Seminar notes: The state and market failure

Deposit in gold

  • a piece of paper as a receipt
  • you can use this paper to buy things — with the gold as security

Meanwhile the gold could be lent out again

  • and this time too in the form of paper receipts

Or, you could do the same thing with bank deposits

Something I said that week — and it sounded contradictory when I said it …

  • you can’t complain about banks as intermediaries
  • but you can complain that there isn’t enough competition in the banking sector
  • they charge too much

But I also said …

  • there are restrictions on the right of banks to compete
  • restrictions on advertising etc

How do these two things go together?

Against competition:

Prevention of systemic risk:

  • banks are integral to the financial system, and their failure can have far-reaching implications beyond just the shareholders and creditors, potentially destabilizing the entire economy
  • regulations that limit competition, such as entry barriers and restrictions on certain high-risk activities, are designed to mitigate systemic risk
  • competition might incentivize them to take excessive risk
  • keep people’s money safe

Monopolies

  • advantages of scale — large banks can do many things that smaller banks cannot
  • network externalities — bigger networks make for better banks — difficult for smaller banks
  • regulation to make sure that they don’t exploit their monopoly positions

The dilemma:

  • you want to encourage competition, but also limit it
  • assumptions regarding rationality

Utility maximization

  • rational individuals make decisions that maximize their utility, which is a measure of satisfaction, happiness, or benefit
  • a rational person will choose the good that they perceive to offer the greatest utility — choose a good that gives lesser utility is irrational
  • but what is “utility” and how do you measure it?

Consistent preferences

  • rational individuals have consistent and stable preferences over time
  • their choices are transitive — if they prefer lahmacun to pizza and pizza to pide then they prefer lahmacun to pide

Information

  • rational agents are assumed to make decisions based on all available information and to update their beliefs when presented with new information

Self-interest

  • individuals act in their own self-interest, seeking to increase their own well-being or profit
  • self-interest can also encompass altruistic behavior if the individual derives utility from the welfare of others.

Cost-benefit analyses

  • rational decision-making involves conducting a cost-benefit analysis, weighing the pros and cons of different options
  • a rational individual will choose an option when the expected benefits outweigh the costs

Game theory

Prisoner’s dilemma

In the classic Prisoner’s Dilemma, two individuals are arrested and accused of a crime

  • they are separated and cannot communicate with each other
  • the authorities do not have enough evidence to convict them on the primary charge but have enough to convict them on a lesser charge

The outcomes are as follows:

  • if A and B both betray each other, each of them serves 2 years in prison.
  • if A betrays B but B remains silent, A is set free, and B serves 3 years in prison (and vice versa).
  • if A and B both remain silent, both of them will only serve 1 year in prison on the lesser charge.

Collective action problems

Although it is in your interest to cooperate, you have a stronger interest not to cooperate while everyone else does — cooperation takes time and might even cost money

  • “tragedy of the commons”
  • bringing food to a party
  • participating in collective actions — activism, trade unions
  • participating in elections
  • smoking — as a way to free-ride on your own future

This doesn’t prove that collective action is impossible

  • only that people engage in it for other reasons
  • why do people vote?

Game of Chicken

Imagine two teenagers, named Alex and Taylor, engaged in a dangerous contest. They are driving their cars towards each other on a single lane road. Here are the possible outcomes based on their decisions:

  • if both swerve, they both “chicken out,” and while they avoid injury, they also suffer a blow to their pride (a moderate, equal payoff for both).
  • if one swerves and the other keeps straight, the one who swerves loses face (receives a low payoff), and the one who continues straight is deemed brave (receives a high payoff).
  • if neither swerves, they crash into each other, resulting in the worst possible outcome for both (a very low payoff).

Real life situation

  • nuclear standoff where neither wants to back down
  • embarrassing if you do it, but if neither does it the earth will be destroyed

Bounded rationality

  • Herbert A. Simon in the 1950s

The assumptions regarding perfect rationality cannot be fulfilled

  • information is limited or skewed
  • cognitive limitations of individuals — we can’t handle all the complexity
  • we use rules of thumb instead of full rational processing

“Satisficing” instead of “maximizing”

  • we go for what’s good enough
  • we can’t find the perfect item

Implications for organizations

  • they are not able to be efficient and rational
  • due to actual limitations of time and processing capacity

More realistic models of decision-making

  • we started talking about this last week …
  • repeating things is a part of one’s education!

Expenses incurred in making an economic exchange or trade, beyond the price of the goods or services being traded

Tangible costs

  • fees and commissions

Intangible

  • the time and effort required to find a trading partner or negotiate a deal.

Types of transaction costs

Search and information costs

  • costs involved in finding a product, service, or trading partner and obtaining necessary information
  • the time it takes to find products and compare prices
  • if it’s very high, we might give up

Bargaining and decision costs

  • arise during the negotiation of the terms of an exchange and the making of contracts
  • the effort to agree on a price, the drafting of contracts
  • everything involved with decision-making process
  • establishing trust —

Policing and enforcement costs

  • after a transaction has been agreed upon …
  • ensuring that parties adhere to the terms of the contract
  • monitoring contract performance, enforcing agreements, and resolving disputes or breaches of contract

High transaction costs might

  • prevent mutually beneficial trades from taking place, leading to market inefficiencies or market failures

Low transaction costs

  • crucial for improving market efficiency, designing more effective institutions, and formulating policies that facilitate smoother transactions.

