Law and Economics on Market Quality

Date May 24, 2016
Speaker YANO Makoto (President and Chief Research Officer(CRO), RIETI / Professor, Institute of Economic Research, Kyoto University)
Moderator NAKAHARA Hirohiko (Counsellor, Cabinet Secretariat)



YANO Makoto's Photo

YANO Makoto

A century ago, Louis D. Brandeis, an associate justice of the U.S. Supreme Court, quoted Professor Charles H. Henderson as saying, "A lawyer who has not studied economics and sociology is very apt to become a public enemy." This is a very thought-provoking statement. In Japan, law scholars and economists are not properly communicating with each other. This situation is very problematic for the Japanese economy.

In social science, a method that appears to have no direct relation is often considered to be an effective way of achieving a goal. This concept, called the "theory of roundaboutness," had an enormous impact on legislation as well as on 20th century economics and social sciences particularly in such fields as corporate governance and mechanism design.

However, it is no good taking a roundabout route in a haphazard manner. We need to find an efficient way of doing so. What social science tells us is to take an evidence-based approach to form ideas based on scientific evidence such as statistical data.

Stagnation in the Japanese economy and market quality

The Japanese economy has been stagnant for a prolonged period of time. During its bubble period, Japan's gross domestic product (GDP) per capita reached a level closest to that of the United States, but has been faltering ever since the burst of the real estate bubble in the early 1990s. I believe that the absence of a high-quality market is the reason.

A market is a pipe channeling new technologies and resources to people's lives. If the pipe is straight, clean, and in good quality, natural resources and science technologies will be channeled through and lead to better livelihoods. However, if the pipe is bent, rusty, and in poor condition, things clog up and stagnate.

According to the Bloomberg Innovation Index, Japan ranks second only to South Korea as the most innovative country in the world. However, in the ranking of GDP per capita, Japan drops to 25th. The combination of a low level of GDP per capita and a high level of the innovation index means that the productivity of innovations is low. We have a situation where innovations fail to translate into better livelihoods. I believe that this is not because of any lack of technological capabilities.

In the late 1970s, when personal computers (PCs) came into being, Japanese companies were just as innovative as their counterparts in the United States. However, when we look at today's PC market, we cannot help but admit that things are not going well in Japan. Probably, one big reason behind this is Japanese companies' failure to capture and incorporate people's needs in developing products.

People used to say that "semiconductors are the rice of industry." From the viewpoint of those economists like myself, this is a very problematic idea. First of all, rice is an inferior good in an advanced economy. In addition, rice is a protected industry in Japan. Obviously, this metaphor would not work out well for the semiconductor industry. Under the post-war food control system, rice farmers did not have to think about the needs of consumers because they could sell what they produce to the government at designated prices. If Japanese people were led to believe that semiconductors were products like rice, it was no wonder that the needs of customers were largely ignored back then.

In contrast, the U.S. computer industry captured the needs of customers, foreseeing as early as the early 1960s that there would come a time when even children would make full use of PCs. Even today, this remains a driver of the U.S. computer industry.

Back in the 1980s, the greatest needs for computers were versatile PCs that allow us to use various software products rapidly advancing in the United States. However, Japanese computers at the time were using hardware chips to generate double-byte Japanese fonts, having a completely different architecture from those in the rest of the world. As a result, customers' needs and wants for state-of-the-art software were not properly reflected in the market.

When DOS/V, which is capable of producing Japanese fonts via software alone, was created in the late 1980s, excellent Japanese software such as Ichitaro was replaced by U.S.-made software such as Word and Excel. If Japan had foreseen this and fulfilled the needs of customers in some way, the situation could have turned out quite differently.

Dynamics of market quality

There are two kinds of markets: high-quality ones and low-quality ones. A low-quality market is often filled with products that do not reflect the needs of customers. It eliminates competition and customers are forced to buy what sellers want to sell. Concealed information spells scams and cheating, and shoddy goods are bound to run rampant in the absence of quality goods. In contrast, a high-quality market can induce the development of products that better reflect the needs of customers. It is highly competitive and free from scams and cheating. All of these point to one thing: the presence of a high-quality market is indispensable to the sound development and growth of an economy. That is a hypothesis that I came up with about 20 years ago.

One of the things that support the hypothesis is the historical fact that a series of industrial revolutions and economic crises have occurred in a cyclical pattern, triggered by changes in market quality. The First Industrial Revolution gave rise to the exploitation of industrial workers, a major labor issue. The Second Industrial Revolution was followed by the formation of industrial monopolies, the Great Depression, and massive unemployment. The exploitation of workers and the monopolization of industries occurred because competition was imperfect, and the Great Depression occurred because information was not properly shared. What we can see in these episodes is a common pattern of events. That is, the advent of technological innovation is followed by degradation in the quality of competition and information, and hence compromised market quality, which culminates in an economic crisis.

