Trivially, Goods Irrespective of Whether Used As Inputs in the Production of Other Goods

Trivially, Goods Irrespective of Whether Used As Inputs in the Production of Other Goods

Efficiency or Obfuscation? Comment on

“Mutual Recognition” by Jacques Pelkmans

Manfred J. Holler[*]

September 17, 2010


In this comment on Jacques Pelkmans’s paper it is argued that the New Approach to European Standardization (NAES), with its two very diverse components of mutual recognition (MR) and security, health, environment and consumer protection (SHEC) can be explained by the fact that the accountability for the corresponding policy is allocated to the national level. The governments and the representing bureaucrats try not to be held responsible for measures that are not popular (i.e. objected by a large number of voters). One solution to this problem is a form of obfuscation as a result of delegating the decisions on regulations to the invisible hand of a market. The other solution is harmonization when regulation (as motivated by SHEC) can be justified by cause-effect reasoning based on scientific technological experience.

1. Obfuscation, the result of a success story?

The New Approach to European Standardization (NAES), laid out in the European Commission’s Green Paper of October 1990, stipulates that, in general, standards will no longer be decided upon by the European Commission in conjunction with the Council. Instead, the Commission is meant to establish standards (a) with the help of European standardization bodies, (b) via providing direct or indirect incentives to companies which should apply standards and should contribute to the financing of the standardization process, and (c) with the support of the national standardization bodies. The mutual recognition (MR) of national regulations on product specifications and of decisions of the European Court of Justice (ECJ) concerning the goods market can be considered as an implication of NAES.[1]

It could be argued that by renouncing the Old Approach that relied on detailed harmonization, the Commission of the European Communities has shed its influence on standardization in Europe to a large degree and has handed over its responsibilities to fairly independent bodies such as the CEN (Comité Européen de Normalisation), CENELEC (Comité Européen de Normalisation Electrotechnique) and ETSI (European Telecommunications Standards Institute). The introduction of MR is a further step in this direction. In Goerke and Holler (1998), taking a public choice perspective, we asked why the Commission should have engineered this deprivation of formal power in European standardization? Why does the Commission rely on the interaction of nominally independent agents in organizing European standardization when it seems a relevant hypothesis to assume that these agents act, at least predominantly, in their own interest or in the interest of those who they are funded by? Is MR an adequate instrument to bring the internal goods market closer to efficiency despite the self-interested agents in the standardization game? Does regulatory competition work as competition on goods markets is supposed to work? Does it enhance efficiency?

Or is NAES just an instrument of the EU authorities, the Commission and the Council, to dispose of the responsibility for European standardization - and also to avoid explicit conflicts due to vested interests? If so, then the introduction of MR can be viewed as a means of obfuscation in this policy arena.[2] Government politicians could be at a disadvantage in popularity and voting on the national level if they are held responsible for the standardization policy of the Commission and the Council, especially if the resulting harmonization is felt tremendously inflexible and biased in favour of some (interest-) groups in the population. The Old Approach, based on detailed (technical) standardization, was not very popular, sometimes even subject to satire and jokes, and it was rather costly. In comparison, it appears that MR obfuscation policy works properly, and the EC does very little to lift the veil. On the one hand, it seems to give back some regulatory power to national institutions, on the other, it seems not only to favour the market of regulations but also support competition between the regulators and even on the internal goods market. But these effects are far from obvious.[3] For instance, in a recent publication, Kerber and van den Bergh (2008) argued that MR leads to a number of inconsistencies: Instead of preserving decentralized regulatory powers and supporting regulatory competition, MR is primarily a path to convergence and harmonization. But Pelkmans (this volume) concludes: “Mutual recognition is a great invention of the EU.” Regulatory MR, “has been very successful over time…The combination of an even more effective approach to existing barriers and an intrusive and targeted pre-emption policy for future ones has effectively spared the single goods market from destructive erosion.” In Pelkmans (2007, p.699), he even observes that MR “is rightly applauded as an ingenious innovation by economists, lawyers and political scientists alike.” But in this paper, he also talks of disillusions. Some sources of these disillusions are also being discussed in this volume. Pelkmans (this volume, p.8 in ms) points out that “in actual practice, when shipments arrive at a border or in harbours, civil servants or inspectors will typically focus on the detailed specifics in their national laws, presumably that is even their routine instruction or impulse.” This procedure may create substantial transaction costs and a high degree of uncertainty.

