The Making of Economic Policy: A Transaction-Cost Politics Perspective

1. The Making of Economic Policy: A Transaction-Cost Politics Perspective Avinash K. Dixit MIT Press, 1996

2. Motivation • The reality of most countries’ trade policies is so blatantly contrary to all the normative prescriptions of the economist that there is no way to understand it except by delving into the politics.

3. Transaction-Costs • In economics, it has come to mean a very general class of information, negotiation, and enforcement problems that affect the internal organization of firms and the outcome of market and nonmarket relations among firms, workers and so on. • A similar and even more severe class of transaction costs (which deals with principal-agent problems, commitment and credibility) pervades political relations and affect political outcomes. • The policy process can be better understood and related to each other by thinking of them as the result of various transaction costs and of the strategies of the participants to cope with these costs.

4. Common Agency • Within this general framework, a particularly important feature of the political process of making economic policy is the “common agency,” where several players in the political game try to influence the actions of one decision-maker. • It leads to a severe diminution of the power of the incentives that can be offered to this decision-maker.

5. Market versus Government • The tradition dichotomy of market versus government, and the question of which system perform better, largely lose its relevance. • Both of them are facts of the imperfect economic life, and they unavoidable interact in complex ways. • The most we can do is to understand how the combined economic-political system evolves mechanisms to cope with the variety of transaction costs it must face that precludes a fully ideal outcome.

6. Principal-Agent Model

7. The players in the Regulatory Process and their inter-relations Regulatory agency

8. The players in the Regulatory Process and their inter-relations Regulatory agencies Firms and Investors

9. The players in the Regulatory Process and their inter-relations Regulatory agency Firms and Investors Consumers

10. The players in the Regulatory Process and their inter-relations Executive Regulatory agency Firms and investors Congress and Committees Consumers

11. The players in the Regulatory Process and their inter-relations Executive Regulatory agency Firms and Investors Congress and Committees Consumers

12. The players in the Regulatory Process and their inter-relations Executive Regulatory agency Firms and investors Voters Congress and Committees Consumers

13. The players in the Regulatory Process and their inter-relations Bureaucracy and other agencies Executive Regulatory agencies Firms and Investors Voters Congress and Committees Consumers

14. The players in the Regulatory Process and their inter-relations Bureaucracy and other agencies Courts Executive Regulatory Agency Firms and Investors Voters Congress and Committees Consumers

15. The players in the Regulatory Process and their inter-relations Bureaucracy and other agencies Courts Supreme Court Executive Regulatory agency Firms and Investors Voters Congress and Committees Consumers

16. Set of Principal – Agent Models Bureaucracy and other agencies Court Supreme Court Executive Regulatory Agencies Firms and Investors Voters Congress and Committees Interest Groups Consumers

17. Principal-Agent model: • It is relevant to analyze relationships with following conditions: • Delegation • Asymmetric information • Imperfect relation between the effort and its results • High costs of monitoring • No alignment of preferences or objectives

18. Principal-Agent model: • In general terms, there exist two solutions to the principal-agent relation: • Involves a structure of remuneration aiming at approaching the incentives of both parts involved (paying a tip). • Rules and institutions capable of avoiding opportunistic behavior of the agent.

19. Positive versus Normative Political Theory: • To what extent those theories are excluding, complementary, or competitors? • Both are based on the premise that agents are rational and look for the own interests. • Dixit suggests a synthesis, labeled ‘transaction-cost politics’ that views policymaking as a process in real time.

20. Normative Political Theory: • Market failure (i.e. natural monopoly) • Requires a criterion to fix with the “best” way this failure aiming at maximizing the social welfare. • Pareto-optimality (efficiency criterion) • First-best and second-best solutions (overcome the market imperfections) • Moral hazard (level of effort of the firm) • Adverse selection (the regulator has no complete information about the costs of the firm) • The regulator is obliged to pay informational rents.

21. Normative Political Theory: • As a consequence of asymmetric information Laffont and Tirole offer as a solution a menu of contract: • Price-caps • Repartition of profits • Thus, the firm would have incentives to revel its true effort

22. Normative Political Theory • The normative solution is rarely observed in the real life • The normative solution requires a high level of discretion of the regulator. This generates incentives for opportunistic behavior • Dixit (1996) observes that the normative theory understand the formulation and implementation of policies as a technical or organizational problems. As if political failures could be avoided through good management, namely, giving power to make and implement economic policy to an economist… • In other words, it does not take into account political and economic institutions. • The benevolent, omnipotent, and omniscient dictator would maximize the social welfare.