The importance of law and economics is in the fact that the implementation of appropriate rules have always served as a trigger to turn around those crises. Specific examples include a series of labor-related laws established in England after the First Industrial Revolution, U.S. antitrust laws in following the Second Industrial Revolution, and U.S. securities laws in the aftermath of the Great Depression.

Market quality and the principle of nondiscrimination

I believe that the quality of a market is determined by two factors: efficiency and fairness. Efficiency means that nothing is being wasted, and fairness refers to a state in which the rules are being complied with. A market functions well when its rules are respected but goes wild when the rules are broken.

This is not to say that any rules will do well. We need to have rules that can derive the benefits of the market. A Japanese dictionary defines the term "kyoso," a word used as a translation of "competition," simply as "vying with one another." However, in an English dictionary, "competition" is defined as "the act or action of seeking to gain what another is seeking to gain at the same time and usually under or as if under fair or equitable rules and circumstances." This is something that many Japanese are not aware of, but competition cannot take place without appropriate rules.

Meanwhile, the determination of fairness is said to be dependent on rules, and, according to an English dictionary, "fairness" means "conforming to an established commonly accepted code or the rules of a game or other competitive activities." Markets are supposed to have competition and thus there are some basic principles underlying market competition.

Ronald Coase, who won a Nobel Prize in Economics for his theory of property rights, argued that the market would not function properly in the absence of an institutional system for enforcing property rights. Prior to this, neoclassical economists defined the market as a mechanism for ensuring voluntary transactions.

However, these two principles alone do not fully explain the market. So, I came up with the third one: anyone must be able to trade with anyone else. I call this the principle of nondiscrimination. My view is that these three principles or rules are underpinning the market.

The principle of nondiscrimination has three effects: 1) efficient distribution of resources, 2) leveled distribution of gains from trade, and 3) freedom of entry and creation and innovations. Here, I would like to focus on the relationship between the principle of nondiscrimination and innovations.

Freedom of entry is the underpinning philosophy of U.S. antitrust laws. The U.S. Supreme Court's 1972 ruling in United States v. Topco Associates states as follows: "Antitrust laws in general . . . are the Magna Carta of free enterprise . . . And the freedom guaranteed each and every business, no matter how small, is the freedom to compete—to assert with vigor, imagination, devotion, and ingenuity whatever economic muscle it can muster."

In other words, ensuring free entry and competition is crucial to maintaining free enterprise activity. As European competition laws have many similarities with those of the United States, this idea will gradually evolve as an established philosophy in many other countries.

Principle of nondiscrimination and Innovations

Looking at this in terms of market quality, we can see the market as a two-way pipe, which uses natural resources to generate and deliver outputs to help improve people's lives, while at the same time providing information that helps link people's needs to seeds for innovations.

Turning to the development of the Japanese market over the years, market quality improved for some time but has been on the decline in recent years. The 1980s, when market quality was up, was a period that witnessed Japan's rise as a major economic power. And then, as a result of rapid changes, the market became dysfunctional, leading to the quarter-century-long stagnation.

I think that up through the 1970s, Japan's automobile industry was a free market that was completely open to new entries. In hindsight, policy measures prescribed by the Ministry of International Trade and Industry (MITI) back then were guaranteeing the freedom of entry to the market.

Honda Motor Co., Ltd. is the best case example. The company began producing automobiles in 1963 and evolved, over the next 20 or so years, into one of the world's leading automobile manufacturers with its production volume reaching a level half of that of Toyota Motor Corporation. This was possible because Honda entered the market with a full understanding of the needs out there.

The needs in the latter half of the 1960s were for cars that emit cleaner exhaust fumes. The United States, sharing the same thought, introduced the Clean Air Act in 1963, which went through major amendments in 1970 to significantly strengthen pollution controls. The law as amended in 1970 is known as the Muskie Act.

Against this backdrop, the needs were turned into seeds for innovation. In 1972, Honda's proprietary reciprocating engine—CVCC, an acronym for "compound vortex controlled combustion"—became the world's first engine to have satisfied the requirements under the Muskie Act, paving the way for its commercial production. In 1973, Mazda Motor Corporation followed with its rotary engine. Some European automakers such as Audi AG were also trying to develop Muskie-compliant rotary engines, but Mazda was the first to succeed.

The CVCC engine was born from an idea developed for diesel engines. As the combustion efficiency of diesel fuel is rather poor, a diesel engine needs to have a sub-chamber to ignite. It is designed to generate an explosion in the main combustion chamber by generating an explosion in the sub-chamber. With the CVCC engine, Honda applied this mechanism to gasoline engines.

