International Markets and European Institutions

International markets and European institutions

International organizations

International organizations include:

• IMF – International Monetary Fund
• ECB – European Central Bank
• World Bank
• WTO – World Trade Organization
• WHO – World Health Organization
• UN – United Nation
• EU – European Union

We do economic transactions and operations every day. Without institutions, it would not be possible. Institutions are a set of rules and habits that allow a society to work. Economic institutions allow economic transactions to occur. Institutions are a mix of habit, written law, and enforcement of those rules. Institutions define what property means and how the ownership can be changed.

The economic system needs institutions to work. In different economic systems, there can be different institutions ruling. For example, if there are price tags, we cannot change the price and negotiate. About intangible things and services, it is more complicated, such as software, and it depends on institutions.

Without rules and mechanisms set by institutions, the market would not exist. Institutions are essential for economics. There are both written and non-written rules.

Institutions are different from country to country, based on the law systems of the country, developed historically. Whenever we have a transaction, which set of rules (institution) should be applied? It is necessary to understand how the rules of the game are. Making an international investment or other difficult economic transactions, it is not an easy issue to understand the right set of rules.

In the past, the problem was solved in an easy way: countries occupied countries, made colonies, and applied their rules to the occupied territory. The dominant country in the area set the rules.

Talking about the international market, we need to understand who sets the rules. That’s what international institutions are for. International institutions set the rules of the game of the international markets. International institutions are created by members coming from different countries: these countries, together designing institutions, agree on a common set of rules. The institution is formed by the countries themselves and negotiates the kind of rule it wants.

Complaining about the rules is quite natural anyway because rules are a constraint. But without rules, many things would be impossible and life would be chaotic. That’s the idea at the base of institutions: rules are necessary, for example, rules of traffic such as not crossing with a red light. It is more efficient to have rules, like crossing the road with a red light would create confusion.

Externalities and public goods

Economic agents respond to incentives: people make decisions based on costs. Inside markets, the main information (incentive) is the “price”. In society, incentives are shaped by laws and institutions: “the rules of the game”.

Examples:

• Higher price means lower quantity demanded
• Unlawful sanctionable activity means fewer illegal activities
• Socially unacceptable behavior means less of it

Institutions have practical relevance: institutions must be evaluated based on their effect on behavior and allocations of resources. In economics, what matters are the consequences of institutions and public intervention. Law, institutions, and public interventions create an implicit price system or try to directly affect market prices to change economic incentives.

To sum up, institutions affect incentives which affect behaviors that influence the performance. Institutions → incentives → behavior → performance.

Efficiency is the focus of economics: we are obsessed with efficiency. We want to avoid waste and reach the maximum social benefit. Efficiency means both avoiding waste and obtaining the maximum (social) benefit.

Efficiency means that economic outcomes are the greatest possible, which implies the maximum possible scope for redistribution and equity. It is not a trade-off between efficiency and equity; they go together: higher efficiency means a higher outcome. Hint: a larger pie, a larger slice for anyone (in theory).

We do not like markets per se, we like markets because they can be efficient and we like efficiency: if markets provide efficiency, then it is fine. The “invisible hand” (A. Smith) works, “let’s people do” is the motto.

Instead, if the markets do not work, some other way to organize production and exchanges must be found. The “invisible hand is invisible because it is not there” (J. Stiglitz), public intervention works better. If the market is not providing efficiency, then public intervention occurs.

Economists and policy makers typically disagree: when is public intervention needed (and how)? When should we “laissez-faire?”

The means of finance is to have international trades. In 1600, in France, a merchant was asked by Jean Baptiste Colbert how the French State could promote commerce (to enrich the nation, mercantilist view). The merchant answered: “laissez-nous faire” (“Leave it to us” or “Let us do”). Meaning that ungoverned market forces would suffice to promote trade and enrich the nation in the best possible way. Was he right? It depends on the market structure.

Public intervention in economics

Public intervention in economics occurs when markets do not work alone. For example, creating a regulation, property rights, etc., or if the market does not exist, to provide an efficient allocation of resources. Public intervention in the economy is necessary:

• To enforce the rules and the institutions that allow markets to work
• When markets do not provide an efficient allocation of resources because they don’t exist or do not work adequately

Or in other words, when there is a market failure.

