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Report n°2: An integrated approach to economic and social contestability in business

When the envisioned solution is not a solution: transparency through expertise transfer

Intuitively, the solution to market failure resulting from asymmetrical expertise would be to provide suppliers with enough expertise that they could correctly evaluate the pricing strategies applied by the recycler. Transfer of expertise to the suppliers would eliminate the possibility of supplier defection in protest against unfair practice. It would therefore appear preferable both from the collectors' and the recycler's standpoint if they were more knowledgeable as this would preserve the recycler's reputation for always applying the right price, and would keep the suppliers' efforts focused on quality. In the event, that expertise would eliminate potential market failures and would reduce the industrial or environmental risks of market failure on a branch of the scrap metal recycling activity.

Analysis of the anticipated effects of this solution of expertise and knowledge transfer to the collectors, however, invalidates this intuitive solution. To understand this, we must tie in the informational conditions prevailing in the transactions, to the spatial conditions of the recycler's activity presented earlier.

Two externalities to be taken into account...
The presence of collectors who all have the same expertise as the recycler over a common geographical region would generate two negative externalities. The first concerns the collectors themselves. Expert collectors would compete for access to the more profitable resources, i.e. those corresponding to higher grades of scrap, usually remunerated at a significantly higher rate. With too many collectors competing for those same higher quality resources, more effort would be required from each one than if there were no competition. In other words, the collectors would exert upon one another a negative externality, which we could liken to too many fishermen competing for fish in the same fishing area.

The aforesaid competition to access the resources would be source of a second externality. Indeed, by focusing their efforts on collecting the more profitable grades of scrap (the "prestige markets" as a French recycler calls it) the collectors would ignore the lesser grades, those containing a larger fraction of waste, which would then be left uncollected and therefore could not be recycled. This would mean less material for the recycler and a negative externality for the community, which wants a quality environment and does not want to see waste scattered around the surrounding countryside.

... and a dilemma to be resolved to prevent economic contestation
The recycler therefore faces a new dilemma: on the one hand transferring knowledge to the collectors would perturb the smooth functioning of the input market and ricochet back to his own activity; on the other hand maintaining asymmetry of expertise creates a problem of credibility on prices and causes the collectors to reduce their efforts. The recycler faces two types of market failure here and must therefore strive for the best outcome: the first where only high quality scrap is proposed and the second where only low quality scraps are brought in. In the first case, low quality scrap is ignored and therefore is not recycled. In the second case, paradoxically, the high quality scrap is not proposed for sale.

Different threats attach to those two outcomes. If the recycler is solely supplied with low quality scrap, he may be unable to meet the quality level demanded on the output market and therefore lose all or some of his customers. Furthermore, the existence of a source of high-value material (the uncollected high quality scrap) left unexploited yet nevertheless accessible might tempt a newcomer to the field. For the recycler, contenting himself with this type of supply would increase the threat of entry of a new competitor. Therefore his economic position on both the input and the output market would be threatened if the recycler were unable to overcome the failure to give appropriate incentives that avoids a concentration of supply on low qualities only.

If the recycler is provided with only high quality scrap, that too means that some resources ("the dead weight") are left uncollected where they were abandoned. This would consist of low quality scrap with a high percentage of waste and contaminants. The safety and environmental risks of not collecting such dead weight provides public authorities with a motive to modify the existing collection arrangements and economic organisation of the branches in favour of a more interventionist policy: if the private recovery channel for metal that contains waste cannot collect the waste that the public authorities consider should be collected for environmental reasons, then they will find another way! From the recycler's standpoint, herein lies a credible threat and one that challenges his very livelihood.

In one form or another, the consequence of such market failures is to increase the threat of perturbation of the input market so that the prospect of new operators muscling in on the act looms large. In the first case, the anticipated profits (in view of the high value of the materials) and the absence of limits ("property rights") on access to the resource increase the recycler's economic contestability. In the second case, the risks to the community when a particular resource is left uncollected increases the probability of public intervention, resulting in the task of scrap metal collection being handed over to new operators.

In these conditions, the recycler finds himself in a double-bind situation. The solution that has been found informally consists in selectively transferring expertise by determining who should receive what information on the transaction terms. The use of information disclosure to selectively transfer expertise and maintain a degree of opacity regarding the description of the purchased batches has resulted in the introduction of a complex system of incentives, which helps the recycler guard against both types of market failure and against the increased threat of new operators entering the input market. We should remark at this stage that integrating the different constraints weighing upon the situation and the different threats and challenges that can affect his activity encourages the recycler to behave as an enlightened regulator of the use of the collection area and access to the different sources of supply therein.

The constraints of this regulatory interplay are as follows. On the one hand, the recycler wants to prevent contestation by defecting suppliers, as their defection would reduce the profitability of his business and contribute to the emergence of industrial or environmental risks attributable directly to his economic activity that would arouse external opposition to that activity. On the other hand, he seeks to eliminate the threat of competitors entering the input market in response to market failures and the existence of potentially pollutant waste sources left uncollected and unrecycled. Uncollected resources are liable to encourage two types of new entrants: (i) a newcomer with sufficient clout to develop recycling activities that would directly compete with the historic recycling operator or (ii) a new supplier accessing the neglected and polluting sources and thereby developing considerable negotiating power. These are two examples of the disciplining effect on pricing practices and the transfer of expertise to collectors that an expectation of threats of external economic contestation to his supply source may have for an historic recycling operator.

This analysis also emphasizes the need for this operator to take into account the potential effects of market failures on his social contestability: social protest may indeed target his activity directly in the event of incidents or tensions in the neighbourhood, but it can also result in total upheaval of the economic organisation of that branch of activity and facilitate the entry of new operators.