Raising the Bar on Products and Process Standards: Economic Principles

Raising the Bar on Products and Process Standards:Economic Principles J. Christophe Bureau Institut National Agronomique, Paris The World Bank, 2003

Overview • Definitions • Economics of standards • The political economy of standards • The role of standards in the process of market integration, trade and economic development • Conclusion

Definitions • Standards, technical regulations and other terms • Types of standards • Examples of standards • Different roads leading to a standard • International standards and standardization bodies

Standards, technical regulations and other terms • "Standard" ("norme"): broad meaning in the general language • More restrictive meaning in official and technical languages: refers to something voluntary • Mandatory standards are called "technical regulations" ("réglements techniques")

Standards, technical regulations (2) • Standards provide "rules guidelines, or characteristics for activities or their results, aimed at the achievement of the optimum degree of order in a given context" (ISO) • Standards include various layers of "quality insurance institutions": rule making, conformity assessment, accreditation

Standards, technical regulations (3) • Rule making: development of technical specifications • Conformity assessment: ensures that one complies with requirements • Accreditation/recognition: ensures that the conformity assessment works • Labels and conduct codes are special cases

Types of standards • Various typologies including according to: • Area addressed: technical, environmental, sanitary and phytosanitary, labor standards, etc. • Economic impact: Compatibility (network effects), minimum quality and interface (information), variety reduction (minimize wasteful proliferation), information and measurement (compatibility and risk of litigation) standards

Types of standards (2) • A distinction particularly relevant in trade issues: Product standards vs Process and Production Methods standards • Specific treatment of process standards in multilateral trade agreements (GATT) • However, hazy area between products and process standards often causes trade disputes

Examples of standards • Technical standards include: • standards sanctioned by an accredited standards body • “de facto” standards (Microsoft Windows; Video cassette recorders) • “ad hoc” standards“ or “consensus” standards (widely used by mutual agreement; non proprietary Digital Video Disks standards)

Examples of standards (2) • Sanitary and phytosanitary standards: • Protection of human health, animal health, flora and fauna • Bans, quarantine regulations, inspection of products, specific treatment or processing of products, maximum allowable levels of residues, etc.

Examples of standards (3) • Environmental standards • Some mandatory, but many voluntary • Some international (ISO 14000, Forest Stewardship Council, etc.) • Many national standards (Canadian Forest Management System Standard; New Zealand Forest Accord; Finnish Certification Standard; Living Forest Project in Norway, etc.)

Examples of standards (4) • Labor standards • Typically a process standard • No international agreement, but a core of United Nations standards; Often poorly enforced • Can lead to the exclusion of certain countries from international agreements (Myanmar) • Pressures may create a de facto standard (child labor in garments in Bangladesh)

Examples of standards (5) • Broader ethical standards • Reflect new concerns of citizens • Combine environment, labor, and possibly other ethical values (SA8000) • Animal welfare standards (e.g. EU regulations) • Fair trade standards (Max Havelaar) • No international agreement, source of disputes between countries

Different roads leading to a standard • Mandatory standards often government defined; Voluntary standards have public or private origin • Manufacturers, users, research organizations, government, consumers, work together to create standards • National standardization bodies coordinate standard setting

Different roads (2) • Examples: • American National Standards Institute (ANSI) • British Standards Institution (BSI); • European Committee for Standardization (CEN) • German Institute for Standardization (DIN) • French AFNOR; • Standards Australia, etc.

Different roads (3) • Widespread use of voluntary standards sometimes makes them mandatory • National and international regulations rely on voluntary, sometimes private, standards • Private standards may use public or non profit association standards (electric standards using fire hazards codes)

International standards and standardization bodies • Growing importance of international standards because of globalization • International institutions setting standards (Codex Alimentarius) • Coordination in international fora (APEC); mutual recognition • International federation and management of voluntary standards (ISO)

International standards (2) • The ISO: • Non governmental; Worldwide federation of 146 national standard bodies • Promotes standardization to facilitate trade • 2937 technical bodies; Staff of 500; 30000 experts participating a year

Overview • Definitions • Economics of standards • The political economy of standards • The role of standards in the process of market integration, trade and economic development • Conclusion

Economics of standards • Useful economic concepts • Desirable economic effects of standards • Potential problems with standards • Strategic use of standards • Economic rationale of government intervention in standard setting • The role of market forces

Useful economic concepts • Quality includes several product attributes (Lancaster). Valued with different weights by consumers • Lack or economic operability of the concept, leads to distinguish vertical and horizontal product differentiation • Quality refers to vertical, horizontal refers to "variety"

Useful economic concepts (2) • "Socially optimal quality" balances costs of higher quality and benefits for consumers • Example of product safety, when marginal cost of risk reduction increases. Defines of optimal level of safety (Antle, Viscusi) • "Optimal environmental quality" based on equalization or marginal pollution abatement costs and marginal damage provides an economic basis for setting a standard

