Markets and market failures

1
Markets and market failures

• Sergei Guriev

2
Plan

• All markets are important for development
• Product markets
• Financial markets
• insurance and credit
• Labor market, human capital
• Land/real estate market
• How do markets work when they work?
• Sources of market imperfections
• Interactions of market failures

3
Neoclassical paradise

• Arrow-Debreu model
• Perfect competition
• No transaction costs
• Symmetric information
• Adam Smiths Invisible hand
• First Welfare Theorem
• Market equilibrium is efficient (whatever the
  allocation of property rights)
• Second Welfare Theorem
• Every efficient allocation can be supported as
  market equilibrium if income/wealth is
  redistributed

4
Invisible hand in real life

• Labor mobility
• Nationwide competitive market
• Financial revolution
• Financing ideas and even search for ideas not
  only investment in tangible assets
• Raising outside options for skilled employees
• Mortgages
• Reinforces labor mobility
• Insurance
• Encourages adequate risk-taking
• ? Health insurance
• Education market
• Incentives to accumulate human capital

5
What are the imperfections?

• Product markets
• Imperfect competition
• Externalities
• Asymmetric information about quality
• Financial markets
• Asymmetric information insuring/lending to wrong
  people
• Moral hazard Securing returns to investors
• Labor market
• Segmentation mobility depends on financial
  markets
• Monopsony power
• Human capital
• Externalities and public goods hard to
  appropriate returns
• Non-alienable, hence relies on efficient labor
  market
• Land and real estate
• Relies on efficient financial markets

6
Imperfect competition

• Burden of monopoly is not only the Harberger
  triangle (very small for the US and even some
  developing economies)
• Imperfect competition (monopoly or oligopoly) may
  be sustainable in the long-run
• Why cant more efficient perfectly competitive
  market structure take over?
• Incumbents lose
• Usually incumbents hold substantial political
  power
• Why cannot compensate incumbents for losses
• Commitment (time-inconsistency) problem
• Collective action problem
• Implications
• Barriers to riches (Parente and Prescott)
• Adoption of new technologies is blocked by
  insiders
• TFP does not grow
• Rent-seeking
• Struggle for monopoly rents subverts institutions

7
Why need financial markets?

• At each moment, firms and household make plans
  for future, taking into account uncertainty
• Need to reallocate wealth across time and across
  states of nature

8
Insurance market

• Reallocating wealth across states of nature
• Customer risk-averse
• Maximizes a concave utility function u(x)
• Agrees to pay for certainty u(Ex)gtEu(x) increase
  wealth in worse states at the expense of better
  states
• Insurance company
• Large, deals with many customers
• Hence (by the Law of large numbers) is
  risk-neutral
• Takes on all the risks for a fee
• BUT some risks cannot be insured even by
  insurance companies
• Competition between insurance companies drives
  price of insurance down

9
Diminishing marginal utility and insurance
Utility
Net benefit of risk sharing
Cost of insurance to the insurance company
Payoff
Bad state
Good state
Expected payoff
10
Asymmetric information and insurance

• Pre-contractual asymmetric information adverse
  selection
• High-risk customers self-select into insurance
• Price of insurance ? for low-risk customers
• Post-contractual asymmetric information moral
  hazard
• The insured lacks incentives to take a good care
  of the insured assets
• The insureds actions are not observable by the
  insurance company, nor by courts, hence cannot be
  included into contract
• Additional problems Commitment problem on the
  insurance companys side
• If market is not developmed
• Bankruptcy of insurance company
• If legal environment is very weak
• Strategic default of the insurance company

11
Credit/Capital market

• Allocate wealth across time
• A firm has a profitable investment project but no
  cash to finance it
• Needs to borrow at a low interest rate
• Households want to get a return on their savings
• Perfect market savings rate borrowing rate
• Real life huge wedge between the two

12
Principal-agent problem

• Same as moral hazard in insurance
• Example Shareholders vs Managers
• Enron, Worldcom, Tyco
• Example Sharecropping
• Why take away incentives from the tenants?
• Problem
• M chooses effort (inputs) that influences output
  (market value)
• But market value also depends on other factors
• Inputs are not observable
• Close monitoring may fail because of collective
  action problem
• External monitors (e.g. auditing firms) may be
  not collusion-proof
• The contract may reward better performance in
  terms of outputs, not inputs
• Outputs are noisy measures of inputs

13
Inefficiency of sharecropping
14
Example US corporate governance scandals

• Tycos CEO Dennis Kozlovski
• 2001 named by Business Week one of the 25
  managers of the year
• Allegedly tunneled 600 mln from company to
  private uses
• 2003 The indictment of Mr Kozlowski and his
  chief financial officer, Mark Swartz, lists 15
  separate charges of grand larceny and 67 charges
  of falsifying business records.

