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The CPI Antitrust Chronicle published Geoffrey Manne’s and my recent paperThe Problems and Perils of Bootstrapping Privacy and Data into an Antitrust Framework as part of a symposium on Big Data in the May 2015 issue. All of the papers are worth reading and pondering, but of course ours is the best ;).

In it, we analyze two of the most prominent theories of antitrust harm arising from data collection: privacy as a factor of non-price competition, and price discrimination facilitated by data collection. We also analyze whether data is serving as a barrier to entry and effectively preventing competition. We argue that, in the current marketplace, there are no plausible harms to competition arising from either non-price effects or price discrimination due to data collection online and that there is no data barrier to entry preventing effective competition.

The issues of how to regulate privacy issues and what role competition authorities should in that, are only likely to increase in importance as the Internet marketplace continues to grow and evolve. The European Commission and the FTC have been called on by scholars and advocates to take greater consideration of privacy concerns during merger review and encouraged to even bring monopolization claims based upon data dominance. These calls should be rejected unless these theories can satisfy the rigorous economic review of antitrust law. In our humble opinion, they cannot do so at this time.



The Horizontal Merger Guidelines have long recognized that anticompetitive effects may “be manifested in non-price terms and conditions that adversely affect customers.” But this notion, while largely unobjectionable in the abstract, still presents significant problems in actual application.

First, product quality effects can be extremely difficult to distinguish from price effects. Quality-adjusted price is usually the touchstone by which antitrust regulators assess prices for competitive effects analysis. Disentangling (allegedly) anticompetitive quality effects from simultaneous (neutral or pro-competitive) price effects is an imprecise exercise, at best. For this reason, proving a product-quality case alone is very difficult and requires connecting the degradation of a particular element of product quality to a net gain in advantage for the monopolist.

Second, invariably product quality can be measured on more than one dimension. For instance, product quality could include both function and aesthetics: A watch’s quality lies in both its ability to tell time as well as how nice it looks on your wrist. A non-price effects analysis involving product quality across multiple dimensions becomes exceedingly difficult if there is a tradeoff in consumer welfare between the dimensions. Thus, for example, a smaller watch battery may improve its aesthetics, but also reduce its reliability. Any such analysis would necessarily involve a complex and imprecise comparison of the relative magnitudes of harm/benefit to consumers who prefer one type of quality to another.


If non-price effects cannot be relied upon to establish competitive injury (as explained above), then what can be the basis for incorporating privacy concerns into antitrust? One argument is that major data collectors (e.g., Google and Facebook) facilitate price discrimination.

The argument can be summed up as follows: Price discrimination could be a harm to consumers that antitrust law takes into consideration. Because companies like Google and Facebook are able to collect a great deal of data about their users for analysis, businesses could segment groups based on certain characteristics and offer them different deals. The resulting price discrimination could lead to many consumers paying more than they would in the absence of the data collection. Therefore, the data collection by these major online companies facilitates price discrimination that harms consumer welfare.

This argument misses a large part of the story, however. The flip side is that price discrimination could have benefits to those who receive lower prices from the scheme than they would have in the absence of the data collection, a possibility explored by the recent White House Report on Big Data and Differential Pricing.

While privacy advocates have focused on the possible negative effects of price discrimination to one subset of consumers, they generally ignore the positive effects of businesses being able to expand output by serving previously underserved consumers. It is inconsistent with basic economic logic to suggest that a business relying on metrics would want to serve only those who can pay more by charging them a lower price, while charging those who cannot afford it a larger one. If anything, price discrimination would likely promote more egalitarian outcomes by allowing companies to offer lower prices to poorer segments of the population—segments that can be identified by data collection and analysis.

If this group favored by “personalized pricing” is as big as—or bigger than—the group that pays higher prices, then it is difficult to state that the practice leads to a reduction in consumer welfare, even if this can be divorced from total welfare. Again, the question becomes one of magnitudes that has yet to be considered in detail by privacy advocates.