Transaction costs and uncertainty also result from EU performance standards. It is not always obvious how prescribed performance can be achieved by technical specification, and what happens to the product if the performance standard changes? However, as Pelkmans (this volume) observes, “a company is, even with the flexible performance standard, still free to construct 'around' the standard (though it needs to acquire certification from a so-called Notified Body, assigned to fulfil these tasks).”

Then, issuing regulations is also a risky and perhaps rather costly project for national bodies. As described by Pelkmans (this volume), there is a notification procedure and the working of the Notified Bodies adds to costs and uncertainty – and accommodates to the vested interests of bureaucracy.[4] This system is “topped up by an intrusive and stringent notification system (with tough sanctions in case of non-notification, emerging from firm rulings by the ECJ), close monitoring by the Commission of failures to notify, detailed scrutiny of draft laws of Member States by a special Committee chaired by the Commission, and…automatic or semi-automatic suspension of the national legislative process for periods varying from 3 months to as much as 18 months, dependent on the need for remedies and their nature.”

Other problems, like the qualification of the equivalence of regulatory objectives, a cornerstone of MR, are not discussed in detail, but one should wonder about how this can be accomplished irrespective of the conditions given by a specific situation. As values change, equivalence is subject to changes, too. Again there are information costs and costs of uncertainty. It will be argued below that uncertainty results in substantial efficiency losses. Of course, these losses are difficult (or impossible) to quantify, however, this does not mean that they do not exist and they could be substantial. However, there should be uncertainties that matter to the value of the good and some that do not, just as there are standards that have an impact on the costs of production and use of the product, and some that do not, depending on the composition of the good. However, what determines the composition of a good and the value of its components? How is the value of a good affected by standardization?

2. Decentralisation and efficiency

The standard argument in favour of decentralisation (e.g., of federalism) is the diversity of preferences. It cannot be gainsaid that in an abstract general equilibrium model utilitarian welfare is likely to be larger if there are more than one alternative made available and preferences are diverse. However, for instance, Pierre Salmon (1987) argues in favour of decentralization even when differentiation in preferences does not matter; in fact, in his theoretical analysis he explicitly abstracts from such a differentiation to “purify” his argument. He discusses the constitutional reform of 1982-83 in France that introduced “parliamentary” sub-central government on the level of regions and departments and formalized the influence of the communes to overall political outcome, but his analysis also applies to multi-level regulatory competition including standardization policy.[5] The driving force of his argument is competition. The idea is that competition operates through local (or, in the international context, domestic) political responsibility that expresses itself in votes and incumbency and in mobility, i.e., “voice and exit” in terms of Albert Hirschman’s notorious categories of participation in hierarchies.

Mobility of firms could matter when it comes to regulatory competition over standards, and as consequence the political agents could be afraid of a poorer economic record for their constituency. But, in the end, it is the voice that is said to control the agents in the political agenda (if voice cannot be constrained by a dictatorial environment). In a democratic political arena all voices (the press, rallies, “orator corners,” interest-group support, etc.) boil down to voting. The competition about votes is seen as the final institution that sanctions past performance and decides on future personnel, and thus motivates the incumbent to take care of the preferences of the voters and the voters’ rating of the incumbent’s performance, of course, evaluated with reference to these preferences. Even if the preferences of the voters are single-peaked and the most preferred positions of the voters can be arranged in a one-dimensional space so that the median-voter theorem applies, the political equilibrium is in general not welfare maximizing if welfare is measured by utilitarian social welfare function and the vote distribution is not symmetric. (This is the case if mean of the vote distribution differs from the median.) Moreover, the median-voter theorem presupposes the competition of two alternatives only. If there are more than two alternatives or if there are more than one dimension, or if preferences are not single-peaked, then an equilibrium may not exist and the selected outcome (e.g., the regulation) will be path dependent and in many cases unpredictable. The potential of strategic voting might add to the complexity of the situation, but successful strategic voting requires forecasting alternative outcomes – which might not be possible in the case that an equilibrium does not exist or there is a multitude of equilibria.