Useful economic concepts (3) • Economies of scale. Internal (e.g. fixed costs) and external (e.g. cluster of industries) • Network economies • The value of a product for consumers increase with the number of consumers of compatible product (fax machines) • The value of the base product is enhanced as the variety of compatible products increases (CD player and CDs)

Useful economic concepts (4) • Imperfect information: search goods, experience goods and credence goods • Moral hazard and adverse selection (important for safety standards, standards ensuring fairness of trade) • Social costs of imperfect information generating market inefficiencies

Desirable economic effects of standards • Standards define the technology; Enhance innovation • Change in use of inputs; Changes in modes and forms of organisation in production (quality management standards) • Increase skill requirements; "race to the top" in terms of quality requirements

Desirable economic effects (2) • Ensure product compatibility(compatibility and interface in information technology) • Division of labor; Improves coordination of production and distribution • Reduce transaction costs, between firms and with consumer, and lowers risks, including risks of litigation

Desirable economic effects (3) • Economies of scale (components). Larger market essential in industries with large fixed costs • Standards create credibility, focus and critical mass in markets for new technologies • Increase globalization of markets (mutual recognition, harmonization)

Desirable economic effects (4) • Provide information to consumers (minimum quality standards) • Generate trust (safety standards; voluntary process standards for credence goods) • Increase consumer awareness and concerns (environmental standards; ethical standards)

Desirable economic effects (5) • Overall, significant economic impacts on: • Macroeconomic growth, in spite of lack of precise measurement (German study: 0.9 points out of 3.3 of GDP) • Integration into a global market (electronics in South Asia). Obviously a necessary but not sufficient condition • Quality improvement (accessing countries to the EU)

Potential problems with standards • Standards not always well defined (standards that involve a negative environmental balance) • Can drive the whole economy into technical errors (fire hazard standards and asbestos) • Can be set at a level that is not socially optimal (environmental standards, under uncertainty on costs and damages)

Potential problems (2) • Can limit market coverage • Minimum quality standards, or de facto requirements (airbags) may raise product prices • May prevent a fringe of some consumers to access lower quality but cheaper products (cars in Europe) • Can impose a particular burden on small enterprises

Potential problems (3) • Proliferation of standards inefficient. Lack of "standardization of standards" costly (US estimates of costs associated to complying to various national standards between bn$ 20 and 40 a year) • Like patents, standards may have a dissuasive effect on innovation • This may involve costs for consumers

Strategic use of standards • Standards can lead to strategic behavior and can be used as barriers to entry against competitors or foreign firms • Standard setting can provide opportunities for collusion (Shapiro) • Governments may use standards to favor domestic firms

Strategic use of standards (2) • Case for strategic use of standards firms well documented in academic literature: • Standards can serve to segment markets • Strategic incompatibility of standards can be used for organizing market power • Variety reduction standards may facilitate oligopolistic coordination within a cartel • Standards used by an oligopoly to discipline a potential competitor

Strategic use of standards (3) • Academic literature shows complex interaction between competition and informational effects of standards. Strategic standard setting may backfire • Shapiro and Varian: "Winning a battle of standards depends on intellectual property rights, control over and installed base of users, ability to innovate, first mover advantages, manufacturing abilities, strength in complements and on brand name and reputation..."

Economic rationale of government intervention • The regulator has to arbitrate between imposing standards in order to : • address informational market inefficiencies • impose a socially optimal quality to an oligopoly that would not do so spontaneously • And the risk that the standards imposed limit competition, be eventually detrimental to consumers

Government intervention (2) • Antitrust bodies have frequently ruled against strategic standards setting that is detrimental to the society as a whole (US macaroni in the 1960s to recent computer standards using patents) • However, in some cases the trade-offs betwen the "bads" and the "goods" of a standard is not obvious (e.g. governments hesitations on GM food in Europe)

The role of market forces • Self control of quality can be based on market forces • Reputation may be a powerful instrument that can replace command and control instruments in case of product safety (e.g. brand name) • Voluntary standards, codes of conducts, certification can be effective tools for ensuring that products are of high quality

The role of market forces (2) • Informational instruments can be a good substitute for mandatory regulation (unpasteurized cheese) • Market based regulation is often less costly than command and control regulation • It can also be more relevant (firms have more information on processes and costs) • Voluntary and informational instruments leave consumers freedom to chose

The role of market forces (3) • Rather than costly inspection and control, liability can be a powerful way to ensure that firms do not sell hazardous or tainted product • The issue is however linked to the existing legal system (e.g. the existence of punitive damages)

The role of market forces (4) • However, market based instruments are not appropriate in all cases. There are many cases where mandatory standards are needed or useful • Consumers trust implicitly come from the knowledge that the government will not tolerate tainted/hazardous product to be sold

Raising the Bar on Products and Process Standards: Economic Principles