Information asymmetry in markets

  • using the used car market as a primary example
  • “lemons” refers to cars that are found to be defective only after they are bought
  • cf. what we said about “moral hazards”

Rationality assumes perfect information

  • or cost-free access to information

But getting information is a transaction costs

  • and sometimes it’s simply impossible to get

Information asymmetry

  • sellers have more information about the quality of a product than buyers
  • sellers know the vehicle’s history and condition, whereas buyers have limited or no knowledge about these factors

Adverse selection

  • buyers cannot differentiate between high-quality goods (“peaches”) and low-quality goods (“lemons”)
  • they are only willing to pay a price that reflects the average quality of goods in the market
  • good quality items are driven out of the market because they cannot fetch a premium over the average price

Market collapse

  • high-quality goods disappear from the market because sellers are not willing to accept the low average price offered by buyers
  • only the lemons remain, further driving down the average quality and price, potentially leading to a vicious cycle

Markets failure

  • when there is significant information asymmetry

Other examples

  • insurance markets
  • labor markets
  • medical services
  • universities — impossible to know what you are paying for

Solutions

  • warranties, brand reputation, and regulatory interventions
  • licensing and certification requirements
  • “Harvard” as a brandname
  • all the technical gadgets in an ad for a hospital

  • the Nobel Prize in Economics in 1991

Why do firms exist in a market economy, where price mechanisms could coordinate production through contracts among individuals?

The short answer:

  • markets are not perfectly efficient mechanisms for allocating resources and executing transactions
  • firms exist where the transaction costs of the market are too high

Within a firm, resource allocation decisions are made administratively rather than through market transactions

  • suppression of the price mechanism
  • an island of conscious power in a sea of market relations
  • a hierarchical decision-making process can reduce the costs associated with market transactions, such as bargaining, contracting, and enforcing agreements

Limits to firm size

  • why firms do not grow indefinitely
  • diminishing returns to the entrepreneur function, including increasing difficulty in managing and coordinating operations
  • as a firm grows, the costs of organizing additional transactions within the firm may rise faster than the costs of carrying out those transactions on the open market

Optimal size for a firm

  • where the costs of organizing an extra transaction within the firm become equal to the costs of carrying out that transaction through the market
  • builds on Coase
  • the rational for an organization
  • the importance of transaction costs

Questions for Williamson

For example …

  1.  Summarize Williamson’s article for me
  2. What does he mean by …?
  3. And so on …

Main ideas

Transaction costs sets the size of the organization

  • same idea as from Coase

People have bounded rationality

  • some kind of governance is necessary
  • people are opportunistic — they seeks side-deals for themselves

Types of transactions

  • distinguishes transactions by their attributes
  • frequency, uncertainty, and the degree of asset specificity
  • these attributes have an impact on the role of the organization

Governance structures

  • hierarchies
  • markets
  • but also hybrids — long-term contracts, joint ventures, or strategic alliances

Vertical integration

  • bringing transactions previously conducted through the market within the boundaries of the firm
  • to mitigate transaction costs related to opportunism and bounded rationality.
  • why firms form networks or strategic alliances, especially when facing high uncertainty or when transactions involve specific assets

Frequency

  • refers to how often a particular transaction occurs between parties
  • frequent transactions require more oversight
  • infrequent transactions — building up some sort of control system is too costly and not worth it

Uncertainty

  • high uncertainty complicates contract drafting and enforcement because it’s challenging to anticipate all possible future states and contingencies
  • under conditions of high uncertainty, hierarchical governance (firms) can offer advantages by enabling more flexible, adaptive decision-making processes and by providing mechanisms for resolving disputes without resorting to costly renegotiation or litigation

Degree of asset specificity

  • investments that are tailored to a specific transaction or relationship, with their value significantly diminished outside of that context
  • creates dependency between transaction parties, as the cost of switching to alternative partners or uses for the assets is prohibitive

Policy and regulatory implications

  • regulation that fails to account for these costs can lead to inefficient economic organization.

Externalities

The costs or benefits that result from an economic activity or transaction

  • affect third parties who are not directly involved in the activity or transaction
  • these third-party effects are not reflected in the market prices of the goods or services involved

Positive or negative

  • depending on whether the impact on bystanders is beneficial or harmful
  • positive tend to be under-supplied — less likely to impose a benefit on someone else
  • negative tend to be over-supplied — easier to impose a cost on someone else

Education:

  • when individuals invest in their education, they not only gain personal benefits (such as higher earning potential) but also contribute to society through increased productivity, lower crime rates, and better citizenship

Vaccinations:

  • when a person gets vaccinated, they not only protect themselves from certain diseases but also reduce the spread of those diseases to others, benefiting public health overall

Pollution:

  • a factory that emits pollutants into the air or water may harm the health of nearby residents or damage the environment, imposing costs on society that are not paid by the factory owner

Noise Pollution

  • loud noises from a construction site or a nightclub can disturb the peace of the surrounding community, affecting residents’ well-being without compensation.

Externalities represent a form of market failure

  • the market mechanism fails to allocate resources efficiently when external costs or benefits are not internalized in the prices.

Requires government intervention

  • imposing taxes or subsidies, setting regulations, or defining property rights, to correct the market outcome and achieve a more socially optimal allocation of resources