Samenvatting Hoofdstuk 2.

Theory abstraction
- It is a (correct) representation of reality
-Used to model phenomena
-Trade-off between richness of the model and applicability
-Helps to understand causal mechanisms

Agency and structures

The term agency is often used in social sciences, and refers to the capacity of individual actors to act
freely and without constraints.
The term structure refers to the environment of the actor, which may have an impact on hit behavior
to a lesser or greater extent. That environment consists of different types of structures, such as
market structures, the structure of informal institutions, governance structures, technology, the
natural environment, and finally, the structure of power in society.

Verder moet alleen nog blz 82 tm 84 geleerd worden over het anglo-saxon model, The continental
European model en the Asian model. Dit staat heel goed in de sheet beschreven:

Anglo-Saxon model:
- UK, USA, Australia, Canada, NZ
- Competitive markets are adequate governance structure to coordinate transactions
- Dominant role of markets and competition
- Government at ‘arm’s length’: strong but at a distance
- Clear allocation of property rights, strict competition law
- Value system: individualistic
- Judicial system: independent public court
- Political system: strong competition between two dominant parties

The continental European model

- Sweden, Denmark, Germany, Netherlands (“Rijnland Model”)
- Value system: collectivist
- Important role for labour unions and employers associations
- Political system: More consultation, less competition (compared to Anglo-Saxon model)
- Room for “organising” the market
- Tripartite negotiation about macro-economic indicators (wages, investments, inflation,
employment rate)
- Judicial system: courts may follow societal interests

The Asian model

- Japan, China, Taiwan, Korea, Thailand, etc.
- Strong role of the state in initiating economic development
- State develops National Plan; private investors are advised to follow the national plan
- Collectivist culture, group orientation
- Tripartite negotiations: labour unions, employer associations and the state
- Strong and high quality bureaucracy
- Democracy is subordinate to tripartite agreements
- Judicial system: courts may follow state interest

Het laatste waar je nog naar kan kijken is deze figuur op pagina 70. Hier wordt de economie als een
deel van het maatschappelijke systeem gezien. (sorry voor kwaliteit, heb met webcam gedaan.)
Samenvatting Hoofdstuk 3
1. Property Rights Theory
The owner has a bundle of property rights:
- The right to disposal
- The right to full excludability
- The right to use the asset
- The right to earn the income
- The right to manage & control the asset
There are two problems that occur in this theory.
 Issue of designing and assigning property rights
( to choose a property rights system, or not?)
(to leave the asset a common good or make it a private good?)
 Issue of exercising property rights
( who is the owner of the asset?)

Properties can be:

- Excludable ( it is possible to exclude others from using the good)
Non-excludable
- Rival ( the consumption of a good reduces the amount of the good available for others) or
Non-rival

Types of Property
1) Private Property ( rival – excludable )
- A private good isn’t the same as an private owned good.
- The holders of private property rights will use their resources as efficiently as possible.
2) Free goods
If AS > AD at all price levels than is P always 0 euro. In this case property rights are not
needed because the product (sell at a P of 0) would be available to everyone.
3) Shared common goods
 Common property resources: ( rival – non-excludable)
The property right haven’t been assigned to specific individuals. These
resources are rival because of their scarcity.

Tragedy of the commons  resources are bounded to be exhausted and may disappear. ( numerical
example at P. 97)
The increase of rivalry of these resources leads to more negative externalities! A solution would be to
establish property rights ( private property or/and public property).

 Club goods: (rival – excludable)

People are entitled to use a resource in return for a contribution (library).
- At a small numbers of members there will be no rivalry and sanctions will be very effective
to coordinate the system.
- At a large numbers of members the good become rival. In that case the problem of free-
riding behavior occurs. The two-part-tariff could be a solution for this ( members have to pay
a flat fee in advance and a per-unit fee).
 4) Public Property ( non-rival – non-excludable)
 Pure public goods:
Pure public goods are always accompanied by positive externalities.
The goods are often supplied by government ( taxes), this to prevent free-
riding).
 Goods that are publicity owned:
- natural monopolies ( government can prevent that customers have to pay a price
that is to high)
- Institutions ( this assures citizens of fair treatment)  police, law court, military.

Bringing structures under state control has some benefits:

- consumption of merit-goods can be promoted.
- weaker members of the society will get help.

Enforcing property rights

- Formal institutions: They are made up of formal constraints ( rules, laws, constitutions)
Advantage: They may serve to enforce property rights when conflicts arisen.
Disadvantage: High costs
- Informal institutions: They’re made up of informal constraints (norms of behavior, conventions,
self-imposed codes of conduct)
Advantage: Low costs
Disadvantage: modern societies can’t function with only informal institutions.