Either of these theories of harm is predicated on the inability or difficulty of competitors to develop alternative products in the marketplace—the so-called “data barrier to entry.” The argument is that upstarts do not have sufficient data to compete with established players like Google and Facebook, which in turn employ their data to both attract online advertisers as well as foreclose their competitors from this crucial source of revenue. There are at least four reasons to be dubious of such arguments:

  1. Data is useful to all industries, not just online companies;
  2. It’s not the amount of data, but how you use it;
  3. Competition online is one click or swipe away; and
  4. Access to data is not exclusive


Privacy advocates have thus far failed to make their case. Even in their most plausible forms, the arguments for incorporating privacy and data concerns into antitrust analysis do not survive legal and economic scrutiny. In the absence of strong arguments suggesting likely anticompetitive effects, and in the face of enormous analytical problems (and thus a high risk of error cost), privacy should remain a matter of consumer protection, not of antitrust.

Profile-Pic-3-professional-200x300Truth On the Market is pleased to announce that Kristian Stout of the International Center for Law and Economics (“ICLE”) has joined our team of writers. Kristian was recently hired by ICLE as Associate Director for Innovation Policy, bringing with him over ten years of experience as a technology professional and entrepreneur. In his role at ICLE, Kristian’s work is focused on the areas of Innovation, Data, Privacy, Telecom, and Intellectual Property.

Kristian has previously been a lecturer in the computer science department of Rutgers University,  is frequently invited to speak on law and technology topics, and has been published in law journals and legal treatises on intellectual property and innovation policy. Kristian is an attorney licensed to practice law in New Jersey and Pennsylvania, is a partner at A&S Technologies, a software services firm, and sits on the board of CodedByKids, a nonprofit organization that provides STEM education to underprivileged children.

Kristian graduated magna cum laude from the Rutgers University School of law, served on the editorial board of the Rutgers Journal of Law and Public Policy, and was awarded a Governor’s Executive Fellowship from the Eagleton Institute of Politics.

He is excited to join the TOTM team, bringing with him a fusion of technological-optimism and a belief in the power of free markets to enhance the welfare of all humanity.

Yesterday the Heritage Foundation released a series of essays on “Saving Internet Freedom.”  These analytical essays are an excellent reference work for interested members of the public who seek answers to those who claim the Internet requires new and intrusive government regulation.  The introduction to the essays highlights the topics they cover and summarizes their conclusions:

“1.    Federal “network-neutrality” regulations. Rules adopted by the Federal Communications Commission (FCC) in February 2015 bar Internet access providers from prioritizing the content that is sent through their networks. This ban limits the ability of Internet service providers (ISPs) to innovate, which limits economic freedom, to the detriment of the Internet and its users. In addition to activities clearly prohibited, the new rule also gives the FCC vast discretion. As a result, critical decisions about what practices will be allowed on the Net will be left to the subjective judgment of five unelected FCC commissioners.

  1. Global Internet governance. Many nations, such as China and Russia, have made no secret of their desire to limit speech on the Internet. Even some democratic nations have supported limiting freedoms online. With the U.S. government’s decision to end its oversight of the Internet Corporation for Assigned Names and Numbers (ICANN), the private, nonprofit organization that manages name and number assignments on the Internet, these countries see a chance to fill the vacuum, and to use ICANN’s Internet governance role to limit expression on the Web.
  2. Regulatory barriers to online commerce. The Internet is a true disruptive force in commerce, challenging inefficient ways of business. Often, these challenges conflict with anti-consumer laws that protect middlemen and others with a stake in older, costlier ways of doing business. These harmful laws have eroded in many cases, but have not been erased from the statute books.
  3. Internet taxation. Sales and other taxation also create regulatory barriers to online commerce. Some politicians and state tax collectors are pushing Congress to pass legislation that would allow state governments to force retailers located in other states to collect their sales taxes. They say they want to equalize the tax burdens between so-called brick-and-mortar retailers and their online counterparts. But instead of eliminating differences, the proposal would create new disparities and impose new burdens, as sellers struggle to deal with the tax laws of some 10,000 jurisdictions and 46 state tax authorities.
  4. Intellectual property. The freedom to create without fear that one’s creation will be appropriated by others is fundamental. At the same time, overly restrictive laws limiting the use of intellectual property erodes other freedoms, not least freedom of expression. The challenge to lawmakers is to balance these two opposing values, to protect intellectual property without undue limits on its fair use or on third parties.
  5. Cybersecurity. To enjoy the freedoms made possible by the Internet, a certain amount of security is needed to protect it from cyber theft, vandalism, and other criminal threats. This security cannot simply be achieved by government mandates. Government should remove barriers that hinder private-sector efforts to protect online networks.
  6. Digital privacy. Under current law, communications by Americans via electronic networks enjoy less protection than a letter sent by mail. Government does have a legitimate interest in viewing private communications in limited circumstances in order to apprehend criminals or terrorists and to protect security. But to do so, the government should be required to obtain a search warrant for each case, holding it to the constitutional standards that protect other communications, such as mail.”

