Specialization and Exchange

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Specialization and Exchange
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What is the economic problem in the Robinson
Crusoe story?

• Before Friday comes in?
• Optimization ? Robbins allocating scarce
  recourses what to produce, how, for whom?
• After Friday comes in?
• Hayek information transmission discovery
• Coase transaction costs
• Coordination
• Motivation

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On the nature of the economic problem

• Reach specialization advantages (Smiths
  division of labor)
• Comparative advantage ? higher productivity
• Origin previous investment
• Ambiguity of purpose e.g., mafia
• Obstacle transaction (i.e., exchange) costs
• Coordination ? information
• Incentive alignment ? information asymmetry

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Authors sequence

• Smith
• division of labor as source of growth
• Hayek
• role of information in the economic problem
• Coase
• transaction costs property rights
• Fehr et al.
• role of human nature

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Production costs

• Types of costs
• Transformation cost
• Exchange or transaction costs
• Coordination
• Motivation
• Relevance
• Lack of empirical content
• Focus attention on different problems

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Costs of production as a function of
specialization
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(aside) Promises as objects of exchange ?
Information asymmetry ? cheatingHow to cope with
it?

• Mistake to take as a default the sequence
  self-interest ? opportunism ? safeguarding
• Need of a broader view instead
• Safeguarding farsighted contracting à la
  Williamson
• Screening types when previous commitment is
  viable
• Providing cooperative starting points ? motivate
  employees to start cooperating
• Educating to mold types, viable at least at
  social (including firm) level

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Solutions to the economic problem

• Custom (?)
• suitable if no technical change?
• Even hunter-gatherers had to decide on marriages,
  when to move, where to hunt, etc.
• Politics
• Markets

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Solutions to the economic problem

• Politics
• Coercion
• Centralization
• Representative decisions by agents
• Weighting of information according to voting
  rights

• Markets
• Voluntary
• Decentralization
• Direct decisions by owners
• Weighting of information according to
  individuals participation in the market

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Politics Markets
Decisions Type of economy Type of economy Type of economy
Decisions Market economies Social market economies Planned economies
What? Purchasing decisions Mixed according to sectors Politics
How? Competition amongst businesses A mix of competition and planning Central planning
For whom? Factors Markets Mix of market and political decisions Politics
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A historical perspective on markets, politics and
development
Timing 19th century Since 2nd 3rd of 20th century Since 2nd 3rd of 20th century
Liberal State Social market economies Developing countries
Political systems Aristocratic democracy Mass democracy Diverse
Rights Negative rights property, freedom, expression, mobilityprotect citizens against themselves and, mainly, the State Mixed constraints of negative rights and promulgation of positive rights (housing, education, health, etc.) Emphasis on positive rights at a low level of (a) wealth and (b) institutional development
End results Institutional development (independent judiciary, competitive political market, civil education) Consensus Europe, 2000 etc. welfare state expanded or reduced only marginally (UK, Thatcher-Blair) Fear of expropriation Weimar, 1920s Spain, 1936 Chile, 1973 etc.Bolivia?
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Market Price System Market institutions

• Price system Microeconomic abstraction
• Calculating machine ? allocation of resources
• Information processing
• Prices have nice properties as signals minimal,
  selective relevant information
• Information has to be discovered
• Market institutions, at least
• Property rights, both allocation enforcement ?
  incentives
• Law independent judiciary ? transaction costs

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Combining markets politics

• Political failures
• Break b/w individual and social optimality
• Use of violence
• Inevitable agency
• Public goods (e.g., poor weighting of info)
• Monopolies (parties, barriers to entry)
• Herding (e.g., formation of beliefs, emotional
  reactions)
• Rationality (how do we take sides in politics?)
• Market failures
• Break b/w individual and social optimality
• Externalities (pollution)
• Public goods (army)
• Monopolies (utility)
• Herding (e.g., speculative bubble)
• Rationality ? no even individual optimum
  (children)

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Combining markets politics The Coase Theorem

• If transaction costs are zero, initial allocation
  of rights does not affect
• final allocation of resources or
• production level
• Example Noisy firm causes externality on
  neighbors
• With positive transaction costs ? may affect both
  ? political decisions should focus on reducing
  transaction costs by
• Clarifying allocation of property rights (who has
  right to what) and
• Securing their enforcement (no expropriation)