23. Positive and Normative Political theory • Dixit 1996 • Dictator benevolent, omnipotent and omniscient second-best literature

24. Positive and Normative Political theory • Dixit 1996 • Dictator benevolent, omnipotent and omniscient second-best literature Informational Economics literature

25. Positive and Normative Political theory • Dixit 1996 • Dictator benevolent, omnipotent and omniscient second-best literature Informational Economics literature PPTR tries to relax this unrealistic premises

26. Positive and Normative Political theory • Dixit 1996 • Dictator benevolent, omnipotent and omniscient second-best literature Informational Economics literature Economic relations Usually involves Multiple principals

27. Positive and Normative Political theory • Dixit 1996 • Dictator benevolent, omnipotent and omniscient second-best literature Informational Economics literature Economic agents, Including regulatory agencies, Bureaucracy, and government are made by people that try to Maximize their own interests

28. Positive Theory • Also starts from a market failure • Regulation necessarily leads to a redistribution. Rarely there are Pareto-optimum corrections or ways of implementing compensations (side-payments) • Given the behavioral premises, individuals and groups would try to influence this redistribution. • Their capacity to do so would depend on the institutions (i.e. property rights)

29. Positive Theory • Many situations apparently inefficient could be understood as a consequence of restrictions imposed by transaction costs among agents. The great majority of the PPTR tries to explain why such inefficient situations are observed even when there are obvious and better ways to deal with that. This involves to identify the source of restriction which are generating transaction costs and to show how it affects the agent choices. Almost always it requires to take into account the political institutions.

30. Why does the regulation (government intervention) tend to be inefficient? • Economic reasons: • Asymmetric information • Uncertainty about effects, costs, and benefits • It does not mean that the regulation is not necessary; however, those problems should be taken into account

31. Why does the regulation (government intervention) tend to be inefficient? • Political reasons: • Regulation necessarily means income redistribution • Quotas, licenses, subsides, establish a price, etc. transfer rents and incomes • Interest-groups will demand this redistributions and politicians offer • Generally, the regulation tends to be inefficient • Rent-seeking • Few beneficiaries and lots of opponents

32. A Synthesis: A Policy Process in ‘Real Time’ • Constitutions are incomplete contracts: • The constitution never lays down the clear, firm, and comprehensive set of rules that the contractarian approach depicts; so there is room for maneuver in individual acts. • Inability to foresee all the possible contingencies and to adjust to them • Last longer than most business relationships • Constitutions are not made behind a veil of ignorance

33. Coase’s Theorem • Once the property rights over a disputed resource (ex. Rents of a monopoly) have been established, and given that the transaction costs are equal to zero, the private negotiations between agents approaches to the efficient level of allocation. (Coase, Ronald, (1960) The problem of social cost. Journal of Law and Economics, 3, 1-44).

34. Example: • A firm pollutes a river which provides a cost of $500 to a farmer along the river.

35. Example: • A firm pollutes a river which provides a cost of $500 to a farmer along the river. • It costs $300 to the farmer to build a station to purify the water.

36. Example: • A firm pollutes a river which provides a cost of $500 to a farmer along the river. • If costs $300 to the farmer to build a station to purify the water. • The firm can eliminate the harmful effect of pollution changing its production process at the cost of $100.

37. Questions: • Should be allowed the firm to pollute the river? • Should the firm be obliged to change its production process? • Who should pay for that? • What are the economic implications if the firm would have the property rights of polluting and the farmer would have to compensate him in order to not pollute?

38. Example: • And, if the property rights belong to the farmer?

39. The Coase’s Theorem: • Coase argues that, for the economic efficiency point of view, the result would be the same regardless the of the property rights given that the transaction costs are null.

40. Numeric Example I: • Cost of pollution over the farmer = $500 • Cost of cleaning from the farmer = $300 • Cost of cleaning from the firm = $100 • Case I: • The farmer has the property rights. • The firm will pay for the right to pollute, It pays $100 at maximum • The farmer would accept more than $300 only since he/she would have to clean the water in order to avoid the cost of $500 • Thus, the is no agreement and the firm purifies the water itself.

41. Numeric Example I: • Cost of pollution over the farmer = $500 • Cost of cleaning from the farmer = $300 • Cost of cleaning from the firm = $100 • Case II: • The firm has the property rights. • The farmer will pay for the firm to not pollute. It pays $300 at maximum • The farmer would accept to pay no more than $100 since he/she could clean the water at this price. • Thus, the farmer pays between $100 and $300 and the firm purifies the water itself.

42. The solution is the same in both cases • The solution is economically efficient

43. Efficiency vs. Equity • Although the reached solution are not affected by the property rights the distribution between the parts involved would be.

44. Efficiency vs. Equity • When the property rights belong to the farmer, the firm has a cost of $100.

45. Efficiency vs. Equity • However, when the property rights belong to the firm, the farmer pays at least $100 and part of the exceeding of $200. This “rent” of $200 will be allocated by negotiations between the parts.

46. What is the fairest solution? • Coase recommends that we should not conclude too fast. • He calls our attention to the reciprocal nature of the problem.

47. Graphic Example. MB for the firm to pollute MC of the pollution over the farmer c a d b 3  1 2

48. If the firm has PR it pollutes until 3. The farmer can convince the firm to pollute until 2 offering more of ‘d’. The farmer would thus win c+d. MB for the firm to pollute MC of the pollution over the farmer c a d b 3  1 2

49. If the farmer has the PR he/she prefers 1 (if there is no negotiation). The firm can compensate the farmer to pollute at 2 offering more of ‘b’. MB for the firm to pollute MC of the pollution over the farmer c a d b 3  1 2

50. Necessary conditions to reach the negotiated result: • Well defined property rights. It implies political and judicial institutions that work well. • Low transaction costs • Information about all costs of each possible result for each part involved.