Supporters of individual freedom and economic liberty will find much to like in these essays.

On Wednesday, March 18, our fellow law-and-economics-focused brethren at George Mason’s Law and Economics Center will host a very interesting morning briefing on the intersection of privacy, big data, consumer protection, and antitrust. FTC Commissioner Maureen Ohlhausen will keynote and she will be followed by what looks like will be a lively panel discussion. If you are in DC you can join in person, but you can also watch online. More details below.
Please join the LEC in person or online for a morning of lively discussion on this topic. FTC Commissioner Maureen K. Ohlhausen will set the stage by discussing her Antitrust Law Journal article, “Competition, Consumer Protection and The Right [Approach] To Privacy“. A panel discussion on big data and antitrust, which includes some of the leading thinkers on the subject, will follow.
Other featured speakers include:

Allen P. Grunes
Founder, The Konkurrenz Group and Data Competition Institute

Andres Lerner
Executive Vice President, Compass Lexecon

Darren S. Tucker
Partner, Morgan Lewis

Nathan Newman
Director, Economic and Technology Strategies LLC

Moderator: James C. Cooper
Director, Research and Policy, Law & Economics Center

A full agenda is available click here.

PayPal co-founder Peter Thiel has a terrific essay in the Review section of today’s Wall Street Journal.  The essay, Competition Is for Losers, is adapted from Mr. Thiel’s soon-to-be-released book, Zero to One: Notes on Startups, or How to Build the Future.  Based on the title of the book, I assume it is primarily a how-to guide for entrepreneurs.  But if the rest of the book is anything like the essay in today’s Journal, it will also offer lots of guidance to policy makers–antitrust officials in particular.

We antitrusters usually begin with the assumption that monopoly is bad and perfect competition is good. That’s the starting point for most antitrust courses: the professor lays out the model of perfect competition, points to all the wealth it creates and how that wealth is distributed (more to consumers than to producers), and contrasts it to the monopoly pricing model, with its steep marginal revenue curve, hideous “deadweight loss” triangle, and unseemly redistribution of surplus from consumers to producers. Which is better, kids?  Why, perfect competition, of course!

Mr. Thiel makes the excellent and oft-neglected point that monopoly power is not necessarily a bad thing. First, monopolists can do certain good things that perfect competitors can’t do:

A monopoly like Google is different. Since it doesn’t have to worry about competing with anyone, it has wider latitude to care about its workers, its products and its impact on the wider world. Google’s motto–“Don’t be evil”–is in part a branding ploy, but it is also characteristic of a kind of business that is successful enough to take ethics seriously without jeopardizing its own existence.  In business, money is either an important thing or it is everything. Monopolists can think about things other than making money; non-monopolists can’t. In perfect competition, a business is so focused on today’s margins that it can’t possibly plan for a long-term future. Only one thing can allow a business to transcend the daily brute struggle for survival: monopoly profits.

Fair enough, Thiel. But what about consumers? That model we learned shows us that they’re worse off under monopoly.  And what about the deadweight loss triangle–don’t forget about that ugly thing! 

So a monopoly is good for everyone on the inside, but what about everyone on the outside? Do outsize profits come at the expense of the rest of society? Actually, yes: Profits come out of customers’ wallets, and monopolies deserve their bad reputations–but only in a world where nothing changes.

Wait a minute, Thiel. Why do you think things are different when we inject “change” into the analysis?

In a static world, a monopolist is just a rent collector. If you corner the market for something, you can jack up the price; others will have no choice but to buy from you. Think of the famous board game: Deeds are shuffled around from player to player, but the board never changes. There is no way to win by inventing a better kind of real estate development. The relative values of the properties are fixed for all time, so all you can do is try to buy them up.