15
How to solve principal-agent problem?

• Align Ms interests with shareholders
• Ideal solution for each 1 earned by
  shareholders pay 1 to CEO
• Effectively make the CEO a residual claimant
  (virtually an owner)
• But
• Incentive-insurance trade-off
• High-powered incentives ? higher variability of
  Ms income ? M has to be compensated for higher
  risk
• Perfect insurance ? same payoff in good and bad
  states ? no incentives

16
Limited liability

• The contract 1 to M for each 1 increase in
  shareholder value must specify NEGATIVE payoffs
  for M in some states
• Indeed if M buys a firm, has to pay a large
  transfer to shareholders ?
• Will need to borrow to finance it ?
• But it indebtedness is too high then
• The interest rate is too high or
• Credit is denied (infinite interest rate)
• Personal/corporate bankruptcy
• Creditors get less than the nominal value of the
  debt
• Interest rates increase further to make up for
  bankrupt debtors

17
Risk-aversion is aggravated by credit market
imperfections

• Wedge between interest rates on deposits and
  loans ? even originally risk-neutral decision
  makers become risk-averse

Utility
saving
(costly) borrowing
Payoff
Initial wealth
18
Debt overhang

• Why cannot debt finance help?
• Standard debt contract Pay back D or give up
  control over firm
• If the probability of bankruptcy is not very
  high, quite efficient
• Otherwise similar to equity
• Debt overhang problem
• M is residual claimant only if cash flows gt D
• But probability of this is low
• If cash flows lt D, M has no marginal stake
• Hence debt finance also has limitations

19
Debt overhang hurts incentives
Income after repaying the debt
Cash flows
D
D?
20
Principal-agent problems ubiquitous

• Investor vs firm
• Insurance company vs ensured
• Employer vs employee
• Public vs bureaucrats
• Landlord vs tenants

21
Financial imperfections a summary

• A solution to principal-agent problem?
• Assets should be owned by those who work with
  them
• Complementarity between human and physical
  investment
• But what if M has no cash
• Why cant she borrow and launch an LBO
• If need to borrow too much, debt overhang would
  suppress incentives
• So nobody would lend at a reasonable rate
• Workable solutions
• Laws and courts to reduce informational
  asymmetries
• Reputational concerns

22
Financial revolution

• Competitive financial markets
• Higher returns to investors ? lower cost of
  finance
• Developed legal system
• Sophisticated financial contracts and instruments
  to overcome asymmetric information and moral
  hazard
• E.g. buyout options in venture finance
• (de Soto) formalized property rights ? collateral
  ? debt finance and other contracts
• Enforcement of creditor/property rights
• Political support for secure property rights may
  be low in unequal societies
• Problematic not only in developing countries
  (Rajan-Zingales)
• UK reposessing a collateral in a mortgage takes
  1 year and 5 value
• Italy 3-5 years and 18-20 value
• UK mortgages 52 GDP, Italy 5.5 GDP

23
Labor markets

• Geographical segmentation
• Local labor market monopsony
• Reinforced by imperfect housing market
• Which is reinforced by imperfect financial
  markets (mortgage)
• Skill segmentation and monopsony
• Financial market
• Need to borrow to quit and startup a firm
• Education market
• Education increases intra/inter occupational
  mobility

24
Human capital

• Incentives to accumulate skills
• Rewarding increased productivity requires
  competition between employers
• Competitive labor market
• Incentives to innovate
• Financing research and development
• Intellectual property rights

25
Land/real estate

• Land is complementary to labor in agriculture
• If agricultural worker does not own land, there
  is a principal-agent problem and
  insurance-incentive trade-off
• Hence need to broaden land ownership
• Land/real estate is also a perfect collateral
• Market for land helps to build financial markets

26
Agriculture, value added ( of GDP) in 2004
Argentina 10 Low income 22
Belarus 10 Middle income 10
Botswana 3 Netherlands 2
Brazil 10 Pakistan 22
Central African Republic 56 Russian Federation 5
China 13 South Africa 3
Czech Republic 3 South Asia 20
Denmark 2 Turkey 13
Europe Central Asia 8 Ukraine 12
European Monetary Union 2 United Kingdom 1
France 2 United States 1
HIPC 32 Upper middle income 7
Low middle income 12 World 4
27
Land and sharecropping

• Equity rural poor are usually the poorest of the
  poor and the most numerous of the poor
• Efficiency vs equity or efficiency AND equity
  (but vs. property rights protection)
• Evidence smaller farms are (much) more
  productive
• From 16 to 40 per cent
• Hence more equal land distribution is also more
  efficient
• Why are smaller farms more efficient
• Increasing returns
• Technology and investment in fixed capital
• Increasing returns can be mitigated through
  contractual arrangements (shared access to
  physical capital)
• Decreasing returns
• Incentives (principal-agent problem in
  sharecropping)
• Solving the incentives problems requires, in the
  end of the day, sale of land to family farmers

