In recent work for the European Commission, myself and colleagues have been evaluating competition in the professional business services markets with the aim of identifying which aspects of the sector inhibit effective competition. In this article I will explain a bit about our findings and highlight the different competition concerns and how economic theory is interwoven into this analysis.
Background
Firstly, what are professional business services (or PBS for short)? For this study they included accounting, legal, architectural and engineering services. These services are typically known as credence goods, in the sense that consumers often don’t know about expected service quality before they purchase the service and are unlikely to be able to evaluate quality after provision.
If we think about purchasing legal services, it might be quite difficult to know how “good” a particular lawyer is when searching for a representative. Regulation has dealt with this to some extent by introducing minimum requirements in terms of training etc and reputation may also help with the situation by informing searchers about poor providers (more on these two concepts later). However, both regulation and reputation are unlikely to help in all instances – a well trained (regulated) lawyer can still provide a poor service if they don’t put in the required effort and reputation may not solve the issue if consumers don’t talk to each other. Therefore, it can easily be seen that quality of both the provider and the service, as well as effort input, is difficult to assess before purchase/provision.
Furthermore, even after the service has been provided, it can often be difficult for the consumer to judge whether the provider did a good job or not. For instance, with the legal services provision, did the lawyer lose the case because of bad luck/destiny or because they did not put enough effort into arguing the case? It can be difficult for consumers – with a lack of knowledge on these specialised subjects – to know.
This point about PBS markets being characterised by credence goods leads to the first conclusion that this sector is characterised by high information asymmetry. We will discuss other market features prevalent in PBS shortly. An important thing to note about info asymmetry is that it can lead to consumers being overcharged for services or overprovided (the provider recommends services which the consumer doesn’t need) and it can make comparisons between providers difficult.
Secondly, when we talk about consumers we can either think of individual consumers (ordinary people) or business consumers. For this study, we primarily focused on business consumers. This ranges from very small consumers such as SMEs purchasing the services of an accountant to file a tax return to large consumers such as multinational corporations that may purchase the services of an architect to build a new sky-scraper office building. On the flip side, the PBS provider can be of various different sizes, with accountants ranging from those that are self-employed to large corporations offering accounting services across the globe.
Obviously, when thinking about business consumers it is clear that professional business services are an input good, so that higher prices and worse quality in these markets not only has a directly negative effect but also has an indirect effect on final consumption prices in general markets. In other words, if PBS over-charge business consumers, then these business consumers will typically have to increase their product prices to account for this, resulting in higher prices for ordinary consumers. This demonstrates why it is so important to promote competition in industries which we may think of as having only a small direct harm.
The model
To make an evaluation of the state of competition in PBS markets we modelled the situation as the market having a set of features, or characteristics, which inhibited the functioning of competition in the market. Such poor functioning results in an inadequate state of competition and poor market outcomes for consumers. That is Market Features -> Inadequate Competition -> Negative Market Outcomes (X->Y can be thought of as X results in Y). To alleviate some of these problems, regulation and market-based correction mechanisms can play a role. We will elaborate on these concepts later but typically we would imagine that regulation would try and directly fix the negative market outcome or mitigate against a market feature whilst the market-based mechanisms would typically affect the functioning of the market or the features, without directly intervening in terms of market outcomes.
In terms of features that are prevalent in this market and which are likely to affect the competitive function of the market, we have already discussed one: information asymmetry. The other features which we considered to play a significant role include: significant relationship-specific investments, multi-dimensionality of quality attributes, distorted demand behaviour and the fact that low quality provision can have large negative externalities.
Let’s start by exploring the first of these, relationship-specific investments. In PBS markets it is common for consumers and providers to work closely together for a tailored product that is not “off the shelf”. This often means large investments on both sides, with consumers investing time and executive resources explaining their problem and how their business functions to the provider and the provider tailoring their services to that particular customer. Consequently, strong relationships can form between customers and providers which can be difficult to break and may mean that consumers don’t look around or switch once they have invested in a relationship. This can obviously have negative effects if the provider charges higher in the future or provides a less good service (within the constraint that things aren’t bad enough for the consumer to switch provider).
With respect to multi-dimensionality of quality attributes, it is often the case that different consumers care differently about different attributes. For instance, one consumer may care highly about price whilst another cares highly about quality. This can make comparisons between consumers difficult and can make solutions like reputation less effective. Moreover, customers often care about different aspects of quality and quality itself is very difficult to determine and assess. Some consumers will prefer a friendly provider, others a technical one, some will prefer that the provider focuses their service on safety whilst others might prefer aesthetics. There are a wealth of different characteristics and it can be difficult for consumers to assess, compare and share amongst themselves.