But the world we live in is dynamic: We can invent new and better things. Creative monopolists give customers more choices by adding entirely new categories of abundance to the world. Creative monopolies aren’t just good for the rest of society; they’re powerful engines for making it better.

Even the government knows this: That is why one of the departments works hard to create monopolies (by granting patents to new inventions) even though another part hunts them down (by prosecuting antitrust cases). It is possible to question whether anyone should really be rewarded a monopoly simply for having been the first to think of something like a mobile software design. But something like Apple’s monopoly profits from designing, producing and marketing the iPhone were clearly the reward for creating greater abundance, not artificial scarcity: Customers were happy to finally have the choice of paying high prices to get a smartphone that actually works. The dynamism of new monopolies itself explains why old monopolies don’t strangle innovation. With Apple’s iOS at the forefront, the rise of mobile computing has dramatically reduced Microsoft’s decadeslong operating system dominance.

…If the tendency of monopoly businesses was to hold back progress, they would be dangerous, and we’d be right to oppose them. But the history of progress is a history of better monopoly businesses replacing incumbents. Monopolies drive progress because the promise of years or even decades of monopoly profits provides a powerful incentive to innovate. Then monopolies can keep innovating because profits enable them to make the long-term plans and finance the ambitious research projects that firms locked in competition can’t dream of.

Geez, Thiel.  You know who you sound like?  Justice Scalia. Here’s how he once explained your idea (to shrieks and howls from many in the antitrust establishment!):

The mere possession of monopoly power, and the concomitant charging of monopoly prices, is not only not unlawful; it is an important element of the free-market system. The opportunity to charge monopoly prices–at least for a short period–is what attracts “business acumen” in the first place. It induces risk taking that produces innovation and economic growth. To safeguard the incentive to innovate, the possession of monopoly power will not be found unlawful unless it is accompanied by an element of anticompetitive conduct.

Sounds like you and Scalia are calling for us antitrusters to update our models.  Is that it?

So why are economists obsessed with competition as an ideal state? It is a relic of history. Economists copied their mathematics from the work of 19th-century physicists: They see individuals and businesses as interchangeable atoms, not as unique creators. Their theories describe an equilibrium state of perfect competition because that is what’s easy to model, not because it represents the best of business.

C’mon now, Thiel. Surely you don’t expect us antitrusters to defer to you over all these learned economists when it comes to business.

There were several letters in today’s Wall Street Journal commenting on my recent op-ed with my son Joe on second best arguments for various forms of crony capitalism.

Overall, these articles are critical of our position, but I do not disagree with them. Our original article was at best a weak defense, with terms like “may be” and “a second-best world is messy” and “there may be better ways.”  The letters are basically amplifying these caveats, and I do not disagree that the second best alternatives Joe and I proposed were flawed.  Clearly, as the letter writers indicate, a first best world with no inefficient regulation would be better.  Would that we could get there. 

But it does seem odd to pick on the Export-Import Bank as the major effort to reduce crony capitalism. The Bank makes money in an accounting sense, but loses in terms of the risk-adjusted cost of capital.  The cost is estimated as $2 billion.  The ethanol program or the import-restriction policies of the Commerce Department and the International Trade Commission are much more costly, and would make better targets for deregulation.  

There is another political point.  Those of us in favor of free markets are fond of pointing out that being pro-market is not the same as being pro-business, and may point to opposition to the Ex-Im Bank as an example.  But while being pro-market is not the same as being  pro-business, it is also true that business is one of the major forces generally advocating freer markets and decreased regulation.  There is a cost to antagonizing a major ally in the fight against inefficient rules.


The Times seems to specialize in stories that use lots of economics but still miss the important points. Two examples from today: Stories about Uber, and about the dispute between Amazon and Hachette.

UBER:  The article describes Uber’s using price changes to measure elasticity of demand, and more or less gets it right.  But it goes on to discuss the competition between Uber and Lyft with taxi companies.  However, what is not mentioned is that taxis are greatly handicapped in this fight because of their own sins.  They have lobbied for price fixing and supply limitation, thus creating the very market that Uber is entering.  It is quite plausible that if the taxi market were a free entry free price market there would be no demand for firms such as Uber.  Interesting to see how Uber does in cities such as Washington D.C. with relatively free entry into the taxi market, compared with New York city with highly restrictive rules.

