Key Issues faced by Modern Firms

BARGAINING LIMITIATIONS

When the mill and the farmer negotiate an efficient agreement they are in effect

creating a market for exchanging property rights to a good.

Prior to their negotiation, a negative externality was present because those markets

didn’t exist. In fact, every externality can be traced to a missing market and private

negotiation remedies the externality by creating a market.

Why might two or more parties fail to address an externality through negotiation,

despite the promise of mutual benefit?

Many of these factors cause the market to fail and thereby to give rise to externalities,

which can also cause bargaining to break down.

1. Bargaining can be impractical and costly in terms of time and effort.

2. Assessment of property rights ca be ambiguous, based on conflicting legal

precedents: the owner of the mill may believe to have the right to pollute

whereas the farmer may believe to have to right to have clean water. In such a

cases the two parties might find themselves in a costly legal battle.

3. Limited information availability

4. Incomplete and so inefficient contracts may be difficult to enforce. In some

cases parties might not be able to monitor compliance with an agreement or

monitoring might by very costly

EXTERNALITIES

The conclusion of the “invisible hand of the market” promotes economic efficiency,

where each consumer’s well-being depends only on her own consumption and where

each firm’s output depend only on its own production decisions.

However, choices can profoundly affect the well-being of others. In such cases, the

competitive markets fail to allocate resources efficiently. Therefore, externalities

born: actions if these affect someone with whom the decision

Externalities are created by

maker is not engaged in a related market transaction. They can be negative if they

affect someone (pollution) or positive if they benefit someone else (public good).

Negative externalities:

- Pollution

- Someone that lights up a cigarette in a close and public place

Positive externalities:

- Abatement of pollution

- The consumer to decides to buy something and the seller who decided to

provide a service 2

NOTES CHAPTER 3 - WARGLIEN

When a consumption or production activity creates an externality, competitive

markets will usually allocate resources inefficiently.

Why? private

When an externality is present the cost and/or benefit of an activity to the

social

party who performs it differ from the costs and/or benefits of that activity, which

include effects on other parties. In a competitive market each consumer purchases a

private MB = P.

good up to the point at which her therefore, a competitive equilibrium

ensures that private marginal benefit equals the private marginal cost.

social MB = social MC.

But from the social perspective, efficiency requires that If either

the consumption or production of the good creates negative externalities, then

equality between private MB and private MC will imply that social MB is < social MC.

From society’s perspective, that means a small reduction in the level of consumption

and production would increase welfare, so that level is too high. On the contrary, if the

consumption or production of goods creates a positive externality, the equality

between private MB and private MC will imply that social MC > social MC. So, an

increase in consumption or production would increase welfare, so the level is too low.

Public goods non-rival non-

Public goods are a positive externality. A public good is a good and

excludable .

A good is non-rival if more than one person can consume it at the same time

without affecting its value to others.

A good is non-excludable if there is no way to prevent a person to consume it.

For example, national defence is a public good, because one citizen’s enjoyment of

national security doesn’t reduce the its value to others and because there is no way to

withhold the benefits of it from any particular person.

INFORMATION ASSYMETRIES

are present when one party has more information on the

Information asymmetries

characteristics of the good or service to be traded.

- Informed parties: used-car sellers, insurance buyers, workers;

- Uninformed parties: used-car buyers, insurance companies, employers;

adverse selection moral

There are two forms of information asymmetries: and

hazard. occurs when the informed party is more willing to trade when the

Adverse selection

trading is less advantageous to a uniformed trading partner. Therefore, it results in a

market failure for high-quality products, because the uniformed party will

rationally lower his/her willingness to pay even further, so sellers of effectively high-

quality good will not be willing to sell at such low price.

occurs in settings with adverse selection when the

Market unravelling

 presence of unattractive trading partners drives attractive one out of the

market by altering the prices at which they can trade.

3

NOTES CHAPTER 3 - WARGLIEN

The problem of Adverse selection has been studies by the economist George Akerlof

(Nobel price 2001). He showed how adverse selection can undermine the possibilities

for trade in a used-car market. Because sellers want to sell bad cars (“lemons”) and

keep the good ones, buyers of the used cars must be wary of quality.

mandates of

The solution to adverse selection is given by the government with

minimum quality standards. MORAL HAZARD

occurs when a person to a transaction takes actions with the trading

Moral hazard

partner cannot observe and that affect the benefits the partner receives from the

transactions. In other words, the moral hazard is present when a person takes more

risks because someone else bears the effects of those risks.

incentive scheme.

Solution:

In a setting with moral hazard, the uninformed party want to ensure that her trading

partner takes actions that promote her interests. Ideally, she would write a contract

that specifies the action her partner must take. Unfortunately, since she cannot

directly observe the trading partner’s actions the contract wouldn’t be enforceable.

Therefore, she has to take a different strategy. Indeed, she can control the result of the

partner’s actions, which is an important consequence of that effort.

incentive scheme, a contract or compensation that

Therefore, she would provide an

rewards or punishes the trading partner’s performance.

CONTRACTUAL INCOMPLETENESS

Often contracts are difficult to complete them, by describing all the relevant

information of the transactions. In many cases, monitoring directly the actions of the

trading partner is impossible to or very costly, therefore, the most of agreements

aren’t enforceable. self-enforcing agreement, where

In order to be effective, the contract has to be a

every party to the contract has an incentive to abide by it, assuming that others will

do the same.

A concrete example comes from Game Theory, where the strategies that make up a

Nash Equilibrium have this property: if the parties agree to play those strategies, none

of them will have an incentive to break the agreement. This situation has a direct

implementation when companies institute an informal inter-organizational link with

external parties, such as long-term contracts and collusions and cartel strategies.

Contractual incompleteness has is major disadvantage when two companies establish

relation-specific investment.

a The former requires great investments for a single

firm, which results as a sunk cost and implies great financial inflexibility. Moreover,

once the investment has been done, even is the contract is incomplete, there is a

fundamental transformation of the relationship that makes changing partner very

4