It’s said that one man’s trash is another man’s treasure. In the same way, one man’s market imperfection is another man’s market opportunity. Imperfections in markets don’t prevent markets from operating – they are a driving force of the market process. As Hayek once said, in the standard economics model of “perfect competition,” there is no actual competition!
A commonly cited market imperfection is “imperfect information.” Lack of information is indeed a problem, but companies and consumers both have incentives to find ways to solve this problem. One way to achieve this is through branding. Suppose you’re on a road trip and need to make a quick stop to eat. You have two options – a local burger joint called Billy’s Burgers, or a McDonalds. You know nothing about the former restaurant – it could be a hidden gem, or it could leave you chained to your toilet for the next three days. You’re just passing through town, so you’re not going to be a repeat customer; this is a one-time transaction. You might not want to take the risk that Billy’s might turn out to be a dud. Meanwhile, with McDonalds, you know exactly what you’re going to get. It’s going to be basically the same as every other McDonalds you’ve ever tried. The same is true for other major chain restaurants. The brand name communicates valuable information to the consumer, alleviating the problem of imperfect information.
But times have changed. We don’t need to rely so much on branding to supplement our information. Nowadays, everyone knows about Yelp, Google reviews, and other similar review aggregators. If you were to take that road trip now, you could just pull up the Yelp reviews for Billy’s Burgers. You’d see the results of hundreds, if not thousands, of others who have been through that town. You’d be able to see the full menu, along with pictures posted by both the restaurant and the customers. Suddenly, your ability to choose between McDonalds and Billy’s can be much more informed.
In fact, a working paper from the Harvard Business School looked into the effect of Yelp on the restaurant industry. The author, Michael Luca, found that a rating increase of one star on Yelp leads to an increase in revenue between 5% to 9% – but that this impact was limited to independent restaurants. Chain restaurants saw no significant effects from Yelp reviews. This makes intuitive sense – I’ve often consulted Yelp and similar apps when deciding about an independent restaurant or a food truck. It’s never even occurred to me to look at Yelp to find a rating for any given Chipotle or Applebee’s. Why would I? I already know what to expect from those places. And I’ve also found that because of Yelp, I’m far more likely to seek out and eat at independent or specialty restaurants instead of chains, because Yelp has made it so much easier to find the gems among the grit.
What to make of all of this? I think there are three takeaways.
Markets are not about reaching and maintaining an equilibrium, free from frictions or imperfections. Markets are an ever-ongoing process, working in response to those frictions and imperfections.
The solution used yesterday may not be the same as the solution used today. Where branding was once key to imperfect information, crowdsourcing has now emerged as a valuable tool as well. Tomorrow’s might introduce a new solution which is totally different – the process will continue to evolve, in ways that aren’t always apparent right now.
Because the process always evolves, there is no fixed, “correct” answer to how to handle market imperfections over time. This should make us extremely reluctant to use regulation. Once you do, you’ve said a single institution (the state) must create a one-size-fits-all solution for everyone. Once implemented, a political solution will inevitably create some winners and losers, which itself inevitably creates interest groups out of the winners who have reason to maintain this new status quo. If a better solution emerges, markets could smoothly transition to it, as we’ve seen with branding giving way to crowdsourcing. But political structures force you to battle with special interest groups and entrenched interests before you can gain new options. This can leave a suboptimal solution in place long after it stops being useful – if it ever was useful to begin with.
Kevin Corcoran is a Marine Corps veteran and a consultant in healthcare economics and analytics and holds a Bachelor of Science in Economics from George Mason University.