The R-word, regulation. Now regulation often gets a bad name, and it especially has a bad name among the kind of people who tend to like Bitcoin. Regulation is some bureaucrat who doesn't know my business or what I'm trying to do, coming in and messing things up. It's a burden, it's stupid, it's pointless, etc. Now those arguments often are correct. But I want to talk in a little more detail in this section about reasons why regulation might sometimes be justified. The argument against regulation is pretty common, it's pretty well understood, I'm not going to repeat it here. And so you'll hear me talking mostly about reasons why regulation might be a good idea. Because that argument is not as well understood, and I want to lay it out here a little bit. But, just to be clear, the fact that I'm spending most of this section talking about why regulation might be good shouldn't be read as an endorsement of widespread regulation or as a feeling that regulation is the greatest thing ever. It's simply that I want to bring a little bit more balance to the discussion in a community where regulation is often considered as always bad or just stupid by nature. All right, so the bottom line argument in favor of regulation is just this, that when markets fail and produce outcomes that are bad, and often agreed to be bad by pretty much everyone in the market, then regulation can step in and try to address the failure. So the argument for regulation, when there is an argument, starts with the idea that markets don't always give you the result that you'd like. So let me give you an example of a way in which the market can fail. And this is a classic example called the lemons market, which originated in a discussion about used cars. So let's talk about a market in concept, a market for widgets, some kind of good that we want to sell. And let's say that widgets can be either low-quality widgets or high-quality widgets. A high-quality widget costs a little bit more to manufacture than a low-quality widget but it's much, much better for the consumer who buys it. Consumers like high-quality widgets much, much better. Now in an efficient market, a market that's operating well, would therefore deliver mostly high-quality, or I'll write it HQ, widgets to consumers. Why? Because the price of the high-quality widget will be just a little bit higher but the widget will be so much better that almost everyone will buy the high-quality widgets. And so this is what you would hope that a market would provide. And under certain assumptions, a market will provide that. But let's suppose that customers, for some reason, can't tell a high-quality widget apart from a low-quality widget. What if they really can't tell which widgets are good and which widgets are not? Think of a used car from the classic example. You're looking at a used car sitting on the lot well, gee, it looks pretty good, but you can't really tell if it's going to break down tomorrow or if it's going to run for a long time. The dealer probably knows if it's a lemon, but you as the customer can't tell the difference. So you can't tell high quality from low quality. So if you think about what happens, where incentives drive people in this kind of lemons market, you can see that as a consumer you're not willing to pay extra for a high quality widget. Why? Because you can't tell the difference. And so if the used car dealer says, sure, this one is perfect. It's not a lemon at all. Go ahead and buy it, it's only an extra $100. Well, it might be that you'd happily pay a $100 for a higher quality car, but you don't really know whether that car, whether that widget, really is high quality. So if you really can't tell which widgets are high quality versus low quality, then you're not willing to pay extra for the high quality one. And if consumers are not willing to pay extra for a high quality one, then producers can make any extra money by selling a high quality widget. In fact, they loose money by selling a high quality widget because they don't get any price premium. They'd be better off buying the slightly cheaper low quality widget and selling it. And so the result is, if consumers really can't tell which widgets are high quality and which are low quality, the market gets stuck in an equilibrium where only low quality widgets are produced, and consumers are relatively unhappy with them. Now this outcome is worse for everybody than a properly functioning market would be. It's worse for buyers, because they have to make do with low quality widgets, when in a more efficient market, they could have bought a widget that was much, much better for only a little bit higher price. It's also worse for producers because the widgets that are on the market are all lousy, consumers don't buy very many widgets. The widget market is relatively small, and so there's less money to be made selling widgets than there would be in a healthy market. And so both consumers and producers are worse off in a world where consumers can't tell the difference between high quality and low quality widgets. That's a market failure. It's called an asymmetric information failure, and the result is a market that's sometimes called a lemons market. Okay so, how can we fix this? Well, there are some market-based approaches that try to fix a lemons market. The first market-based approach relies on the seller's reputation. The idea is that if a seller tells the truth to consumers about which widgets are high quality and which are low quality, then the seller might get a reputation for telling the truth. And once they have that reputation, then maybe they can sell high quality widgets for a higher price because consumers will believe them. And therefore, the market can operate more efficiently. The problem with this is yes, this sometimes works but sometimes it doesn't depending on the precise assumptions you make about the market. But if you think about it, this is not going to work as well, as a market where consumers can really tell the difference. Because for one thing, it