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2008 February 02 Saturday
Market Responds To Fraud By Lowering Prices?

Marginal Revolutionary Tyler Cowen argues that in markets with fraud prices will drop to eliminate the cost of fraud.

Think just for a moment about what fraud means. Fraud means that the seller is lowering costs, raising revenue and enjoying higher profits.

In the short run that is bad for the customer. But in the long run it means there will be more suppliers and more competition for our business and thus lower prices.

Take the proverbial cheat auto mechanic. Maybe half the time he will charge you even when he hasnít done any useful fixing. But in the long run that extra revenue will draw about twice as many auto mechanics into the industry to compete for your money. Yes, they will be ripping you off half the time but prices will fall by a roughly proportionate amount.

In the long run, you, as a consumer, will do okay. You pay twice as often as you ought to, but as a consolation each time you pay only about half as much.

I do not buy this argument for a few reasons. First off, the fraudulent car repair shops will replace parts that aren't broke. The costs incurred do not get eliminated by lowering salaries of repairmen. Second, the new entrants into the auto industry use more capital to set up shops that is waste. All the repair shops will need to cover their capital costs. There'll be more shops and hence more total capital costs. Third, people pulled into repair are pulled away from other more productive work. Fourth, the fraudulent shops will enjoy higher profit margins than the honest (and likely more competent) shops and this will tend to drive honest shops out of business. So the problem becomes worse.

Update: In the comments "m" points out that taking your car to and from repair shops incurs additional costs that Tyler's argument does not eliminate.

By Randall Parker    2008 February 02 08:58 PM Entry Permalink | Comments (3)
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