These two features are closely related to the fact that the service is generally tailored to the customer and is not a homogeneous product that can be re-sold to another consumer.
Distorted demand behaviour can arise because some goods are infrequently purchased or there is mandated provision of a service. Some services, such as tax returns are required annually and it may be legally required that returns are carried out by a PBS provider. In this case, consumers have no option but to choose a PBS provider. This can limit their outside options which already increases the bargaining power of PBS providers. Further, if consumers are required to purchase a service, then they may not actually care about the quality of the service they receive, so long as they can tick a box. In this case, providers don’t necessarily have an incentive to compete on quality and we may see negative outcomes along this dimension. In a similar fashion, if consumers don’t purchase a service frequently then it may be expensive for them to search and so they may return to the same provider without evaluating if any better provider exists. This can give a perverse incentive to companies, with “better” companies not receiving custom and therefore not having an incentive to offer a good service.
Finally, PBS markets can play an important function in society and poor quality can have large negative externalities. For instance, if an architect was of poor quality and designed a bridge incorrectly and the bride later collapsed, this would have a large societal cost in terms of deaths and injuries, reflecting the significant negative externality posed by poor quality provision. (Granted, this is quite a strong example!)
So, we have seen that there are a number of features which are likely to inhibit competition. We haven’t elaborated in too much detail what these theories of harm are but more details are provided in the paper. Before discussing how this inhibited competition can be measured in terms of outcomes, and the ultimate effect on market outcomes, we should remember that these features aren’t necessarily unique to PBS. Many markets are characterised, for example, by information asymmetry. More importantly, many markets with such info asymmetry still function well. Therefore, the existence of negative features in themselves does not necessarily mean that the market won’t work well.
Competition outcomes
In the paper we discuss a few ways to measure the negative competition outcomes, including high market concentration (and usually a low number of providers), segmented markets, the existence of tacit or overt collusion, high barriers to entry, firms competing over signals rather than value for money, strong customer-provider relationships and low switching rates.
Most of these outcomes are quite self explanatory, although they may be difficult to observe (e.g. collusion). In terms of firms competing over signals, by this point, we mean that providers may not be able to effectively demonstrate to consumers that they are a good value for money provider (i.e. cheap and provide a good quality service) but can signal this through other methods, such as advertising or having fancy buildings to demonstrate their importance.
Market outcomes
We don’t really care about the competitive situation of the market in itself. What we care about is the effect this has on market outcomes, namely price and quality. We also care about innovation and the availability to the service, where the latter is probably quite important in this market where capacity constraints may be rife.
Now the inhibition of competition is likely to result in higher prices and lower quality, with consumers having little option but to purchase, particularly when the service is mandated. In markets where competition is low, we would also expect innovation to be low and for providers to be reluctant to take on new business.
None of these outcomes are good for consumers and can have knock-on effects to final consumers.
Regulation and Market-based Correction Mechanisms
I don’t want to discuss these points in too much detail (see the paper for more) but regulation has been introduced by various governments to (allegedly) try and reduce some of these problems and improve market outcomes for consumers. For instance, regulators might impose price caps on providers, to stop them overcharging or may mandate certain qualification requirements to try and improve quality. However, there is much discussion in the literature about how effective regulation is and the negative consequences that regulation can have (e.g. qualifications may improve quality but it also restricts access which can push prices up). There is also a discussion about whether regulation is designed to improve the situation for consumers or is the result of lobbying by providers to restrict entry into PBS markets.
Another solution comes from the market, and includes reputation, litigation, service trials and complex pricing structures. It is not immediately clear why some markets exhibit these mitigation solutions whilst others don’t (and how we can arrive at such an equilibrium). But it is clear that these solutions are present in some markets and can help to overcome negative features that may exist. For instance, reputation plays an important role in mitigating information asymmetry in some markets. For instance, in the car market (typical Akerlof territory), if the salesperson sells too many dodgy cars then they will have a reputation for being a bad salesperson and may lose future business. This acts to constrain the behaviour of salespeople in the car market and result in an improved outcome for consumers. However, this solution may not be optimal for PBS markets, where consumers care about different aspects of quality (i.e. the feature of multi-dimensionality) and therefore have difficulty agreeing/sharing opinions on providers.
Conclusion
Overall, we have outlined some market failures which may occur in professional business services markets and discussed how these features can affect competition and ultimately market outcomes. By better understanding these mechanisms, policymakers can design better policy to address and mitigate failures and result in improved consumer welfare.
This discussion has been presented at the OECD workshop on Regulatory Barriers and the a recording of the presentation and the source material can be found here. Inevitably, the full report goes into much more detail and discusses the competitive effects more thoroughly. UPDATE: the published report can be found here.