Corporate Law

Regulatory Sandboxes: The Panacea for Modern Capitalism

Kashish Makkar

Capital concentration has become the synonym of modern capitalism, and it is due to the simple economic concept of Rent-Seeking.


“The defining characteristic of a free market is the creation of wealth”

Jeff Bezos crossing the $150 Billion mark in July, 2018 is easily the most remarkable event to go down in Modern History. Clearly, it was the free market allowing creation of wealth that made it possible, right? Wrong. Simply, if the free market is a catalyst for wealth creation, it must allow Amazon’s employees to get richer as well, and must also allow the creation of newer corporations like Amazon. Instead, capital concentration has become the synonym of modern capitalism, and instead of ensuring wealth creation for all, it is making sure that wealth remains concentrated in a few hands. This concentration of wealth can be explained via a basic economic concept called Rent-Seeking.

Rent-seeking, as understood in Econ-101, is a return on a factor of production that is greater than the normal return required to incentivize the use of this factor. In a free-market, this makes economic agents use more of this factor as compared to others and as a result, greater competition drives its returns down. However, this concept of rent-seeking becomes problematic once it is shielded from market forces. Once isolated from market forces, the competition cannot drive-out the economic profits, thus, making rents permanent It is Rent-seeking in this pejorative sense, that defines modern capitalism.

Evidence of such rent-seeking is writ large in any regulated industry. Crucially, rent-seeking and regulation in an industry are not just co-related variables, but, history of regulation suggests that it facilitates rent-seeking. It incentivises the resource-owners to divest their resources into lobbying so that there can exist regulations which create trade barriers for their competitors, or, burden them in compliance costs. Simply put, regulators facilitate entrepreneurs to use their earned rents to give them regulations which ensure continual rent-seeking for entrepreneurs against the forces of the market.

In this article, I will argue that it is this rent-seeking that has led to the destruction of competition in the modern markets, leading to a concentration of ownership and soaring of the executive-labor pay gap. Later, I will suggest how the policy measure of regulatory sandboxes could be the panacea for modern capitalism.

Rent-Seeking, Regulation, and Destruction of Competition

A simple deconstruction of the regulation and rent-seeking theory can be done by looking at the simple example of Taxi Unions in the Coastal State of Goa in India. Goa is one of the prime tourist destinations of India, however, no cab-aggregator has been successful to operate their service here. Is it because tourists and residents do not prefer a convenient mode of ride-hailing? No. Instead, the Taxi Union in Goa has managed to outdo the existence of these cab-aggregators. Using a combination of tactics involving government lobbying, and threats of violence having the tacit consent of the state, the Union managed to drive the aggregators out.

The status quo in Goa allows the Taxi drivers to earn monopoly rents for their services. This not only deprived the customers of an economical and better ride-hailing service but also deprived the society of wealth creation. An efficient market would have led to a spurt in demand for taxi services, and a growth for the industry as a whole. Instead, in the status quo the wealth of consumers, in the form of excess fares, is appropriated by the taxi operators.

As noted previously, rent-seeking is not inherently problematic. Any industry introducing any disruptive product, service, or process is bound to generate extraordinary rents for entrepreneurs. Quite innately, rents provide a first-mover advantage to entrepreneurs and give them resources that have the potential to be used as a leverage against industry regulators. However, once these rents are used to influence regulations, rent-seeking becomes problematic. Interested, influenced, and custom-designed regulations lead to obstruction in operation of market forces and therefore, shielded rent-seeking. This monopolised rent-seeking leads to more leverage for the lobbyists which leads to more regulation. This vicious cycle is the root-cause for the destruction of competition in any market.

The taxi-drivers in Goa are a micro-example of this reality, whereas, evidence of such cycles are writ large. How is General Electric the largest equipment manufacturer for almost all the core sector industries? How has Google managed to outdo almost all other search engines that have emerged across time? How does Lockheed Martin manage to sustain its position as the largest government defense contractor for more than a decade?

All of the above corporations, apart from being the leaders of their industry, have another thing in common. No, their ownership doesn’t secretly vest with the Rockefellers or the Rothschild. Instead, these companies are one of the biggest lobbyists in D.C. The sheer amount of money spent by these corporations to secure protective regulations for their businesses is astounding in the least.

