Economic Research Forum (ERF)

When market contestability is not enough

In economies where the state maintains a big footprint, as in the Middle East and North Africa, improving the performance of public enterprises and dominant private firms would seem to require a stronger threat of competition. But as this column explains, such enhanced market contestability may not be enough if there is inadequate competition in the marketplace for policy ideas and public opinion.

In a nutshell

If there is no contestability in the public square, contestability in markets might not suffice to force improvements in the economic performance of state-owned corporations or to unleash the growth potential of a regional economy.

Getting contestability right in both the market for goods and services and the market of public opinion – what Albert Hirschman called ‘voice’ – is crucial to ensuring that the threat of competition elicits the desired response from public enterprises.

The development of economies in which the public sector is a large contributor to economic activity depends on contestability in the public square as much as in the market – both are achievable in the MENA region.

Since the early 1980s, economics has viewed ‘contestability’ as essential to forcing enterprises to improve their performance, even when they are dominant in a market.

What matters is the threat of competition – that is, whether a market is contestable – according to the pioneering work of the late William Baumol, John Panzar and Bob Willig. Contestability is measured by the ability of firms to enter or leave a market easily, regardless of prices or the number of firms that participate in that market.

Contestability rises as entry and exit costs fall. It rises in a given sector as the sunk costs of operating an enterprise – outlays that have been made and cannot be recovered – fall because it is less expensive for new firms to set up shop and less costly for incumbents to get out.

Contestability also rises if both incumbent and non-incumbent entrepreneurs in a given industry have equal access to frontier technologies. Incumbent firms – no matter how dominant or protected by their governments – can be jolted out of complacency if markets become contestable, because customers are given options and enterprises have incentives to change and innovate. Or so the theory goes.

Albert Hirschman, writing a decade before the term contestability entered economic parlance, told the tale of a state-owned enterprise (SOE) that was seemingly unmoved by competition – perceived or real.

In his seminal 1970 book Exit, Voice and Loyalty: Responses to Decline in Firms, Organizations and States, Hirschman argued that consumers can ‘exit’ their relationships with their preferred providers of goods and services if they become dissatisfied, thus exerting pressure on enterprises to improve their performance. And in Hirschman’s story of an SOE, contestability happened – but with unexpected results.

The tale is simple: changes in market conditions allowed new enterprises to compete with an established SOE. The market was contested, customers exited from their relationship with the SOE, but the incumbent SOE’s response was inadequate. As revenues fell, the SOE did little to invest in developing a new business model that might allow it to operate, even if at a reduced scale.

In fact, market contestability can weaken SOEs if they incur rising operational deficits. These deficits can be sustained for a while, but not forever. The fiscal authority is usually pressured to come to the rescue, thus reducing market pressures on the enterprise.

In other words, unreliable public services that lead customers to exit their relationship with an SOE, can lead to public sector deficits. The market’s contestability prompted by the emergence of other service providers did not lead to swift corrective actions.

The saga of the SOE narrated by Hirschman is an example of contestability in the market that did not yield the expected results. Perhaps public expressions of dissatisfaction by citizens and enterprises – what he called ‘voice’ – might have been more effective in pressuring the SOE and the government to adapt more quickly to rising competition.

We do not know for sure, of course. But this is an episode that at least should give us pause for thought about the power of market contestability by itself to force improvements in the economic performance of a state-owned corporation. Hence an emphasis on governance of SOEs is a welcome development in the 21st century conversation about the path forward for developing economies.

This is a particularly important lesson for the Middle East and North Africa (MENA), where the state maintains a big footprint in the economy. Simply put, contestable markets might not unleash the growth potential of the region. ‘Contestability’ in markets might not suffice if there is no ‘contestability’ in the public square.

Getting contestability right in both the market for goods and services and the market of public opinion – Hirschman’s ‘voice’ – is crucial to ensuring that the threat of competition elicits the desired response from public enterprises.

Market-oriented policies are usually associated with reducing entry costs, but normally not exit costs or even with the retooling of state-owned enterprises. For example, in the past decade, a number of MENA countries have been among the top global reformers in reducing the number of procedures and permits required to open and run an enterprise.

But there has been little change in firm dynamics. In fact, there is compelling evidence that politically connected firms respond to competition not by retooling or innovating, but by securing access to opaque forms of subsidies. Consequently, the private sector in the region continues to be dominated by incumbent firms, which are significantly older than those in the rest of the world and have incentives to engage in ‘rent-seeking’ to maintain privileged market positions.

Deeper institutional reforms are needed to nurture meaningful market contestability. Antitrust or competition policies are required to deal with entry and exit costs as well as sunk costs, which, when high enough, produce natural monopolies. Those natural monopolies can be regulated by an independent agency capable of keeping them ‘on their toes’, as economics Nobel laureate Jean Tirole puts it.

In the public square, Hirschman’s ‘voice’ represents a mechanism through which civil society can provide feedback to its leaders. Meaningful feedback to policy-makers about how their chosen policies – such as using taxpayer funds to subsidise underperforming public enterprises – can be channelled in different ways.

For example, academics, journalists and thought leaders together constitute an ecosystem that provides a valuable sounding board for policy-makers about the effects of their decisions, or at least about how their policies are perceived. It is about the contestability of policy ideas in the public square.

But it is probably not enough to have a vibrant ecosystem of feedback providers for policy-makers in the market of ideas about policy choices. The participants in this intellectual market must also have access to information – particularly social and economic data that allow for analyses of economic trends.

It pays to have an academic community, both domestic and international, that can access macroeconomic and microeconomic data to conduct research that helps to explain economic trends. Ideally, such experts would also be allowed to conduct – at low cost – independent evaluations of the impacts of policies. Indeed, the latest World Development Report 2021 – Data for Better Lives – provides a broad look at the uses and reuses of data for development.

Emerging research conducted at the World Bank suggests that data transparency has a good chance of helping to accelerate the pace of economic growth. We interpret such preliminary findings as evidence that contestability in the public square can pay development dividends, regardless of the nature of political systems.

The development of economies in which the public sector is also a large contributor to economic activity depends on contestability in the public square as much as in the market. Both are achievable in the MENA. If pursued as twin goals, the fiscal costs could be negligible because improving access to data takes political will but does not require significant resources. Why wait?

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