the required training.

  Consider the business of servicing automobiles. In Maryland, where I live, no license is required for auto mechanics. Service stations are legally permitted to hire as mechanics people with no training or credentials whatever. The Exxon service station near my house, however, has two signs advertising that its mechanics are all “ASE certified.” ASE is the National Institute for Automotive Service Excellence. Its website declares:

  The independent, non-profit National Institute for Automotive Service Excellence (ASE) was established in 1972 to improve the quality of vehicle repair and service through the voluntary testing and certification of technicians and other automotive service professionals. [my emphasis]

  Why would profit-seeking service stations pay to have their technicians tested and certified by ASE when no regulation compels them? They do so, of course, to improve the quality of their technicians’ work, enhance their reputations, and thereby attract more business. For the technicians themselves, the ASE courses are an investment in their own skills and earning power. ASE offers a wide variety of certifications in specialties such as alternative fuels, medium/heavy trucks, school buses, undercar, damage analysis and estimating, and many others. Customers benefit.

  Another illustration of how incentives in the free market lead to voluntary, third-party certification of product quality comes from a recent New York Times article:

  With huge losses from food-poisoning recalls and little oversight from the federal Food and Drug Administration, some sectors of the food industry are cobbling together their own form of regulation in an attempt to reassure consumers. They are paying other government agencies to do what the FDA rarely does: muck through fields and pore over records to make sure food is handled properly.

  Even though government officials are supposed to check on and assure food quality, they don’t, at least not to the satisfaction of the California lettuce and spinach growers discussed in the article. But the profits of the growers depend on their producing safe and healthy food and assuring their customers that it is safe and healthy. Providing that assurance requires independent inspections, so the California growers formed the Leafy Green Products Handler Marketing Agreement which pays for their own inspection system. Driven by profit-and-loss incentives, the growers are regulating their own products and processes because they have found their official FDA regulation to be ineffective and insufficient.

  Participation in marketing agreements is voluntary, but in California, more than 95 percent of the leafy greens industry signed up, in part because major processors like Dole and Fresh Express agreed to participate. Produce growers had little choice but to follow.

  Consumers benefit.

  Because nearly all enterprises in an advanced economy carry liability insurance, insurance companies are a powerful regulating force in free markets. Insured companies prefer to pay lower premiums rather than higher, and insurance companies prefer to pay fewer and smaller claims rather than more and higher claims. Accordingly, insurance carries with it strong incentives to keep goods and services safe.

  Indeed, insurance companies have a strong incentive to regulate—set appropriate standards for—the quality and safety of the products of companies they insure. This incentive led to the creation of perhaps the largest and foremost of third-party certifiers, Underwriters Laboratories (UL). “Underwriter” means “insurer” in this context.

&nbs
p; Underwriters Laboratories is an international organization that “evaluates more than 19,000 types of products, components, materials and systems annually with 20 billion UL Marks appearing on 72,000 manufacturers’ products each year.” UL originated at the 1893 World’s Columbian Exposition in Chicago, where newly-invented electrical power was both dazzling attendees and causing fires. Fire insurance companies needed guidance as to the safety of electrical appliances and the resistance of different materials to fire, so they provided the funding for what became Underwriters Laboratories in 1901. Let us emphasize that bit of history: Private, for-profit insurance companies, responding to market incentives, created an independent standard-setting and certifying organization. UL has no authority to require manufacturers to obtain its certification (the now-famous UL product safety mark). Nevertheless, thousands of companies voluntarily seek UL approval and design their products to UL standards. Though created to serve insurance companies by certifying for them the safety of products they insure, UL serves manufacturers at the same time by helping them improve their product designs. The benefit to consumers is obvious.

  A crucial element of quality and safety regulation by market forces is competition among certifiers, not just among service providers or goods producers. This competition, or even the potential for such competition, tends to hold certifiers to meaningful standards at reasonable cost to their customers. The process is another instance of how profit and loss guide discovery of the enterprises, products, and processes that create the most value for the public. Competition among certifiers spurs innovation in the standards themselves and in techniques for assessing quality. UL does not have a legal monopoly on product-safety certification; rather it faces numerous competitors including ETL SEMKO, The Canadian Standards Association, and a variety of specialized certifiers of products in particular fields. ASE competes with a wide variety of technical schools that offer their own diplomas in auto repair and maintenance. Other competitors are automobile manufacturers, such as Audi, Mercedes, and Volvo, which offer their own training programs for mechanics who want to specialize in servicing their brands. This competition drives UL and ASE to hold their standards reasonably high, but not so high as to be burdensome, and to develop a variety of different categories of certification in response to their customers’ needs.

  I experienced competition among certifiers directly, once, when shopping for a present for my wife. One jeweler I stopped in on (on word-of-mouth recommendation from a friend) showed me a pair of what he said were very good diamonds that could be made into earrings. They were pretty. They were also expensive. Trying to persuade me to buy them, the jeweler brought out certificates vouching for their high quality. As I looked over the certificates, he pointedly said, “You see these are not from the Gemological Institute of America.” He said that, in the industry, that organization was suspected of grading diamonds too generously in order to please some jewelers willing to overstate the quality of their stones; he did not want any suspicion on the grading of the diamonds he was showing me. Accordingly, he had paid extra to have them certified by the European Gemological Laboratory, a more reputable institution, according to him.

