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 Smith’s 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 can’t 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. No investment t+2 Success High demand t+3 Market research Investment Moderate demand t+1 Failure Low demand t 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)>Eu(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 Expected payoff Good state

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 insured’s actions are not observable by the insurance company, nor by courts, hence cannot be included into contract • Additional problems: Commitment problem on the insurance company’s 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. Total revenue Tenant’s share of revenue Cost of production(borne by tenant) Crop Sharecroppingequilibrium Social optimum Inefficiency of sharecropping

14. Example: US corporate governance scandals Tyco’s 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 M’s 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 M’s 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 Initial wealth Payoff

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 > D • But probability of this is low • If cash flows < 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 can’t 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

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

29. Redistributing land • Land market? • But tenants are cash-constrained • Most often don’t 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: Cardoso’s 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 • Lula’s 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