takes a while for a producer to build up a good reputation. In order to build up a good reputation, they have to sell high quality widgets at low prices for a while, until consumers learn that that seller is telling the truth. And that makes it harder for an honest seller to get into the market. The other problem that can occur is that that seller, even if they've been honest up to now, if for one reason or another, their sales are shrinking or they think they want to get out of the market, their incentive is to massively cheat people all at once and then leave the market, rather than continuing to be honest and then leave the market. And so in the beginning of a seller's presence in the market, and at the end of a seller's presence in the market, reputation tends not to work. This sort of reputation based approach also tends not to work in businesses where consumers don't do repeat business with the same entity or where the product category is very new. And so there hasn’t been enough time for sellers to build up a reputation, like say in a high tech market, like, say Bitcoin exchanges. The other market-based approach is warranties. That's the idea that a seller could provide a warranty to a buyer that says that if this thing turns out to be low quality, if it doesn't work well for you, I'll give you a new one, I'll pay you back or something like that. And that can work up to a point as well but there's also a problem there. That this warranty is just another kind of product which could also come in high quality and low quality versions. A low quality warranty is one where the seller doesn't really come through when you come back with the broken product. They don't really replace it. They don't really give your money. They make you jump through all kinds of hoops. And so this is not a panacea either. So, if you have a lemons market which has developed, and if these market-based approaches don't work for the particular market that you're dealing with, then regulation might be able to help. And there are three ways in which regulation might be able to help address a lemons market. First, regulation could require disclosure. They could require, say, that all widgets be labeled as high quality or low quality, and then have penalties on the firms for lying. That gives consumers the information that they were missing. A second approach to regulation is to have quality standards. It's to require that no widget can be sold unless it meets some standard of quality testing. And have that standard set so that only high quality widgets can pass the test. That way you have a market that's all one kind of widget, but at least it's high quality widgets, assuming that the regulation works as intended. Or you can have required warranties so that all sellers have to issue warranties and then enforce the operation of those warranties, so that sellers are really held to the promises that they make. So all of these are forms of regulation which obviously could fail, which might not work as intended, which might be miswritten or misapplied. They might be burdensome on sellers and so on. But there's at least the possibility that regulation of this type might help to address the market failure due to a lemons market. So this is one example of how regulation can be an efficient thing to do if it's done well, when there's a certain kind of problem, namely, the inability of consumers to tell the difference between a high quality and a low quality product offering. And so people who talk about Bitcoin exchanges, for example, and argue for regulation of them, sometimes point to them as an example of lemons market. Another example of a market failure, or a place where the market doesn't operate the way that you would like it to in order to serve consumers, is price fixing. Price fixing simply is a case where different people are selling a product in the market and they just agree with each other that we're going to raise prices or we're not going to lower prices. Related to price fixing is an agreement not to compete, where companies that would otherwise go into competition with each other agree not to compete with each other. For example, if there were two bakeries in town, they might agree that one of them will only sell muffins and the other will only sell bagels. And that way, there's less competition between them than there would be if they both sold muffins and bagels. As a result of the reduced competition, presumably, prices go up, and the merchants are able to foil the operation of the market. Because after all, the reason that the market protects consumers well in its normal operation is through the vehicle of competition, that sellers have to compete in order to offer the best goods at the best price to consumers. And if they don't compete in that way then they won't get business. So an agreement to fix prices, or an agreement not to compete, circumvents that competition and prevents competition from operating in the market. So another way that the market can fail is when people takes steps that prevent competition. These kinds of agreements, either an agreement to raise prices or an agreement not to compete, these are illegal in most jurisdictions. This is part of antitrust law or competition law. In general, antitrust or competition law is aimed to prevent cases where the market gets stuck in a situation where there isn't enough competition to protect consumers. Or cases where somebody acts in a deliberate way to try to prevent someone from competing with them, acting in a way other than simply offering good products at good prices. Antitrust law is very complicated, I'm giving you sort of a sketch of it. But this is another instance where we know that there are failures that can occur, and where the law will step in to prevent, in the easy cases, things like price fixing or agreement not to compete. But in more difficult cases, even some attempts to reduce competition in the market through, say, mergers or other kinds of activity, another example where regulation might be helpful.
