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Book excerpt: Raghuram Rajan on how markets can work for community benefit

An excerpt from Raghuram Rajan’s The Third Pillar: How Markets And The State Leave The Community Behind.

books Updated: Feb 26, 2019 16:05 IST
Raghuram Rajan
Raghuram Rajan
Hindustan Times, Delhi
Raghuram Rajan,The Third Pillar: How Markets And The State Leave The Community Behind,New book
Former governor of Reserve Bank Of India Raghuram Rajan.(HT File Photo)

Markets endanger themselves when they stop working for the broader citizenry, because it may rise up to shut them down. Today, some people are disenchanted because they feel large firms are closing opportunities for small firms and individuals. Others are angry because they have suffered painful losses of wealth and incomes and see little support forthcoming from the community or state. Yet others fear their jobs will be displaced by technology or foreign competition. For far too many, the markets have been disappointing. We must take actions to restore public faith in the power of markets to improve well-being.

Growth in the economic pie, which requires innovation and competition, will help. To enable this, barriers that currently protect dominant incumbents must be brought down so that markets are accessible by all. Everyone’s ideas and products can then compete to generate that growth. Widely accessible markets are also less likely to be seen as only vehicles for the rich to grow richer. Within markets, powerful participants must be trusted to do the right thing by society. The right explicit objectives and monetary incentives for such participants will help, but so will community-provided social rewards for those who behave admirably. In this chapter, I will suggest three steps to help restore faith in markets and make them more reliable vehicles for sustainable inclusive growth.

First, people need to believe once more that corporations can be trusted to take the right actions for society’s well-being. The mantra of shareholder value maximization worked well to dissuade the government from insisting that private corporations were extensions of government departments. Unfortunately, it has also led important constituencies, especially labour and the general public, to worry that top management is out to rip everyone off in the interests of shareholders. We need a better objective that promotes not just efficiency but also trust.

Second, a market dominated by a few is unlikely to create opportunities for the many. Competition today in an industry is the best way to guarantee society is benefited, not just today but also in the future. We have to examine and reduce barriers to competition, including new forms of incumbent property rights that have built up in recent years.

Finally, policies can help jump-start adjustment but both the market and the community will also adjust on their own over time. They should be given the space and time to do so.

Changing from profit maximisation to value maximisation

We have seen that along with the search for more productive efficiency, shareholder value maximization also encourages aberrant behavior, such as violating implicit contracts with employees. Can corporations not do better? If the private sector is to be trusted by the community, and if it is to be a reliable check on the state, it does not just have to be well behaved, it has to be seen to be well behaved. At the same time, though, the private sector cannot give up its hard-nosed focus on productive efficiency, for that is an important contribution markets make to society. How can these varied goals be reconciled?

Maximising the value of the firm

Shareholders are only one set to claimholders on the firm. One possible alternative is to ask top management to maximize the value of stakeholders in the firm, as is sometimes suggested to corporate bosses in Continental Europe. Yet this prescription needs, at the very least, to be fleshed out. Who exactly is a stakeholder? If a customer is one, is not one way of maximizing her value to give her everything she wants free? If so, how will the firm survive?

Here is a better alternative. It may seem a small tweak, but it would alter firm behaviour significantly in some situations. Not only would it increase firm value, but it would increase public understanding and support for the public corporation. Specifically, let the objective set for firm management be to maximize the value of the firm, but define firm value to be more than just the value of the financial investments in the firm by those who have a long-term attachment to it. So, for example, the investment made by an employee in learning a hotel’s culture of hospitality is a specific investment. It is specific in that it has little value in another hotel with a different culture, and it is an investment because it takes time and effort for the employee to learn it. The value of that specific investment is the stream of additional profits the hotel will generate from the great customer experience provide by its long-term employees specialized in that culture. Others who make specific investment include long term suppliers who have built a relationship with the hotel and have specialized personnel and equipment catering to it. In contrast, one-off suppliers who are protected by contract or price-conscious customers who flip-flop between hotels would not be deemed to have made specific investments in the hotel.

By taking as its objective the maximization of the value of financial and specific investments, management inspires greater trust in key constituents, offers a more socially acceptable picture of the corporation and, in fact, maximizes the economic value of the firm.

Enhancing competition to build trust in markets

A second aspect of markets that needs attention is the degree of competition in them, and the increasing dominance of large firms in each sector.

Industry dominance and market power

The benign view of an industry dominated by a few large firms has much to do with the Austrian economist Joseph Schumpeter. He believed that competitive discipline did not come from existing competitors in the market at a point in time, but from the disruptive innovator who would strike ‘not at the margins of the profits and their outputs of the existing firms but at their foundations and their very lives’. Schumpeter’s view was that a monopoly firm’s paranoia about possible future threats to its monopoly profits would be the spur to innovation, and the reason it would give its customers a good deal. The continuation of its monopoly would be its reward.

Allowing the market and community to adjust

Not every aberration or distortion needs policy action. Sometimes the market itself creates the incentives for correction. For instance, the wage differential between the skilled and the moderately skilled has stopped growing, as we noted earlier. The high wages of doctors attract more youngsters to become doctors (supplementing any natural inclination toward medicine). It also creates strong monetary incentives for tech firms to create artificial-intelligence medical diagnostic systems, where ordinary doctors could be replaced by nurse practitioner interviewers with far less training. The competitive market targets those who benefit the most from it since the profits these entities make are most worth disrupting. Therefore, even as the quality and quantity of health care expands significantly, and even as countries grow older and richer, the need for doctors could moderate, normalizing their wages and reducing income inequality.

Similarly, the abundance of machine-made or foreign goods, and the fall in local wages, could also prompt a shift in taste toward goods with more human and local content. We already see some of this. The more accurate but cheap quartz or digital watch has been displaced by painstakingly handcrafted and intricate mechanical watches at the high end of the luxury scale. Local farmers markets pop up like mushrooms in rich suburbs or cities in the United States, as customers abandon the supermarket for local produce. Consumer tastes could shift. Jobs that require working with one’s hands rather than with one’s mind or that require local work could reemerge, once again reducing the wage premium to education.


The temptation when imbalances arise is to hack all the pillars down to the lowest height among them. This typically will bring back equilibrium, but at a much lower level for society. Far better to push a pillar down only if absolutely necessary, and instead, focus on elevating all pillars to the greatest common level. That is the only way society will progress. In this vein, the temptation today will be to constrain competitive markets to give communities a chance at recovery. That might unleash other forces such as cronyism that would be hard to reverse. Instead, it is better to improve the functioning of the market, even while also refocusing the state and strengthening the community.


The Third Pillar: How Markets and the State Leave the Community Behind

By Raghuram Rajan. Harper Collins, 434 pages, Rs 799

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First Published: Feb 26, 2019 15:35 IST