What causes market failures? How important are market failures in practice? Market failures are everywhere, not only in some sectors. This underlines the importance of regulation. The only case in which there is no market failure is perfect competition. Markets work perfectly in perfect competition, whose conditions are:

• Many small buyers and sellers. In reality, they are often few and large (e.g. multinationals).
• Homogenous goods (for the consumer, they are all the same). In some sectors, we are closer, but generally, goods are differentiated.
• Perfect information: everyone has all the information. In reality, there is asymmetric information, and we are very far from perfect information.
• Constant returns to scale: if you double the amount, everything is double. In reality, it is more efficient to have a larger scale; economies of scale exist.
• No externalities. In reality, there are a lot, more than we think.

Perfect competition is just theoretical. As perfect competition is a theoretical abstraction, market failures are the norm, which implies that institutions are of crucial importance.

Market failures

The most relevant cases of market failures requiring a microeconomic role of government are externalities and public goods. At the local or national level, they are easy to face, through government intervention. On the global market, at the international level, there is the need for public intervention, but we do not have an institution that is global. National government intervention might not be appropriate: a supranational or international institution would be necessary.

Externalities

Externalities are quite common in economics; an externality occurs when the action of an economic agent impacts other economic agents. It is a cost (negative) or a benefit (positive) that an action imposes on other economic agents.

• Negative externality if it generates costs.
• Positive externality if it generates benefits.

Externalities can be:

• Pecuniary: monetary, they affect the price mechanism (i.e. through prices)
• Non-pecuniary: actions that have real effects (i.e. direct real effects).

Non-pecuniary externalities give rise to inefficient outcomes because they are external to the subject generating them and therefore they are not taken into account in market prices. From the point of view of the individual agent (consumer or firm), such effects on third parties are:

• not considered when making choices,
• external to the agent’s optimization process,
• outside of the individual cost-benefit analysis.

Example: Pollution can be considered as an example of negative externality: the company maximizes the profit without taking into account the social perspective. A firm produces a widget at a cost C; production is polluting, which causes people to suffer from various diseases, a cost E on society. In the firm’s optimization process, the cost of pollution is not taken into account. The total widget production will be higher than what would be socially optimal. The aggregate cost-benefit analysis should include both production and pollution costs. Pollution makes the cost of producing aluminum higher. With the negative externalities, we have overproduction (from Q optimum to Q markets).

Lectures, instead, can be considered as an example of positive externalities. University sells lectures at the cost C (wage of prof); lectures cause people to be more innovative, a benefit E on society. In the university’s optimization process, the social benefit of lecture is not taken into account. Total lecture production will be lower than what would be socially optimal. The aggregate cost-benefit analysis should include both the cost of professors and social benefits.

How to deal with externalities?

Externalities imply that the market either over or under supplies the goods and services. The first tool to deal with externalities is public intervention through:

• Taxes (in order to produce less to avoid overproduction)
• Subsidies (in order to incentivize people to produce more)

Or, alternatively, the second corrective public intervention is regulation:

• to create the rules of the game. Direct regulation should clearly define property rights and provide sanctions, thus influencing the “rules of the game”, affecting perceived costs, and changing the incentives.

There are also some kinds of private solutions to externalities. Government action is not always needed to solve the problem of externalities. There are also:

• Moral codes and social sanctions
• Charitable organizations
• Integrating different types of businesses
• Contracting between parties

The Coase Theorem

The Coase Theorem is a proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own. Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain; transaction costs are the costs of finding an agreement. Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible.

When externalities are significant and private solutions are not found, government may attempt to solve the problem through:

• Command-and-control policies (i.e. regulation); usually take the form of regulations:
  • Forbid certain behaviors
  • Require certain behaviors
  Examples:
  • Requirements that all students must be immunized
  • Stipulations on pollution emission levels set by the Environment Protection Agency (EPA)
• Market-based policies (i.e. tax/subsidy)
  • Government uses taxes and subsidies to align private incentives with social efficiency
  • Pigovian taxes = taxes on the source of externality are taxes enacted to correct the effects of a negative externality. But are Pigovian taxes always optimal?

Examples of regulation versus Pigovian tax

If the EPA decides it wants to reduce the amount of pollution coming from a specific plant. The EPA could:

• Tell the firm to reduce its pollution by a specific amount (i.e. regulation)
• Levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian Tax)

Other market-based policies consist of creating a market. Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another.

• A market for these permits will eventually develop.
• A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost.

Example: industry vs laundry

An industry emits smoke that deposits on cloths of a nearby laundry. Smoke does not have any other side effect. The industry can cut emissions by installing filters. The laundry can avoid smoke deposit by installing a ventilation system.