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Coase theorem example
Initial allocation of rights Profit for firm Loss for neigh-bors Firms decision Compen-sation, C Final allocation of rights
Neighbors 40 60 Closes to avoid paying compensation 60 gt 40 0 Neighbors
Firm 40 60 Closes because neighbors would compensate 40 lt Clt 60 Neighbors
Neighbors 60 40 Continues after compensating the neighbors 40 Firm
Firm 60 40 Continues 0 Firm
Costs and benefits in current values
Assuming that the legal system considers damages
as an upper limit of compensation
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The Fable of the Bees

• Pollination as an externality
• Contracting bees for pollination
• Visit http//www.beepollination.com/
• We provide services to California. Almond 
   growers by locating strong, healthy  beehives 
   for almond pollination.
• We also provide services to Beekeepers by
   locating suitable almond contracts for their
   particular bee business.
• See a simple pollination agreement at
  http//edis.ifas.ufl.edu/AA169
• The beekeeper shall supply the grower with
  _______ hives (colonies) of bees to be delivered
  to the (cucumber, watermelon field, etc.) as
  follows ....

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Sources of transaction costs

• Unclear allocation of property rights
• Commons and anti-commons problems
• Land titling why are mortgages impossible in
  most countries?
• Number of parties ? Solution legal fictions
• E.g. firms as nexus of contracts
• Restrictions on trade
• Wealth constraints
• Endowment effect
• Example few reallocating agreements after
  litigation
• Biological rationale behind possessory instinct
• Artificial
• Licenses for taxis, pharmacies, musicians, TVs,
  etc.

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The lighthouse in Economics

• Public goods ? market underprovision
• No rivalry b/w users
• Impossible to exclude users
• e.g., defense
• See http//en.wikipedia.org/wiki/Public_good
• Empirical evidence on lighthouses
• Coase art. exclusion ? club good private
  building and operation of lighthouses
• Marginal cost 0 ?
• Inefficient if price gt 0?
• Inefficient with respect to what? Need to
  compare real options

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The tragedy of the commons

• Unrestricted access to a resource leading to
  over-exploitation
• Reason individual benefits, social costs
• Examples fishing grounds, air pollution, road
  congestion, etc.
• Solutions
• exclusion (private or communal property) trade
• regulation
• Exercise
• Visit www.perc.org on the interaction of
  politics and markets in solving environmental
  problems

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Anticommons

• Too many restrictions to access a resource leads
  to underutilization
• Misleading analysis
• The problem is not too many property rights but
• High costs of gathering the consent of
  rightholders
• The case of mortgages ?

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Why are mortgages irrelevant in most countries?
( i.e., they hardly reduce default risk
interest rates)

• Property right based on consent ?
• Consent ? Enforcement
• Survival of property right ? Transaction costs
• Need institutions and organizations to reduce the
  cost of gathering consents Titling
• Publicity rule priority of property rights on
  the basis of the date of publicity , not private
  contract
• Public registers to facilitate information on
  rights
• Works on this topic

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Political failures

• Preference transmission
• voting paradox cyclical (i.e. not transitive)
  collective preferences, even if individual
  preferences are transitive
• Arrows impossibility theorem
• Preferences production
• Market for ideas
• Lack of competition
• Herding
• Also in markets

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Needed empirical comparative analysis

• Do not see neither the State nor the market as
  ideal solutions
• Starting point use consistent assumptions about
  human beings in private public spheres
• i.e., avoid this common mistake
• Selfishness of market participants leads to
  market failure
• Solution public regulation that often assumes .
  altruistic regulators and silly regulated
• Markets and Politics not only failthey also
  interact
• Can we use politics to get more efficient
  markets?
• Can we use markets to get more efficient politics?

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2008 Crisis

• Market of political causes?
• Mixed nature of financial markets
• Monopoly of money
• Role of central banks
• Banker of last resort
• Price fixing interest rate
• Example in a bubble, interest kept too low
  (Spain, -3) ? How does this distort lending
  decisions?
• Mortgage market
• subprime lending partly mandated by law in the
  US, to the extent lenders had to grant of loans
  to people below average income
• Everywhere, home buying was subsidized by
  Governments

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Case on regulation Stores opening hours

• Possible market failures
• Externalities?
• Monopoly?
• Public goods?
• Rationality?
• Possible political failures
• Preferences transmission?
• Regulatory capture? Who benefits?
• ???

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Organization as solution to economic problem
The nature of the firm

• Why do organizations (firms) exist?
• Minimization of transaction costs
• There are not market failures but business
  opportunitiese.g. Carmax
• Other explanations do not explaine.g.,
  economies of scale can be contracted
• example trucking intermediaries reach economies
  of scale and network, specially with respect to
  returns, but they contract in the market with
  owner-operator
• But within-firm exchanges also suffer transaction
  costs ?

