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Two Cheers for Industry Self-Governance

| Aug 5, 2014 | Opinion

It’s no secret that individuals can do more when they act together. For the past century, Americans have become accustomed to the idea that collective action on issues like national security, food safety, and environmental regulation is something that belongs to the U.S. government. Since the 1990s, however, private industry has started to regulate itself to address many of these same issues.

Corporate BuildingOn its face, industry self-regulation seems like a good thing. Provided that societal problems get solved, it is hard to see why anyone should worry about whether institutions responsible for regulation are private or governmental.

But in fact, many people do worry. They make statements such as: “Corporations only care about money,” and, “Self-governance is just a publicity stunt.” Unfortunately, statements like these are more bumper stickers than analyses. The fact is that private standard-setters can perform some tasks that governmental standard-setters simply cannot, and they can perform many other tasks more efficiently. We should not be too quick to criticize regulation merely because it has been created by industry.

Since the 1990s, private initiatives have pursued policy goals ranging from saving dolphins to food safety. In many cases, these initiatives have worked remarkably well. For example, as a result of such initiatives, worldwide dolphin mortality has fallen ninety-seven percent. In addition, private food standards in Europe have changed how farmers grow food around the world, from Africa to Australia.

As with all collective action, none of these initiatives would have been possible without some mechanism to overrule dissenters – those who fail to cooperate and comply. In practice, the key control mechanism has been provided by big customers who demand their suppliers comply with private standards. Indeed, industry self-governance only seems to work when three conditions are present: big customers, high fixed-cost suppliers, and thin supplier profit margins.

Formal economic modeling leads to two important insights about the efficacy of self-regulation. First, the big customers don’t have to be unanimous. Beyond some critical mass, it no longer matters that some customers would be happy to accept goods or services that do not meet the higher standards. Indeed, suppliers that try to specialize in serving such customers actually lose money.

The fact that a critical mass of big customers can force industry-wide standards onto suppliers implies a rough political “constitution,” namely that as long as enough big customers “vote” for a standard, dissenters must acquiesce or leave the industry.

Of course, just knowing that a constitution exists does not say much. We also need to know – at a minimum – what the “voters” prefer. In the case of big corporate customers, this also depends on markets. Conceptually, there are three basic scenarios.

The first possibility is a competitive market. Perfect markets famously give customers exactly what they want. Indeed, any firm that refuses is immediately replaced. Political scientists have long known that private standards require imperfect markets.

The second possibility is an oligopoly market. Concentrated industries are often able to limit or eliminate price competition. Even so, competition tends to reemerge along other dimensions. These can be material (product quality) or psychic (celebrity endorsements) or ideological (social responsibility). Moreover, companies that fail to compete are remarkably vulnerable; because prices are similar, consumers can switch brands quickly. This means that market share can plummet overnight over seemingly minor issues like sustainable fishing or coffee worker wages. This makes industry executives extremely sensitive to consumers. For a company like Target, the size and demographics of this “shadow electorate” are not very different from the voters who customarily turn out for national elections.

Finally, some industries manage to suppress competition altogether. This lets executives do whatever they like so long as the company breaks even. Like all humans, we expect their actions to reflect a complex mix of greed, desire for praise, and ethical conviction.

So, which markets do existing private standards operate in? The safest answer is “a mix of all three.” However, I have already noted that modern initiatives invariably feature big customers and high fixed-cost suppliers. This implies that private standards work best in oligopolies. This is confirmed by frequent observation – most notably in fisheries and lumber industries – that a successful private standard should avoid raising the final price to consumers. This caveat strongly suggests an oligopoly market dominated by quality competition.

So far I have considered what big customers want. More often than not, however, they are not the only voters. Instead, experience suggests that big customers frequently share power with others.

One reason is information. Particularly in complex fields, suppliers often know much more about how to design standards. But if they share this information, customers may demand even higher standards. Delegation reassures suppliers by giving them enough votes to block this outcome. There is also a second reason to delegate: enacting a strong standard is good, but public recognition is better. Delegating power to well-known advocacy groups immediately shows that the standard is more than a simple “publicity stunt” or “greenwashing.”

In theory, these delegations can always be rescinded. So long as they last, however, the power is real. This explains why private politics often proceeds through a series of walkout threats, with the organizers trying to keep defection rates low enough to preserve the organization.

These forms of private politics seem to resemble a conventional public debate. However, there are also important differences. In order to be credible, walkout threats must sometimes be carried out. This can lead to rival standards and a Silicon Valley-style “standards war.” The resulting competition can force both standards to evolve in a constant struggle to woo voters. The effect has been particularly dramatic in lumber standards, where the differences between NGO- and industry-dominated standards have grown steadily smaller over time.

Maintaining multiple, warring standards is wasteful. Even so, competition offers intriguing possibilities. Economists have long known that standards wars reveal some types of information more efficiently than hearings and testimony. For example, claims that self-regulation is “unaffordable” or “will drive jobs overseas” are almost impossible to settle through political debate. The fact that some companies already practice a standard should immediately put most doubts to rest.

So far I have discussed how private voters interact to produce standards. But what we really want to know is when private power and private standards are legitimate. First, I have argued that quality competition can force oligopolies to design standards to please a shadow electorate of consumers. This electorate will often be at least as representative as the narrow interests that shape conventional agency regulation. Evidence that executives are anxious to protect their market share would go a long way to establishing when private regulation ought to be respected. Transparency rules that make it easier for consumers to watch and, if need be, punish companies would further buttress the argument.

Second, firms that possess dangerous power in the first instance should be allowed to get rid of it through delegation. So long as the delegation endures, a standards body that includes, say, the World Wildlife Federation can reasonably claim to represent environmentalists.

Finally, the introduction of standards war-type methods promises a new way of practicing politics. Courts should be open to the possibility that standards wars make political outcomes more resistant to random accidents and deliberate dishonesty.

Legitimacy is also an international issue. No matter how well-intentioned, deploying Western economic muscle to impose standards on the developing world seems painfully neocolonial. In the long run, the only principled defense is delegation; that is, making private standards more democratically inclusive than any competing institution.

Ultimately, citizens must decide for themselves whether private standards are legitimate. But it’s important to get the answer right. Government will never find the time and resources to regulate every problem. And even if it could, industry usually knows much more about how to design solutions. Society can have more private standards if it wants them.


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