If the median-voter theorem does not apply, then the incumbent agency runs the risk to get defeated in voting by whatever platform it proposes. Not to be identified with any platform (i.e., obfuscation) is a possibly successful strategy in this case. Preferences on standards show intransitivity and cyclical patterns and proposed regulations are not likely to be evaluated by single-peaked preferences in a one-dimensional space. Moreover, failure in standardization can be salient and thus have an impact on the performance rating of an institution that can be made responsible, while a smooth working of standardization will hardly augment the rating of this institution. A policy that gets the invisible hand of regulatory competition involved, and thus limits the incumbents’ accountability, looks like an elegant way to overcome this asymmetry. Yet who are the agents in this competition and who determines the rules and what are they? Pelkmans’s contribution to this volume demonstrates that regulatory competition still misses the invisible hand story that we like to tell for goods markets.

3. Uncertainty and inefficiency

The above suggests that a first-best approach to regulatory competition does not deliver arguments to support its introduction. While the public choice analysis supports its implementation, there still might be welfare arguments in favour of it. More specifically, MR can be interpreted in Coasean terms: MR is meant to reduce transaction costs as no detailed standardization is necessary if SHEC is not involved. European regulation can fall back on national regulations and the equivalence of their performance. And it is the equivalence rule that allocates the “property rights” of the national regulatory agents and the importing and exporting firms, perhaps to the disadvantage of domestic suppliers, as Kerber and van den Bergh (2008) argued. However, the Coasean reasoning is about efficiency, and not about distribution, and it seems quite an achievement that rights and obligations are assigned. Moreover, one could argue that a disadvantage that a domestic supplier has on his home-market is balanced by the advantage it experiences on the external markets. Moreover, the asymmetry supports the argument that MR “constitutes a powerful instrument to enhance the contestability of markets” (Cervone, 2005, p.433). But contestability is not an issue in Pelkmans’s contribution to this volume.

The message of Coase theorem is: Given (property) rights are well defined and transaction costs are zero, then contracts can be signed between the parties involved so that even in the case of externalities an efficient allocation prevails. We already argued that MR implies a shift of standardization costs but not necessarily a minimization. The total costs of national regulations can be substantial. Less obvious are the effects of an increase of uncertainty that goes along with NAES and MR, as pointed out above. In can be easily shown that in the case of uncertainty the Coase theorem does not work.[6] Indeed, Medema and Zerbe (2000) claim that uncertainty in a contract arrangement is a form of transaction costs. The obfuscation policy may reduce political costs and MR may be neutral with respect to the sum of direct costs of standardization, although we argued differently above, the corresponding uncertainty and coordination problems could increase inefficiency substantially.

To illustrate the coordination, we will discuss a simple strategic choice situation in the form of a game that tries to mimic the effects of uncertainty on MR and standardization. In fact, the game has the form of a stag-hunt game. Let’s assume there are two national regulatory agencies, 1 and 2, and each of them can choose between the two pure strategies “voluntary harmonization” (VH) and “national regulation” (NR). Of course, mixed strategies of the form (p, q) are also possible. Here, p and q represent the probabilities that agencies 1 and 2, respectively, choose their first strategies, i.e., VH. The payoffs that result for each pair of strategy choices are given in matrix 1. Note that agency i (i = 1, 2) can guarantee itself a value of 3 by choosing NR (within the MR framework) if the conditions of SHEC and equivalence of regulatory objectives are satisfied. If agency j  i fails to deliver regulatory objectives that are equivalent, as j goes for VH, and agency i chooses NR that satisfies the European rules relevant for MR, then j will achieve a rather poor outcome.