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Transaction costs are present in both
organizations and markets

• A familiar example
• Babysitting by older child or by hired person ?
  different exchange (coordination and motivation)
  costs are present in each solution, but both are
  positive in both cases
• Make or buy decisions in a firm

Performance and organizational choice For each
level of x, firms choose the organizational form
that optimizes performance. In principle, only
these optimal choices are observedfor instance,
vertically integrated units when x gt xo.
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Firms as nexus of contracts
Manager Z
Government
Firm A
Individual X
Firm B
Individual M
Individual Y
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Firms as nexus of contracts

• Nexus, legal fiction ? Reduce cost of transacting
• Contracts or hierarchies?
• True Many contracts in the firm are relational ?
  
• they define hierarchies ? resources allocated
  by command, not by agreement
• But these contracts are voluntary, defining such
  hierarchical structures
• Hierarchy ex ante voluntary allocation of
  rights asymmetrically to create a private legal
  order in which to complete enforce contracts ex
  post
• Examples
• labor contract
• franchising

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The nexus is not merely contractualSource
Arruñada, B., Foundation of Impersonal Exchange,
Univ. of Chicago Press, forthcoming. Example
The market for lemons
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Contract b/w principal P agent A Ex ante Judicial decision Ex post
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Contract b/w principal P agent A Ex ante Judicial decision Ex post
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Contract b/w principal P agent A Ex ante Judicial decision Ex post
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Originative contract b/w Er E Ex ante Subsequent contract b/w E B Judicial decision Ex post
Employee sells car to B
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Originative contract b/w P A Ex ante Subsequent contract b/w A T Judicial decision Ex post
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Originative contract b/w B1 O Ex ante Subsequent contract b/w O B2 Judicial decision Ex post
Double sale of land
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Originative contract b/w LP GP Ex ante Subsequent contract b/w GP CC Judicial decision Ex post
Borrowing by a hidden LLP
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Originative contract b/w P1 Pn M Ex ante Subsequent contract b/w M Pnj Judicial decision Ex post
Sale of new shares
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Originative contract b/w P1 Pn M Ex ante Subsequent contract b/w M T Judicial decision Ex post
Representation
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Problem

• Secure property rights not enough
• Growth requires investment
• Secure rights enforcement ? property rule
  consent
• Good allocation of resources
• Transferable rights low transaction costs ?
  liability rule
• Specialization ? delegation
• Multiple rights many people on each asset
• Property (real, in rem) rights good enforcement
  but high transaction costs if multiple rights

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Solution Voluntary and verifiable dilution of
property rights

• Contract rule protected by consent e.g.,
  Merchant Law
• Ruling in favor of the uninformed party (the
  acquirer) makes the information asymmetry
  irrelevant
• Property rule requiring publicity e.g., real
  property
• Publicity makes the information asymmetry
  manageable
• Registration makes the information asymmetry
  irrelevant
• Preserving the role of consent keeps the
  enforcement advantage of property rights
• Consent in choosing agent
• Consent in property rule
• Ensuring commitment and publicity by independent
  intervention ex ante. This
• Avoids opportunistic choice of rules ex post by P
• Obviates information asymmetry to T

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Originative contract b/w P A Ex ante Subsequent contract b/w A T Judicial decision Ex post
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Originative contract b/w P A Ex ante Subsequent contract b/w A T Judicial decision Ex post

Judges apply market-enabling contract rules when adjudicating subsequent contracts, protecting innocent third parties
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Originative contract b/w P A Ex ante Subsequent contract b/w A T Judicial decision Ex post

Automatic contract publicity OR Formalized publicity Market-enabling rules used when adjudicating the subsequent contract
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Objectives of the firm

• Individuals have objectivesfirms do not
• Firms (as well as markets) just behave as a
  consequence of individual decisions pursuing
  these objectives
• They reach equilibriums, more like markets than
  individuals
• Profit maximization
• Also an abstraction, an analytical tool
• Profit maximization as a competitive constraint,
  not an objective
• Competition ? only firms with adaptive decisions
  will prosper and survive
• Competition also in political market (e.g.
  subsidies)
• Consequences for strategic management
• normative what the firm should do?
• positive why the firm is behaving in a certain
  way?
• Are firms rational? Do they commit suicide?
  Why?

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Boundaries of the firm

• The concept of boundary in firms and markets
• Markets boundaries? ? Useful to study the
  economy
• Firms boundaries? ? Useful to study the
  market
• Cases
• McDonalds
• Trucking construction
• Resale price maintenance
• Pampered for free
• Firms are not necessarily the relevant
  competitive unit for competition policy? (see
  below)

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Pampered for free