The article also misses another point.  It discusses an agreement recently signed by Uber that limits “surge” pricing in times of disasters.  But what is not mentioned is the effect of this restriction in reducing supply and increasing demand during the very times when transportation services are most needed.  While we economists have won some public relations battles, we have not weaned the public away from its hatred of “price gouging.”


AMAZON: The story about the Amazon-Hachette dispute is interesting.  But again, some of the key economics is missing. 

Traditional publishers serve two purposes: They organize the physical publishing of books, and they certify quality.  Neither of these functions is needed any more an a world of ebooks.  For ebooks, there is no need of physical publishing, and reader comments are a good substitute for quality certification, at least for fiction.  Amazon provides other services to help inform consumers about books that might be of interest.

Moreover, authors should have a natural affinity with ebook publishers.  For physical books, there is a conflict between authors and publishers.  Authors are paid a royalty based on dollar volume, so they want a price that maximizes revenue.  All of the author’s costs are fixed costs.  Publishers have the marginal cost of actually printing and distributing the book, so their goal is to maximize profit, revenue minus cost.  When costs are positive, the profit maximizing price (MR=MC) is greater than the revenue maximizing price (MR=0), so authors traditionally think that publishers have overpriced their books.  This conflict does not exist for ebooks (marginal cost is zero) so Amazon and authors both want the revenue maximizing price.  As a result, I predict that in the long term Amazon will win because it will have a comparative advantage in dealing with authors. 

As another Israeli-Muslim armed conflict begins, it instructive to consider the lethality of previous conflicts.  The best estimate is that about 35,000 Muslims have been killed in all of the Israel-Muslim conflicts since 1948. During that same period, about 10,000,000 Muslims have been killed by other Muslims.  The Arab-Israeli conflict overall is the 49th deadliest conflict since 1950.  Of the total 85,000,000 deaths in that period, the Israeli-Arab conflict is responsible for .06 percent of all fatalities.  Hard to understand why this conflict generates so much attention and news. Also hard to understand why so many blame Israel for killing Muslims when many many more Muslims have killed each other. (All data from Daniel Pipes website.)

Debates among modern antitrust experts focus primarily on the appropriate indicia of anticompetitive behavior, the particular methodologies that should be applied in assessing such conduct, and the best combination and calibration of antitrust sanctions (fines, jail terms, injunctive relief, cease and desist orders).  Given a broad consensus that antitrust rules should promote consumer welfare (albeit some disagreement about the meaning of the term), discussions tend (not surprisingly) to emphasize the welfare effects of particular practices (and, relatedly, appropriate analytic techniques and procedural rules).  Less attention tends to be paid, however, to whether the overall structure of enforcement policy enhances welfare.

Assuming that one views modern antitrust enforcement as an exercise in consumer welfare maximization, what does that tell us about optimal antitrust enforcement policy design?  In order to maximize welfare, enforcers must have an understanding of – and seek to maximize the difference between – the aggregate costs and benefits that are likely to flow from their policies.  It therefore follows that cost-benefit analysis should be applied to antitrust enforcement design.  Specifically, antitrust enforcers first should ensure that the rules they propagate create net welfare benefits.  Next, they should (to the extent possible) seek to calibrate those rules so as to maximize net welfare.  (Significantly, Federal Trade Commissioner Josh Wright also has highlighted the merits of utilizing cost-benefit analysis in the work of the FTC.)

Importantly, while antitrust analysis is different in nature from agency regulation, cost-benefit analysis also has been the centerpiece of Executive Branch regulatory review since the Reagan Administration, winning bipartisan acceptance.  (Cass Sunstein has termed it “part of the informal constitution of the U.S. regulatory state.”)  Indeed, an examination of general Executive Branch guidance on cost-benefit regulatory assessments, and, in particular, on the evaluation of old policies, is quite instructive.  As stated by the Obama Administration in the context of Office of Management regulatory review, pursuant to Executive Order 13563, retrospective analysis allows an agency to identify “rules that may be outmoded, ineffective, insufficient, or excessively burdensome, and to modify, streamline, expand, or repeal them in accordance with what has been learned.”  Although Justice Department and FTC antitrust policy formulation is not covered by this Executive Order, its principled focus on assessments of preexisting as well as proposed regulations should remind federal antitrust enforcers that scrutinizing the actual effects of past enforcement initiatives is key to improving antitrust enforcement policy.  (Commendably, FTC Chairwoman Edith Ramirez and former FTC Chairman William Kovacic have emphasized the value of retrospective reviews.)

