What is structural reform?

Good microeconomic policy requires two things. The first is a commitment to the entrenchment of well functioning markets and to letting market competition determine economic outcomes in all circumstances where competition is appropriate. The second is good regulations (i.e. rules) to guide economic outcomes when competition is not appropriate. The forces of competition can exert powerful pressure on producers to find

the least cost way of serving customer needs, and to innovate in order to better serve those needs. Individual producers can benefit from any cost savings they make, in the form of higher profits. And consumers and downstream using industries can benefit as competition from other producers squeezes those profits and drives prices down towards costs. This dynamic process leads to prices that reflect production costs, and costs that are as low as possible. The first condition ensures allocative efficiency – resources are put to their best uses. The second ensures productive efficiency – the maximum output is achieved from those resources. Both types of efficiency ensure the highest possible levels of income. Not only does competition help to maximize income levels, but it does so

in an administratively efficient way. In theory, the same patterns of production and consumption could be achieved through a system of centralized decision-making. But the administrative requirements for such central planning are burdensome, and the information requirements for doing it successfully are prohibitive. By contrast, the market place achieves these outcomes in a decentralized way. No bureaucrat needs to decide which individuals should run which companies producing which products at what price. For those countries where regulatory capacities are in short supply, this can be a significant benefit from letting the market place decide. This is not to say that there are no administrative or legislative requirements

for market competition. Basic laws are needed to set the boundaries of that competition. For example, corporations’ law is needed to allow for limited liability companies, thus limiting the downside risks to shareholders from poor corporate performance. Accounting standards and disclosure requirements

are needed so that shareholders and creditors can assess the economic performance of companies in a transparent way. Bankruptcy laws are needed so as to limit the downside risks to outside creditors of poor corporate performance. But no case-by-case decisions are needed about which producers should survive and which should go out of business. Another benefit of competition and decentralized decision-making is that it

can make an economy more flexible and robust in the face of external shocks. Producers used to out-guessing rivals on a daily basis will be better placed to react to adverse global market developments than producers who have no rivals, or are used to being told what to do by bureaucrats. Furthermore, producers with rivals will have a financial incentive to be better informed than those rivals of likely global market developments. By contrast, bureaucrats have no profit motive to collect such information. Finally, producers with rivals are likely to be the best placed to respond to adverse shocks, because competition is likely to have weeded out the poorer performers. Small economies in particular need to be relatively open to global markets, because they do not have the variety of resources to produce everything at home. Flexibility is the key to protecting themselves from the variability of global markets. And competition can enhance flexibility. Potential rivals are as important as actual ones. Even a monopoly supplier

will be unable to inflate costs or profits on a sustained basis if this attracts the entry of a competitor who can produce at lower cost or with a smaller profit margin. So long as it is possible for a competitor to enter at any time with few irreversible costs, this will discipline an incumbent’s behaviour. So the number of actual competitors is less important than the absence of barriers to entry and exit. Contestability is the key to effective competition. As a corollary, good microeconomic policy means protecting competition,

not protecting particular competitors. The difference is crucial, although it is not always observed, even in the most enlightened economies. The benefits of competition will only emerge if firms and workers have the incentive to enter into or exit out of specific activities. Entry, exit or survival of any particular player should not be preserved by administrative means. There is a growing body of empirical literature that supports the idea that the entry and exit of firms is a key determinant of productivity in developing countries (Roberts and Tybout 1997). Foreign competition can play an important part. It can come from allow-

ing cross-border trade to occur in an unimpeded fashion. It can come from allowing foreign direct investment, so that foreign suppliers set up a permanent local presence. The latter sort of competition can bring additional benefits, in the form of new capital, technologies and business processes. But any attempt to ‘manage’ the process by allowing only a specific number of foreign players, rather than allowing free entry and exit of foreign players, is an instance of protecting particular competitors, rather than protecting competition. Further, such managed competition risks handing over existing monopoly profits from domestic to a few foreign players, with little benefit to

What is structural reform? 7

domestic consumers and users in the form of lower prices, and a net loss to the economy as a whole. Competition from domestic new entrants is arguably even more important

than foreign competition. A recent study examined the empirical evidence on the relative importance of discriminatory barriers to foreign competition, and non-discriminatory barriers to any new competition, among a group of East Asian economies. The results were striking. The gains to the region from unilaterally reforming the non-discriminatory restrictions on competition in seven selected services sectors were almost six times those from forming an East Asian preferential trade area, and three times those from a successful Doha Round (Dee 2007). East Asia need not fear that unleashing the forces of competition would see their economies overrun by foreign multinationals. The critical barriers to competition are often those protecting incumbents against domestic new entrants. Promoting competition is a much broader agenda than putting in place

competition law, narrowly defined. Anti-trust legislation is about ensuring that abuses of monopoly power do not occur. Competition policy, broadly defined, is about removing the barriers to entry and exit so that positions of monopoly power do not persist. This book is more about the latter than the former. Indeed, structural reform is about competition policy in its broadest possi-

ble sense. The policy agenda includes removing barriers to foreign competition, be it from cross-border trade or from foreign direct investment, and not just for particular trading partners. It includes removing barriers to the entry of domestic new entrants, and allowing existing firms to exit the market place in an orderly fashion if the market dictates that they cannot survive. It includes ensuring that the minimum regulation exists to guide economic outcomes in those circumstances when markets alone may not deliver the most efficient outcomes. It includes ensuring that the right institutions are in place to review and remove the unnecessary impediments to the functioning of markets. It includes ensuring that the right institutions are in place to design, implement, enforce and review the functioning of more appropriate regulation. It includes devising strategies to protect the credibility of those institutions, despite the inevitable attacks from special interests. It includes developing transparency of institutional processes, and nurturing an educated and informed commentariat, so as to bring economic policy-making out of ‘smoke-filled back rooms’ to help establish that credibility. Above all, it involves establishing a presumption in favour of non-intervention in the economy.