Rent-Seeking and Executive Pay

The vicious cycle of rent-seeking and regulation can also explain the soaring gap between executive pay and workers’ compensation. For production of any commodity principally four factors of production are employed, viz. land, labor, capital, and entrepreneur. In a scenario where lobbying is used to shield the market from competition, the returns earned can only be attributed to either capital or entrepreneur. This is simply due to the fact that the returns are earned on account of the risk taken by the entrepreneur and their executives, for undertaking the lobbying exercise. Similarly, the money used for lobbying is that of the owners of capital. Therefore, the monopoly rents earned in this paradigm get attributed as profit for entrepreneur or returns for capital investors.

Relatively, in a paradigm when entrepreneurs don’t lobby to shield their industry, new players can enter and thrive in the industry. This leads to increased competition for land and labor as factors of production, leading to an increase in their compensation. Increased competition in the industry also limits the entrepreneurial and technical knowledge to licenses, thereby reducing their profits from monopoly rents to license fees.

It is the vicious cycle of rent-seeking and regulation that refrains the latter paradigm to emerge, and therefore, is the foundation for the soaring gap in executive pay and worker’s compensation.

Can we do away with Regulation?

A careful perusal of the problem at hand suggests that it is the deleterious relationship between monopoly rent-seekers and regulators that forms the core of everything that’s wrong with modern-day capitalism. As noted previously, rent-seeking is inherently unavoidable in any new industry. Therefore, the prima facie response for a solution to the problem would be to do away with the regulation.

However, is an unregulated market feasible at all? The trajectory of developmental economics suggests that the answer to this is an unequivocal, no. The Smith- Schumpeter idea of an ‘invisible hand’ regulating market forces has been rejected as obsolete almost a century ago. Therefore, regulation is imperative for any economy. As a result, a solution needs to be carved out where the regulators don’t function hand-in-glove to serve rent-seekers interests.

But, clearly, the problem of regulation cannot be solved with more regulation, i.e., oversight over the existing regulators. Therefore, there is a need for an institutional change in the regulatory structures which both, ensures transparency and fosters competition. This solution could be found in the path-breaking concept of Regulatory Sandboxes.

Regulatory Sandboxes: The future of Regulation

Most regulatory structures in modern markets are reactive, as against being proactive. The implications of this are simple, one, it leaves the markets totally unguarded for any new disruption. Simply, there exists no protection for consumers when a disruptive product or technology is introduced. But, two and most importantly, it leaves the markets open long enough for entrepreneurs to gain enough rents to use them as a leverage during lobbying when regulators finally take cognisance of the industry.

It is at this juncture that the concept of Regulatory Sandbox becomes crucial and need of the hour. A regulatory sandbox is a well-defined space, within which companies can experiment with innovative and disruptive products in a basic regulatory environment for a limited period of time while they validate and test their business model. The space is custom-designed as per the need of the entrepreneurs and keeping in mind the basic consumer rights.

Regulatory sandboxes are a one-stop solution for restoring balance to modern capitalism. It manages to break the vicious cycle of rent-seeking and regulation as it significantly tackles it by, first, ensuring that every entrepreneur has to abide by certain regulations, even when they have just created the disruption. This ensures that though there may be a legislative vacuum regarding the product introduced, they cannot earn rents without any check on them. Second, even if they earn rents, no other competitor can be blocked access by their lobbying since it will be an obligation on the national regulator to provide a similar environment for every entrepreneur who seeks to venture into the industry.

Third, since a sandbox is a custom-made regulatory structure, it will foster innovation as it will not restrict any new player by making it abide to regulations determined for a predecessor in the industry. Fourth and Lastly, if on account of lobbying, an attempt is still made to introduce a protective regulation, it will be met by strict scrutiny. This is for the simple reason that regulatory sandboxes will make the regulatory structures transparent and accessible to almost all the players in the market and will provide them with a level playing field. As a result, any change in regulation that could be detrimental for the operation of market forces could be challenged as arbitrary, discriminatory, and therefore, a violation of the right to free trade.

Therefore, the future of modern capitalism lies in regulatory sandboxes which can single-handedly foster competition, provide impetus to innovation, and reduce capital concentration.

Kashish Makkar is one of the founding editors of Law School Policy Review.