What should underlie cost-benefit analysis of antitrust enforcement policy?  The best approach is an error cost (decision theoretic) framework, which tends toward welfare maximization by seeking to minimize the sum of the costs attributable to false positives, false negatives, antitrust administrative costs, and disincentive costs imposed on third parties (the latter may also be viewed as a subset of false positives).  Josh Wright has provided an excellent treatment of this topic in touting the merits of evidence-based antitrust enforcement.  As Wright points out, such an approach places a premium on hard evidence of actual anticompetitive harm and empirical analysis, rather than mere theorizing about anticompetitive harm (which too often may lead to a misidentification of novel yet efficient business practices).

How should antitrust enforcers implement an error cost framework in establishing enforcement policy protocols?  Below I suggest eight principles that, I submit, would align antitrust enforcement policy much more closely with an error cost-based, cost-benefit approach.  These suggestions are preliminary tentative thoughts, put forth solely to stimulate future debate.  I fully recognize that convincing public officials to implement a cost-benefit framework for antitrust enforcement (which inherently limits bureaucratic discretion) will be exceedingly difficult, to say the least.  Generating support for such an approach is a long term project.  It must proceed in light of the political economy of antitrust and more specifically the institutional structure of antitrust enforcement (which Dan Crane has addressed in impressive fashion), topics that merit separate exploration.

First, antitrust enforcers should seek to identify and expound simple rules they will follow in both case selection and evaluation of business conduct, in order to rein in administrative costs.

Second, borrowing from Frank Easterbrook, they should place a greater emphasize on avoiding false positives than false negatives, particularly in the area of unilateral conduct (since false positives may send cautionary signals to third party businesses that the market cannot easily correct).

Third, they should pursue cases based on hard empirically-based indications of likely anticompetitive harm, rather than theoretical constructs that are hard to verify.

Fourth, they should avoid behavioral remedies in merger cases (and, indeed, other cases) to the greatest extent possible, given inherent problems of monitoring and administration posed by such requirements.  (See the trenchant critique of merger behavioral remedies by John Kwoka and Diana Moss.)

Fifth, they should emphasize giving full consideration to efficiencies (including dynamic efficiencies), given their importance to innovation and economic welfare gains.

Sixth, they should announce their positions in public pronouncements and guidelines that are as simple and straightforward as possible.  Agency guidance should be “tweaked” in light of compelling new empirical evidence, but “pendulum swing” changes should be minimized to avoid costly uncertainty.

Seventh, in non per se matters, they should pledge that they will only bring cases when (1) they have substantial evidence for the facts on which they rely and (2) that reasoning from those facts makes their prediction of harm to future competition more plausible than the defendant’s alternative account of the future.  (Doug Ginsburg and Josh Wright recommend that such a standard be applied to judicial review of antitrust enforcement action.)

Eighth, in the area of cartel conduct, they should adjust leniency and other enforcement policies based on the latest empirical findings and economic theory, seeking to pursue optimal detection and deterrence in light of “real world” evidence (see, for example, Greg Werden, Scott Hammond, and Belinda Barnett).

Admittedly, these suggestions bear little resemblance to recent federal antitrust enforcement initiatives.  Indeed, Obama Administration antitrust enforcers appear to me to have been moving farther away from an approach rooted in cost-benefit analysis.  The 2010 Horizontal Merger Guidelines, although more sophisticated than prior versions, give relatively short shrift to efficiencies (as Josh Wright has pointed out).  The Obama Justice Department’s withdrawal in 2009 of its predecessor’s Sherman Act Section Two Report (which had emphasized error costs and proposed simple rules for assessing monopolization cases) highlighted a desire for “aggressive enforcement,” without providing specific guidance for the private sector.  More generally, an assessment by William Shughart and Diana Thomas of antitrust enforcement in the Obama Administration’s first term concluded that antitrust agency activity had moved away from structural remedies and toward intrusive behavioral remedies “in an unprecedented fashion,” yielding suboptimal regulation – a far cry from cost-beneficial norms.