Meanwhile, the 1970s saw the emergence of needs for higher fuel economy besides cleaner exhaust fumes. From 1974 through 1978, Honda's Civic model was ranked No. 1 in fuel economy in the United States. With this, Honda earned high acclaim to become the top automaker in the United States. Mazda's rotary engine did not have as much impact perhaps because of poor fuel economy.

However, both of those engines made a huge contribution in demonstrating Japan's technological capabilities to the rest of the world. When a major oil crisis hit in the 1970s, Japanese cars dominated the world. I think that this remarkable accomplishment owes considerably to the success of the two engines that had built an image of Japan as a technology powerhouse.

Seen in this light, the starting point for Japan's success was the freedom of entry to the market. Without that, neither Honda nor Mazda would have been able to invest in the development of new technologies in expectation of huge profits in the future. So, that was why the Japanese automobile industry has been able to remain the global leader for the past several decades.

How entry restrictions inhibit innovation

Meanwhile, some other industries have been unable to innovate because of regulatory barriers that inhibit entry to the market. The case of personal data assistants (PDAs) is one example. Since the early 1990s, we, consumers, have been clamoring for a function that enables us to make text inputs in the same way as they write on a piece of paper. We have also thought of devices with rotating screens to use both landscape and portrait orientations. The starting point of the lineage of technology leading to these functions is the Zaurus, an electronic notebook developed by Sharp Corporation in the 1990s, which offered leading-edge technologies in PDAs (or pocket computers).

Despite this, the image of today's Sharp is clouded by the product name "Galapagos" that the company chose for its electric book-reading device in 2010; now, the word "gala-kei" is commonly used to refer to old-fashioned mobile phones that disappeared from the market around 2010. I think that the transition from the Zaurus, which conjures up the powerful image of a gigantic dinosaur, to the Galapagos, the insular island chain inhabited by endemic species, was the desperate signal that Japan has lost its leading edge in IT technology.

The first-ever electronic notebook was put on the market by Casio Computer Co., Ltd. in 1973, while Sharp introduced one with similar functions as today's models in 1987. The handwriting recognition technology was jointly developed by Sharp and Apple Inc., which were also recognizing the importance of enabling customers to input data by writing on the screen. Sharp beat Apple by one year in turning the technology into commercially viable products. So, it is presumed that back then, Sharp was a step ahead of Apple in PDA and electronic stationary technologies.

Subsequently, however, while Research In Motion Limited (RIM), a Canadian company currently known as BlackBerry Limited, launched a full-fledged phone/email device, the BlackBerry Quark, in 2003, and Apple introduced its first iPhone in 2007. Around this time, Sharp discontinued selling the Zaurus devices. The reason is clear; both the BlackBerry and iPhone offered integrated mobile phone and electronic notebook functions.

When I started using a Zaurus in the mid-1990s, I wondered why Sharp had not combined mobile phone functions into its PDAs despite such an obvious business opportunity. I then immediately realized the very simple answer; the Japanese mobile phone service market was so highly protected that it was basically impossible for a newcomer to enter. In Japan, the first generation (1G) mobile telephone technology was introduced in 1985, followed by the 2G in 1993 and the 3G in 2001—all linked to the allocation of frequency bands administered by the Ministry of Posts and Telecommunications.

The door to the market technically opened in 2001 and SoftBank Group Corp. made its way into the mobile phone business. Still, entering the mobile phone service market remained extremely difficult—if not impossible—for non-telecommunications companies. As the producer of the Zaurus devices, Sharp must have been well aware that a combination of mobile phone and PDA functions would be a perfect recipe for bountiful profits. As far as I understand, the only reason why the company nonetheless failed to integrate the two sets of technology is the government's policy for the telecommunications sector, which virtually inhibited new entrants from getting into the market. I think that the oligopoly of radio frequencies during that period of time is blamable for severely suppressing the development of Japan's overall telecommunications market. If Japan were to prevent today's plight, it would have had to liberalize its telecommunications market at the time of the U.S.-Japan Structural Impediments Initiatives talks from 1989 to 1990.

U.S. companies are on the constant lookout for new business opportunities. Japanese companies cannot develop new technologies into commercially viable products in a timely manner unless the government liberalizes the market at a sufficiently early stage. Had Sharp and/or other like companies embarked on the development of mobile phone-cum-PDA devices in the mid-1990s, Apple would not have been able to dominate the market as it does today. As such, there is no long-term prosperity in an economy where the market is incapable of properly reflecting the needs of customers.