  Two years later I read in the newspapers of allegations that graders in the New York laboratory of the Gemological Institue of America (GIA) had taken bribes in exchange for higher-than-deserved ratings. GIA had already acted to protect its reputation with an internal investigation, and it fired four New York employees. The episode bore out the jeweler’s suspicions about the GIA.

  Two lessons emerge from this story: One is that regulation by third-party certification will not work perfectly. No kind of regulation can work perfectly, because human beings are imperfect; we are prone to both honest error and dishonest dealing. That, of course, applies to both private-sector certifiers and government regulators.

  The other lesson is that free competition among certifiers pushes them to offer a good product at a reasonable price just as free competition among goods and service providers pushes them to do the same. When customers have a choice among certifiers, malfeasance or shabby work tends to be discovered and corrected. This is the main reason public policy should not grant any government regulatory body a monopoly on licensing or certification. When certifiers compete, those that do a better job over time tend to gain business and those that do worse tend to lose business. The greater reliability of regulation by market forces comes not from the trustworthiness of any particular certifier, but from the process of competition among certifiers. That process tends, through profit-and-loss selection (discussed in Chapter 2), to reveal the certifiers and certification standards that really create value for the general public.

  Just as no business person knows for sure what products or processes will provide the most value for customers at the least cost, no regulator or certifier knows that either. That goes for all the many regulatory agencies that burden markets in the U.S. today: the Fed, the SEC, FDA, USDA, FTC, FCC, FINRA, CFTC, or any of the regulatory agencies now being created under the (remarkably named) Patient Protection and Affordable Care Act or the (Dodd-Frank) Wall Street Reform and Consumer Protection Act. Just as entrepreneurial innovation and profit-and-loss feedback are necessary to guide business people to discover ever more value-creating products and processes, so they are necessary to guide certifiers and regulators to discover ever more value-creating kinds of standards and better ways of testing and analyzing quality.

  With respect to the strictness or laxity of standards, as the diamond-certification story shows, third-party certifiers who must compete with others cannot afford to set their standards too low. Their certification would begin to lose its value if, say, ASE, the Gemological Institute of America, or Underwriters Laboratories were to become careless in their testing, or if they tried to attract more business (in the short run) by certifying substandard performance or products. Service stations would turn from ASE, jewelers would turn from the Gemological Institute of America, manufacturers would turn from UL. They would turn to some other certifier or some other kind of quality assurance. This is precisely what happened with the California spinach and lettuce growers. When their existing monitoring system, FDA inspection, showed itself to be insufficient, they created their own.

  At the other extreme, if a certifier were to set its standards unreasonably high or charge excessively for its services, its potential customers would find that meeting the standard costs more than the value of the certification, so they would go without certification or turn to a more reasonable alternative. Or create one for themselves.

  For market forces to regulate a particular market well, businesses that want certification of their products and services must be free to go without if they cannot find a certifier that offers them the value they want. Only this freedom can reliably keep a spontaneously-ordered system of certification under constant pressure to improve. If the law permits only one certifier to operate (e.g., a government regulator or licensing body), or if businesses are required to obtain certification from only one or a few specified certifiers, society loses the dynamic process through which better standards and methods can be discovered and used.

  The FDA’s legal monopoly on certifying drugs and medical devices provides a useful illustration of this principle. Its “customers” are not legally permitted to market their goods without FDA approval, nor are they permitted to turn to alternative certifiers. This restriction on freedom of exchange leads to serious problems, as we shall see below.

  Which works better, all things considered? Regulation by free market forces or regulation by government bureaucracy? I have made the strongest case I can for the former—for complete freedom of peaceful exchange—and I hope some readers are persuaded that market forces might regulate hairdressing better than state licensing laws do, that auto mechanics should need no license, and that market competition adequately protects us from overpaying for diamonds.

  But perhaps those are easy cases with little at stake and small danger of trag
ic errors. What about services or products where people’s lives are at stake? What about pharmaceuticals and medical devices?

  With these a regulatory error can mean death or disfigurement. Remember Thalidomide? Isn’t government regulation necessary, some readers are undoubtedly asking at this point, for drugs? Can we safely tolerate freedom of exchange between pharmaceutical companies and drug stores, doctors, and hospitals, before the FDA has certified the safety and effectiveness of drugs and medical devices to be exchanged?

  The logic of the argument I’m presenting actually cuts the other way: the more there is at stake—here human lives and safety—the more important it is to take advantage of market feedback and the healthy incentives of free exchange, because they get better results than restrictions imposed by legislators and bureaucrats, all of whom face the problem of incomplete knowledge as well as perverse incentives. Let’s consider pharmaceutical regulation.

  Regulating Pharmaceuticals

  Here’s an exercise similar to the one we did at the opening of this chapter with hairdressing: Suppose Congress were to repeal the FDA’s legal authority to block the purchase and sale of drugs and medical devices, relying thereafter on freedom of exchange and regulation by market forces—what would happen? What institutions and incentives would we expect to arise to pressure drug companies to make their drugs appropriately safe and effective? What’s the best the free market could do?