Market Design in Regulated Industries

Can we achieve organic market institutions in electricity without market design, or is that a false dichotomy?

Right now my work is giving me opportunities to revisit ideas about market design and institutional change, a challenging process in closely-regulated industries. Below is a heavily edited essay from the Knowledge Problem archives in 2007 addressing this question:

“How does one invoke Hayek in one breath and the speak of “designing” a market in the next while keeping a straight face?”

Good question, and one I struggle with every day as an economist who works on a closely-regulated industry and comes from a very organic/complexity/ dynamism perspective. This question lurks in my mind constantly. One of the most enduring insights from Hayek's extensive work in economics and institutional theory is the importance of allowing and encouraging “spontaneous order”: order can be undesigned, can be unpredictable, and can embody decentralized information (Schmidtz & Boettke, Stanford Encyclopedia of Philosphy, 2021). A conundrum of regulated industries is that the conditions for spontaneous order do not emerge organically out of the administrative regulatory framework; that framework has to be modified deliberately to make room for emergence and for self-organization. That deliberate process is fraught with public choice problems because the regulated incumbents generally prefer the status quo and will invest resources in influencing regulatory and policy making processes to maintain that status quo.

At a practical level, I reconcile emergent order and market design by acknowledging that when we are dealing with markets or industries that have historically had a significant amount of regulation and government control and involvement (as Adam Thierer says, industries that are in captivity), the movement from heavily regulated to thriving market processes is very unlikely to be organic. It’s also unlikely to be a healthy transition, because embedded regulation creates embedded special interests who would like to see the regulation persist and will resist change, so if the transition process is too “laissez-faire”, the embedded special interests are likely to succeed at manipulating the transition to their advantage because they have political power and the incentive to exercise it. For evidence on this point I give you post-Soviet Russia.

In regulated industries like electricity, that’s one of the big challenges: how do you get to the situation in which market processes are organic, given that you are not starting from an atomistic, almost-clean-slate beginning? How do you get to the organic market processes when you are starting with historic incumbents (and regulators) that are themselves creatures of the administrative, regulatory process? Coming up with market rules that do not favor those incumbents over potential entrants is what I mean by “designing markets” as alluded to above.

The challenge of regulatory evolution in response to technological change, and in the interest of removing barriers to innovation, is that it should be a removal of regulation in the sense that it lowers barriers to participation from entities other than the regulated incumbent. Here my inner Hayekian teams up with my inner Demsetzian, if you will, to ask “compared to what?”: if regulatory institutions are going to change, how does that arrangement perform relative to other realistic, feasible alternatives to such a policy?

But the truly Hayekian sense in which I can reconcile the organic/complexity approach with “designing markets” is the sense in which Hayek writes in Law, Legislation, and Liberty. Market processes for the mutually beneficial, voluntary exchange of rights always occur within a context of law, of legal institutions, whether formal or informal or a combination of both. Many of what we think of as the most free and most capitalist of our market institutions, such as financial exchanges, involve elaborate contracts and laws against force and fraud enforcing those contracts. This legal context determines the rules by which we exchange; the context and the rules form the market institution. The quality of that institution and its variation across places or across time can affect how much exchange actually occurs, and how much net benefit is created through exchange. Even in free markets, the market institution is carefully designed, although in most organic markets the design process is a very distributed one, building upon centuries of legal precedent and experience, so it doesn’t look like it’s highly designed or deliberate. At that level, the distinction between organic market emergence and deliberate market design is a bit of a false dichotomy.

The problem is that in markets coming out of regulation or in markets that have never existed before, the market institution has to be designed, deliberately, in less-than-organic circumstances. That’s the hard part, because it introduces a political dimension to the design of market institutions that is not present in more organic situations, because there are special interests in the status quo and special interests in the future setup, all trying to influence the design of the rules in the market institution.

Another lens through which you can think about it is imperfection. In a perfect world there should be no need to reconcile Hayekian and organic perspectives with deliberate design, because there would be no transaction costs and everything would be fluid and self-organizing. Reality is not perfect, so we have to be willing to recognize the situations in which some deliberate organization is necessary to get us to a point where we have institutions that can support self-organization.