MBA in 2 minutes | Lesson 8: When does government need to regulate

Updated: Jan 8, 2021

We will be solving practical challenges through MBA concepts. No theory only applications !

Today's lesson is a cross linkage between managerial economics I studied at ISB and regulations studied at The Fletcher School of Law and Diplomacy.

The lesson can be of particular interest to folks who have keen interest in Government consulting and might land in a situation where they need to consult government on regulations eg. in contemporary space can be of cryptocurrency.

The key question here is why do Governments need "regulation" at all. It's an interesting question as the current Chief Economic Advisor had asked me this as he was my direct professor at ISB and we had a chat as I was shaping my policy venture in parallel.

Step 1:

When does government need to step in and regulate in free markets- such as US and India. Well, there are 6 scenarios. However in this lesson we will be delving deep in 1/6 market failures i.e. adverse selection.

Step 2:

So what is adverse selection. It is a case of bad lemons over good in market.

Let's say you are in a mandi (vegetable market) and there are 60% good lemons and 40% bad lemons.

  • For good lemons, buyers are willing to pay as high as Rs. 100 and sellers are willing to take as low as Rs. 90

  • For bad lemons, buyers are willing to pay as high as Rs. 50 and sellers are willing to take as low as Rs. 25

Buyers do not know the quality of lemons but the sellers do. Now let's contemplate how much is a buyer willing to pay in market. The average price will be : 60%*100+ 40%*50= Rs. 80/- but evidently the market will not clear at this price (refer the price sellers of good lemons are willing to sell at).

Hence, buyers will know it's only bad lemons getting sold at Rs. 80/-.

Hope the basic math wasn't a lot to digest but it's needed to convey the point. If you now apply this to real life industries such as insurance, the above "information asymmetry" is a typical problem where you and I know of our health situations but insurance firms don't as they make revenue when we don't cash in.

Well offcourse, one way to resolve this in good lemons sellers market is to send a costly signal in mandi -chopping off multiple lemons and showing quality-that bad lemons seller cant do but this might be im-practical.

Step 3:

Thus at a systemic level, this is where Governments step in and play a role. Because there is potential market failure, Government can regulate that insurance consumers need to mandatorily disclose all the "illnesses" to fix information asymmetry-> market failure.

Taking a full circle back to cryptocurrency, Governments are left right and center regulating it world wide. My fear is they are doing so because they don't understand it fully. In one of my HBS classes we were evaluating a crypto startup, the first 1 hour of the class was spent in understanding the basics of the sector and that was the case at HBS !

It's the fear of the unknown getting onto Governments. Well off-course there are other 5 levers of market failures (will cover in later stage of MBA lessons) that might be impacting crypto, but my initial thought is that we shouldn't block the industry overall but rather apply practical regulatory fixes.

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