Enforcing property rights in case of negative externalities:

 Coase Theorem:
The solution to negative externalities is assigning property rights to these externalities. Both
parties will be able to reach an optimal solution without state intervention if:
 It is clear who possess the property rights
 Negotiations about solving the problem are costless
 There won’t occur wealth effects
Both parties will gain by trading legal entitlements regardless of which party has been granted the
property rights. The trading process will continue till an efficient allocation of resources has taken
place and neither party can improve its position unless the other party loses.
If this case the negative externalities had been completely internalized ( all social costs inflicted are
taken into consideration).

Different incentives
The existence of different property rights systems is because of the existence of different kinds of
incentives.
Common property regime  the existence in which property is shared among groups.

Incentives problems:
 Pure public goods/club goods.
In this case free-riding may cause (financial) problems. Taxing the whole community would
be a solution. But then non-users have to pay too. Sometimes it is better to charge only the
users ( public transport).
 Information goods.
 Information goods are non-rival and non-excludable. But there are solutions to prevent that
third parties will take information. These preventions turn the good into excludable goods:
- Copyrights and patent rights (formal)
- Secrecy (informal)

2. Contract theory
A contract: is an oral or written agreement between two parties who consent in advance to
exchange goods or services.
 formal contracts
 informal, implicit contracts

With problems like uncertainty and opportunistic behavior must be dealt with as fully as possible: the
degree to which these issues are handled determines the completeness of the contract.
Incomplete information and bounded rationality (limited cognitive competence) lead to incomplete
contracting.

 One-off, simultaneous contract (spot transactions)

Is an immediate exchange of property rights. The parties comply direct with the agreement
and the contractual relationship ends immediately.
 Nonsimultaneous contract
The contract will be fulfilled at a stipulated point in time in the future, which will increase the
risk of noncompliance.

Two types of theories:

1. Agency theory
Refers to formal contracts that are legally enforceable. And deals with the question: How to
incorporate the right incentives in a contract to prevent opportunistic behavior and reach an optimal
efficient outcome?
Contracts: the need of parties to ensure themselves against risk.

- Risk aversion; means that a person prefers a secure outcome to an insecure one.
 see box 3.4 p108.
- Risk neutrality; means that a person is indifferent between a secure and a insecure outcome.

Between a risk neutral and a risk averse person (insurance company and his insurants) can arise a
welfare improving contract, where an optimal allocation of risk exist.

Two parties:
 principal: party that gives an assignment and delegates the task.
 agent: party that receives the task and has to carrying out the task.
These parties haven a principal-agent relationship whereby the agency theory also be called the
principal-agent theory.

The principal-agent relationship becomes a problem when two conditions hold:

1) Conflicting interests
2) asymmetric information
These conditions give rise to:
 Adverse selection problem (Arises due to ex ante opportunism.)
Example: Insurance market (see box 3.5 p 110)
Via a process of self-selection low-risk people will choose another insurance than high-risk people.
Adverse selection poses problems that may lead to welfare losses.
 Moral Hazard problem ( arises due to ex post opportunism.)
After the contract has been signed the agent might take advantage of the fact that he has more
information about his own efforts than the principal, his actions may go unnoticed. That is what we
call Moral Hazard (Hidden Actions).
Moral Hazard may occur when one party has more information ans exploits the situation. VB:
- Employer – subordinate
- doctor – patient
- client – attorney
The risk of opportunism by the agent could lead to efficiency losses ( also called agency costs).

Agency costs: (see figure 3.1 p 114)

1. Monitoring expenditures
2. Bonding expenditures:
3. Residual loss:
( principal-side)
agent makes bonding costs to show the principal that he does serve
the interests of the principal.
the monetary value of the principal welfare loss that remain after 1
and 2 are taken into account.

2. Implicit contract theory

It is possible to design a self-enforcing agreement with which agents comply because it is in
their interests. Such an agreement is related to self-enforcing and self-regulating mechanisms.

Types of Self-enforcing and Self-regulating mechanisms.