1 / “voluntary harmonization” (VH) / “national regulation” (NR)
VH / (5,5) / (0,3)
NR / (3,0) / (3,3)

Matrix 1: A stag-hunt regulation game

Obviously, the game in matrix 1 has two Nash equilibria in mixed strategies whereby the equilibrium (VH, VH) strictly Pareto dominates the equilibrium (NR, NR). A result that finds both agencies choose VH, i.e. “voluntary harmonization,” should be the deal. However, under the umbrella of obfuscation and accompanying uncertainty (NR, NR) cannot be rejected as a possible outcome. Imagine that the veil of ignorance is very thick and the agents take refuge in the principle of insufficient reason that proposes equal probabilities for VH and RH, then the expected utilities of choosing VH and NR are 2.5 and 3, respectively. Given this, NR is the utility maximizing choice.

If the veil of ignorance is less thick and agency 1 expects that agency 2 will choose VH with a probability q > 1/2, then 1 will choose VH if q > q*. Hereby q* is the probability such that the expected utilities of choosing VH and NR are equal. In the numerical example of matrix 1, we get q* = 3/5. Similarly we can calculate p* = 3/5 such that agency 2 chooses VH if it expects that 1 chooses VH with probability p > p*.[7] Therefore we can expect an efficient result (VH, VH) if both p > p* and q > q* apply. In addition to efficiency, (VH, VH) represents a (strict) Nash equilibrium and therefore none of the agencies has an incentive to choose otherwise, given the strategy choice of the other one.

This example illustrates that the more obfuscation and uncertainty the less likely an efficient outcome will result if the game in matrix 1 describes essential features of a regulatory market as assumed here.

4. Conclusion

In the above I have argued that NAES with its two very diverse components of MR and SHEC can be explained by the fact that the accountability for the corresponding policy is at the national level. The governments and the representing bureaucrats try not to be held responsible for measures that are not popular (i.e. objected by a large number of voters). One solution to this problem is a form of obfuscation induced by delegating the decisions on regulations to the invisible hand of a market. The other solution is harmonization when regulation can be justified by cause-effect reasoning based on scientific technological experience. SHEC standardization is in the quiver of latter perspective. I am not sure that this conclusion concurs with the “rationale, logic and application in the EU internal goods market” that Jacques Pelkmans promises in the subtitle of his paper. However, it could contribute to solve what Pelkmans called a “curious paradox.” He notes: “It has turned out to be difficult to get MR accepted with all its consequences, despite the almost universal acclaim of its great merits. The widespread recognition on its own has neither led to a sweeping liberalisation of the internal market, whether in goods or services, nor to much of a deeper analytical economic understanding” (Pelkmans, 2003, p.1).

References (as yet not standardized)

Breton, A., P. Galeotti, P. Salmon and R. Wintrobe (eds.) (2007), The Economics of Transparency in Politics (Villa Colombella Papers), Aldershot: Ashgate Publishing.

Cervone, Elisabetta (2005), “EU conduct of business rules and the liberalization ethos: The challenging case of investment research,” European Business Law Review 16, pp.421-456.

Goerke, L. and M. J. Holler (1998), “Strategic standardization in Europe: A public choice perspective,” European Journal of Law and Economics 6, 95-112.

Illing, G. (1992), “Private Information as Transaction Costs: The Coase Theorem Revisited”, Journal of Institutional and Theoretical Economics 148, 558-76.

Kerber, Wolfgang and Roger van den Bergh (2008), Mutual Recognition Revisited: Misunderstandings, Inconsistencies, and a Suggested Reinterpretation. Kyklos 61: 447–465.