Laws and regulations for enhancing market quality

Necessity is the mother of invention. We must first define economic policy as infrastructure for transforming people's needs into concrete products or services via the market and then promote the development of technologies to link the needs to seeds for innovation. The Japanese government had been doing this very well with its policy vis-à-vis the automotive industry up until the1980s but has been unsuccessful thereafter. New laws and regulations are meant to be an instrument to break such an impasse in the government's policy. However, establishing ill-designed laws and regulations, such as the radio frequency regulations, would make things worse.

Richard A. Posner, a famous American lawyer/economist, wrote in his book as follows: "Suppose courts, in determining the rights and duties of parties to contracts, do not use the criterion of efficiency to guide their decision, but use instead some noneconomic criterion of fairness. What effect do their decisions have on the process of exchange?"

This question applies to all sorts of social decision and policy making. We need to create a society that can promote innovation by making effective use of the market. Japan, which had such an economy in the period immediately after World War II, should be able to rebuild it. As a starting point of this endeavor, it is important to ponder the question raised by Posner.


Q1. When the Japan Law and Economics Association (JLEA) was established, I thought that it would become a key catalyst in creating a better society. Unfortunately, however, it has not developed as expected. How can we rebuild it?

A: The JLEA's activities are carried out in such a way that leading economists in academia take a leadership role to inspire others to join the initiative. However, my personal view is that it would be difficult to make tangible progress unless we make steady efforts to teach the importance of economics in university classes. Some time ago, there was a move to incorporate more elements of economics into the national bar examination. While such efforts should be continued, it would be desirable to have more economic discussion in law school classrooms.

In this regard, Japan is currently standing at a starting point of its endeavor toward achieving what Professor Brandeis said a hundred years ago. We need to make continuous efforts to promote the importance of law and economics in various places and occasions, for instance, at research institutes such as RIETI and in university classrooms.

Q2. As a result of the suspension of nuclear power generation, Japanese electric power companies have been incurring 100 billion yen in losses every year. In the end, consumers are the ones who must pay the price in the form of higher electricity bills. From the perspective of law and economics, how do you view this situation?

A: The big problem is that the Japanese society did not have a shared understanding of what the law says. In other words, technologies were used without proper explanation about the potential risks or danger involved. When people were explained about a plan to construct a nuclear power plant, typically, the first thing they were told was how safe it would be. However, that kind of technology cannot be free from the risk of hazards.

Accurate information concerning this point has not been communicated to the general public and information is not being properly shared. A law is established and adopted by a majority vote, but voting should take place based on the precondition that relevant information is shared by all members of society. From the perspective of law and economics, taking any action without fulfilling this precondition is unacceptable. So, unless we first clear this hurdle, it would be difficult to put nuclear technology in good use.

Q3. It is surely important to enable the market to play its intended role as much as possible. However, since leaving everything to the market may result in an unequitable distribution of income, appropriate adjustments must be made by means of taxation and fiscal measures. But then, there is a possibility of trade-offs, giving rise to the concern that such government interventions may undermine the function of the market. So I think it is important to consider how we should communicate with the market on issues that cannot be solved by the market, and how we can identify the trade-off relationship and design institutional systems based on that understanding. What is your view in this regard?

A: I agree with what you have just said. But what I often wonder is whether the kind of problems cited by many people as those that cannot be addressed by the market are really the kind of problems that should be dealt with by the market. I kind of feel that we have been discussing whether or not the market is capable of doing something without making a clear distinction as to whether it is truly meant for the market to deal with. Market quality is closely related with the issue of income distribution, and there are cases of free riders. If the problem of free riders persists, it creates income inequality where some people reap big rewards for doing little while others gain little for their efforts.

My current research interest is in explaining the mechanism of how market failure causes the misallocation of assets, which is something that has not been explored before. But setting that aside, there are poor people in reality, and it is necessary to address the poverty problem. So, we need to clarify what issues we are trying to address. I think it is problematic to highlight the market's shortcomings without such clarification.

The reason why I focus on market quality is that I was not fully convinced by the theory of market failure when I learned it as a university student. So, in an attempt to provide a new angle to look at the issue, I reworded it as "market quality."

However, aside from the issue of improving market quality, there exist various problems that the market is intrinsically incapable of dealing with, such as the provision of public goods. And we need to address such problems properly.

My point is that some of those things that are perceived by many as public goods may not be so in fact. For instance, electricity, which has long been considered as akin to public goods, can be sold as separate pieces of goods today. As such, what constitutes a public good is to change with the advancement of technology in the world. Therefore, we need to have flexibility, rather than holding on to fixed ideas, in distinguishing public and non-public goods, rather than drawing making distinction distinguishing public goods.

*This summary was compiled by RIETI Editorial staff.