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
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
Transaction costs
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.
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
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