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Standardization Enhances Market Efficiency July 5, 2009

Posted by federalist in Finance, Government Regulation, Markets.
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Standardization is a public good.  So do we need government to promote it?

Standardization of products and specifications is invaluable to market efficiency.  For example, a standard “letter”-sized sheet of paper will fit in a standard envelope, or binder.  It is sold in “reams” of 500, making it easy to compare prices.  It can be used in almost any printer or scanner.  Imagine if each paper company manufactured proprietary paper dimensions to increase the likelihood that only their file cabinets and folders could keep their products organized?

Mechanical fasteners tend to be standardized.  Only a handful of screwdrivers are sufficient to adjust almost any screw.  What if you had to go to the manufacturer to buy a special set of tools for every individual product you wanted to repair?

Common languages, formats, and specifications are the backbone of the information markets, just as standardized shipping containers, roads, and vehicles are the backbone of our physical markets.

Unfortunately there are incentives for producers to secure rents by avoiding standards.  Inkjet printer manufacturers have proliferated proprietary ink cartridges in order to inhibit competition for replacements.  Most beverages are sold in standardized containers, but odd-sized bottles are an occasional ploy to make a product literally stand out from its competitors that can be tucked away in standard shelves.

Whenever the market wouldn’t overly penalize it, a manufacturer would prefer to create a specialized component that only it can economically manufacture instead of a standardized component that performs the same function but that is broadly and competitively produced.  I.e., unjustified specialization is an attempt to extract monopolistic rents from the market by avoiding competition.  However, unlike true monopoly, specialization is always suboptimal because it also avoids the economies of scale (in both production and use) that result from standardization.

What market forces resist specialization?  Only the ability of consumers to detect and properly incorporate the cost of specialization into their behavior.  But in the real world there is information and behavioral inertia that will always prevent markets from reaching optimal levels of standardization.  No consumer is equipped to analyze a product for specialized components, and determine where specialization was justified, or what the added cost of specialization will be over the life of the product.

What market forces promote standardization?  There is an upfront cost to be born in defining standards, and no individual consumer or producer has an incentive to make that investment.  Standardization is something of a public good.  Therefore, do we need the coercive hand of government to promote standardization to ensure the good functioning of markets?  I have wondered before whether we can rely on the gentle hand of non-governmental organizations to nudge markets to more optimal behavior.

The issue of standardization has come up in the surprising domain of consumer finance markets.  (I have considered the question of government regulation of finance generally.)  Clearly the promotion of “plain-vanilla” consumer finance products will produce more efficient markets by reducing the potential for consumers to be confused by more complicated products that are easier to stuff with extra profit and more difficult to comparison shop.  This column elaborates:

Prof. Thaler discussed the new regulatory model. “The standard beer can is 12 ounces,” he said. “That makes it pretty easy to compare beer prices. So now consider mortgages. It’s not that you regulate the interest rates or the fees. But one way to make shopping easier is to make comparing the products simpler.”

Thus, suggested Prof. Thaler, every bank or mortgage broker would have to offer two “safe-harbor” products with “standard terms that are easy to understand”: a 30-year fixed mortgage with no points or prepayment penalties, and a five-year adjustable-rate mortgage. The market would set the interest rates. “By having these generic, simple mortgages,” said Prof. Thaler, “you make everything else comparable.”

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