Problem: negative externality, industry imposes a cost on laundry.

Solution: tax, subsidy, regulation? Who should pay? Who is right?

Hp: ventilation system is cheaper than filters.

Suppose we have two choices:

• The laundry is right: industry must install filters.
• The industry is right: laundry will prefer to install the ventilation system.

Clearly, the second option is socially preferable because it solves the problem at the lowest cost. How can we reach this outcome? It depends. (Note: here is not a matter of overproduction).

Assume that they can cooperate at negligible transaction cost. Since the ventilation system is cheaper, aggregate profits are higher than with the filters. The ventilation system is more efficient; hence it must be possible to divide the additional profits so that both parties are better off. This implies that a market solution is possible. Free markets will lead to the optimal outcome (i.e. ventilation system).

Free markets happen when transaction costs are low. If transaction costs are low, the regulation does not matter.

REG 1: the industry has the right to pollute, and so the laundry will install the ventilation system.

REG 2: the laundry has the right to enforce the installation of filters by the industry, and so the industry can pay the laundry to install the ventilation system.

In both cases, the cooperation implies the installation of the ventilation system, i.e. efficient solution. When there is cooperation, the efficient solution is reached.

Note that under cooperation, the aggregate surplus is the same with any kind of regulation. But individual surplus is not:

• REG 1 (industry rights): laundry is worse off
• REG 2 (laundry rights): industry is worse off

If transaction costs are low, cooperation leads to the social efficient outcome. But regulation still affects the distribution. This is the essence of the Coase Theorem.

Assume that the parties cannot cooperate (i.e. transaction costs are too high). This completely prevents any cooperative solution; one possibility is direct regulation. The only efficient allocation of property rights is to give the industry the right to pollute. This regulation incentivizes the laundry to install the ventilation system, which solves the issue as it prevents the realization of the negative effect of the externality.

TAX 1: tax the source of externality (industry) [Pigovian] – we should tax the industry enough to pay/subsidize the installation of the ventilation system.

TAX 2: tax everyone (both industry and laundry) – we impose a tax on everyone (i.e. on profits or on production). Again the amount of the tax should be enough to subsidize the installation of the ventilation system.

We could also subsidize the installation of filters or some other combination, but it is clearly inefficient.

Institutions matter!

Global externalities

Examples of global externalities are:

• Global warming
• Financial shocks transmitted from one market to another
• Exchange rate fluctuations
• Effects of national economic policies transmitted to foreign countries (“macroeconomic externalities”)

Public goods

Excludability: refers to the property of a good whereby a person can be prevented from using it. Excludable goods are those for which one can at low cost prevent those who have not paid for the good from consuming it.

Rivalry: refers to the property of a good whereby one person’s use diminishes other people’s use. Non-rivalrous goods may be provided at a very low (or almost zero) marginal cost to more consumers.

A pure public good is:

• Non-rivalrous, i.e. consumption by an individual does not reduce the availability of the good for others
• Non-excludable, i.e. it is impossible to exclude from consumption someone who does not pay, if not at a very high cost.

Pure public goods are generally provided by the government (or by some community), and they are financed through taxation.

(Note: not all goods and services provided by the public administration are a public good in the economic sense).

Types of goods

• Private goods are both excludable and rival.
• Public goods are non-excludable and non-rival.
• Common resources are rival but non-excludable.
• Natural monopolies/Club goods are excludable but non-rival.

The private sector does not offer pure public goods because of the free-riding problem. Users or consumers of the public good benefit from it, as they cannot be excluded, even if they don’t pay for it, therefore production or provision costs cannot be repaid. For this reason, a public good is not provided by the market.

A free-rider is a person who receives the benefit of a good but avoids paying for it. Since people cannot be excluded from enjoying the benefits of a public good, individuals may withhold paying for the good hoping that others will pay for it. The free-rider problem prevents private markets from supplying public goods.

Prisoners’ dilemma type of situation:

Cost of paving a road to two houses is 4000€. The benefit for each household is 3000€. Collective benefits outweigh costs: it is socially efficient to pave the road. Individually, each household would choose not to pave the road as the cost is larger than the individual benefit.

Solving the free-rider problem

The government can decide to provide the public good, ensuring that all beneficiaries contribute to its cost through taxation or other means. This intervention ensures that public goods are supplied efficiently and equitably, overcoming the limitations of the free market in this context.