One may only hope (which after all makes “all the difference in the world”) that Federal Trade Commission and Justice Department officials, inspired by their teams of highly qualified economists, may consider according greater weight to cost-benefit considerations and error cost approaches as they move forward.

My son Joe and I have an op-ed in today’s WSJ that should stir up some controversy.

Opinion Wall Street Journal

The Case for Crony Capitalism

Many government regulations choke off entirely legal avenues of potential bank profits.


Paul H. Rubin And

Joseph S. Rubin

July 7, 2014 7:34 p.m. ET

Economics has a formal “theory of the second best” that in simplified terms may be expressed this way: If a government intervention leads to inefficiencies in markets but can’t be eliminated, an additional intervention may be the next-best alternative to eliminate the inefficiencies caused by the first.

It’s not the optimal solution to government-induced inefficiency, but it may be the best we can do. And it applies in many cases to what today is variously called “corporate welfare,” “loopholes,” or even “crony capitalism.”

The U.S. economy is rife with inefficient interventions—laws, regulations, taxes and subsidies that lead to inefficient markets. What some disparage as crony capitalism is in many cases an attempt to reduce the costs of these interventions.

Consider the Export-Import Bank, a federal agency that assists U.S. firms in financing international transactions. A first-best efficient policy would be to eliminate the agency, on grounds that if private banks will not finance a transaction, then the transaction is not worthwhile. The government shouldn’t become the financier of otherwise unprofitable transactions.

Yet that’s not the whole story. The Foreign Corrupt Practices Act, for example, makes it illegal for U.S. businesses to pay bribes to foreign officials. But it is not always so easy to determine what is illegal, and companies may be penalized for normal business practices. It is certainly not cheap to comply. The Ex-Im Bank website says that “to avoid such consequences [of the FCPA], many firms have implemented detailed compliance programs intended to prevent and to detect any improper payments by employees and by third-party agents.”

This adds to the costs of U.S. firms doing business abroad, lowering the amount of legitimate trade. Maybe the Ex-Im Bank is a reasonable, second-best response. One government subsidy may be necessary to help overcome other inefficiencies imposed by the government to begin with.

The banking bailout is another purported example of cronyism and corporate welfare. The poor lending practices of banks were undoubtedly part of the cause of the Great Recession. But banks, as well as government-sponsored enterprises such as Fannie Mae FNMA +0.50% and Freddie Mac, FMCC +0.51% were under tremendous pressure to make loans to unqualified borrowers.

Many other government regulations choke off entirely legal avenues of potential profit for banks by limiting with whom and under what circumstances they may do business. Examples include the financing of online and payday lenders, and firms that process payments for these lenders. If regulations cause banks to take excessive risks and limit profits, it may be efficient to provide some protection from these risks when things go bad, particularly if the damage is in large part caused by government policies.

Some claim that Medicare Part D, which pays for drugs, was a giveaway to the pharmaceutical industry. But 40 years of research has clearly shown that the Food and Drug Administration’s regulatory process makes drug development and approval unnecessarily and inefficiently expensive. Perhaps, in this environment, supplementing the costs of drugs may move us toward a more efficient drug policy, and bring more life-saving drugs to market.

Corporate taxes are too high, retarding investment. But when cutting rates is impossible, maybe tax breaks that encourage investment of various sorts is the second-best response. Environmental Protection Agency regulations are costly and inefficient. In some cases waivers or exceptions are less a payoff to cronies than a way to counter inefficient restrictions.

A second-best world is messy, and there may be better ways to overcome government-induced inefficiency. Yet sometimes what appear to be special favors may actually be moves in the direction of efficiency.

Of course, some examples of crony capitalism are worthy of the term, and the scorn that goes with it. For example, the various farm price-support programs, including sugar quotas and the ethanol program, which raise food prices world-wide and increase poverty, would be very difficult to justify under any second-best theory.

Nonetheless, as long as there is a push for more regulation, and particularly inefficient regulation, with little opportunity to rein in the already severe drag that these regulations impose on the economy, second-best solutions may be useful to temper some of their costs.

Paul H. Rubin is an economics professor at Emory University. His son, Joseph S. Rubin, is an attorney at Arnall Golden Gregory LLP in Washington, D.C.