28
Reality land distribution isVERY unequal

• Gini of land distribution (Otsuka et al. 1992,
  data for 1970s) is much higher than Gini for
  income distribution

Bangladesh 0.42 Brazil 0.84
India 0.62 Colombia 0.86
Indonesia 0.56 Peru 0.91
Nepal 0.56 Uruguay 0.82
Thailands 0.45 Venezuela 0.91
29
Redistributing land

• Land market?
• But tenants are cash-constrained
• Most often dont have access to finance
• Even if buy land through a debt contract
• Debt overhang will suppress incentives
• Hence land reform certain govt intervention to
  promote small farms and farmer ownership
• Expropriate land
• Subsidize land purchases by tenants
• Tax large farms

30
Land reform Korea

• Land Reform Act 1949
• Transferred land to Korean peasants/tenants (at a
  low price)
• From Japanese owners (little compensation)
• From large Korean owners (with compensation)
• By 1964, 72 land was cultivated by owners
  (compared to 17 before reform)
• Only 5 by tenants (compared to 42)
• Large positive effect on productivity
• Political economy
• Large Korean landlords cooperated with Japanese
  during the war both large Korean landowners and
  Japanese landowners were stripped of political
  influence

31
Land reform Soviet union

• Revolution 1917 Communists (mostly industrial
  workers party) promised land to landless workers
• 1918 expropriation of aristocrats (large
  landowners, not farming)
• 1920s expropriation of kulaks (large farmers),
  redistributing land to poor peasants, formation
  of collective farms
• Effectively, destruction of private property (on
  ideological grounds)
• Over Soviet time disastrous performance of
  agriculture, from exporting grain, Russian became
  a large net importer
• (only changes back in 21st century)
• Somewhat similar experience in Mexico after 1917
  revolution

32
Chinese land reform incentives without private
ownership

• Before 1978 planned inputs and outputs
• Since 1978 contract responsibility system
• Have to fulfill the plan (buy planned quantity of
  inputs at controlled prices, sell planned
  quantity of outputs at controlled prices)
• Whatever is produced on top of the plan can be
  sold in the free market, profits appropriated by
  farms
• Collective farm allocates shares of the
  village-level plan to families
• Reform
• Provides incentives
• Reform can only improve peasants welfare
• Political economy
• Credible commitment from long-term-oriented
  benevolent dictator (Communist Party)

33
Market-assisted land reform

• World Bank model
• Qualified grants/subsidized loans to landless to
  purchase land
• (Plus substantial red tape to sort out frivolous
  attempts)
• Elasticity of land supply matters
• Compare to National Project Housing in modern
  Russia
• South Africa
• Goal to redistribute 30 of land in 1994-99
• Fell substantially below the quantitative goals
• But productivity and equity improved

34
Market-assisted land reform, Brazil

• 1985 Constitution allows expropriation of large
  land holdings that are idle or do not perform
  social funciton
• Until 1998, no action
• Some estimates 60 land idle
• 37 largest landowners own more land than 2.5
  million smallest ones
• 20 wealthies own 90 of land
• MST (Landless Rural Workers Movement) land
  occupations Occupy, resist, and produce
• Violence on both sides
• 1998 Cardosos Novo Mundo Rural
• Mixed results great idea but implementation is
  still problematic
• MST objects high debt costs
• 2002 Lula comes to power committed to land
  reform but lack money to subsidize land
  redistribution

35
Brazil, continued

• Lulas Promise to give land to 400,000 families
  and give titles to 500,000 squatters
• Delivered only 245,000
• MST is very unhappy
• Continues to squat
• Established 1800 schools and even a university
  (2005)
• Lula has not won the first round of elections
• But will probably win the second
• Political economy
• Substantial weight of Ruralista party (large
  landowners)
• Even-market assisted reform is similar to
  expropriation the rich pay taxes to fund
  government subsidies to the poor

36
Tenancy reforms

• Constraints on tenancy contracts
• Tenants become more expensive
• Both poverty reduction and efficiency gains
• India Besley and Burgess (2000) vs Banerjee,
  Gertler and Ghatak (2002)
• BB poverty reduction but no productivity gains
• BGG substantial productivity gains
• Concentrate on reform in West Bengal where really
  worked

37
Land reform Summary

• Agriculture is still VERY important in developing
  countries
• Land distribution is very unequal
• Principal-agent problem is so important that
  small farms outperform large farms
• Financial and land markets are underdeveloped
  hence the case for land reform
• Land reform
• if implemented well, promotes both efficiency and
  equity