 Reputation:
when you have cheated on your contract partner others will know that and your
reputation and business/career will be damaged.
 Tit for that:
Deceiving your business partner may cause him to retaliate in the same way. This
help to prevent contracting parties from breaking their promises.
 Third parties:
Installing third parties to resolve disputes and to evaluate performances. These
independent (third) parties can act as a mediator and arbitrator.
 Commitments:
If contracting partners have invested in each other in various ways, this lead to
bonding effects. This then could lead to feelings of solidarity and loyalty.
Credible commitments; if parties are about to transact a high value product, the
party that stands to lose the most may demand extra security to support the
contract. This security often takes the form of a down-payment( borg betalen).
 Unification of parties:
If parties decide to fuse (vertical or horizontal integration), the advantage is that
arrangements that previously existed between 2 independent companies, are now
dealt with internally.
Relational contracts
The open-ended contract or the relational contract contains several implicit mutual understanding
and self-enforcing mechanisms. This type of contract is often found in farm- working relationships.
The involved parties need informal institutions which are able to inspire confidence that everyone
will live up the agreement.
As long as the benefits of complying with the implicit agreement are beneficial to both parties, self-
enforcing mechanisms will be effective.
3. Transaction Costs Economics TCE
Transactions costs: All costs that arise from the specification of a contract and monitoring
compliance with the agreement.
Vb: Monitoring costs , enforcement costs, negotiation costs, search costs.
In TCE, the search for an efficient governance structure implies that actors are assumed to be
optimizing ( minimize tc).
In TCE, is assumed that human behavior can be characterized by bounded rationality and
opportunism.

Search goods: products for which quality characteristics are easy to observe in advance.
Experience goods: products for which quality characteristics are difficult to observer in advance.

 Asset specifity ( see example coal mine, p. 120)

If one party has made transaction-specific investments, this results in high dependence which may be
abused by the other party. The specific- investments made consists of a large amount of sunk costs
( expenses that can’t be retrieved once incurred). ( see example coal mine, p. 120)
Hold-up Problem: In a contractual agreement, the other party may abuse the inflexibility of the
party who has made the transaction-specific-investments.

Different types of asset specifity:

- Site specifity; resources made which are highly immobile and only usable at one specific
spot.
- Physical asset specifity;
- Human asset specifity;
- Dedicated asset specifity;
- Intangible asset specifity;
involves investments in equipment that are designed for a
very specific purpose. ( a boiler that only can burn a particular
type of coal)
refers to the firm-specific knowledge that workers may
accumulate.
a general investment that is made specifically with the
objective of selling a large amount of product ton one
particular customer. (he is dependent on the customer).
immaterial valuables such as brand name capital.

 Uncertainty
Transactions often involve uncertainties due to the behavior of the parties and to the developments.

 Frequency
The tc also depend on the frequency with which parties interact. If they have regular dealings they
will develop certain implicit mutual understandings and trust. This may lead to more investments in
transaction specific resources, because the costs will be easier to cover by a long-term relationship.
When a supplier is awarded a contract to deliver a good for a long period, he has an advantage
compared to his competitors. He can now continue to develop.This will give him more market power.

Depending on the degree to which these above mentioned dimensions play a role and to the degree
to which bounded rationality and opportunism are present, actors choose the governance structure
that fits the best. Choosing the appropriate governance structure can reduce the TC.

Different Governance Structures See figure 3.2 p.124

 Ideal Market/ Spot market (stock exchange, flower auction)
 - Anonymous actors
- complete contract
- Perfect competition
- High-powered market incentives ( if somebody modifies his effort, it will have
directly effect on his earnings)
- information exchange is low
- Once-off transactions
- main coordination device: price
 Market Hazard
- contract becomes incomplete
- market hazard is accepted as incidental risk
 Institutionalized market ( contracting with guarantees, certification)
- actors are not anonymous
- repetitive transactions
- information exchange is medium
- main coordination devices: price and formal institutions
 Hybrid ( joint venture, franchise system, cooperative)
- actors not anonymous
- repetitive transactions
- main coordination devices : price, formal and informal institutions
- Information exchange is medium/high
- they partly ‘pool their resources’ ( share parts of their assets)
 Private Firm
- firm = hierarchy = vertical integration
- property rights are transacted under unified ownership ( in return for a specified
level of compensation ,owners of property rights offer their products to be put in
productive use under control of a authority)
- low powered incentives ( if someone changes his effort, this won’t be noticeable)
-information exchange is high
- repetitive transactions
- main coordination devices: authority/fiat , formal and informal institutions
The use of fiat as a coordinating device has some advantages:
 it gives flexibility to supervisors to reallocate tasks without renegotiation.
 it may effectively curtail opportunistic behavior.
 it makes it possible to deal with conflict without the costly use of legal arbitrage.
 Regulation ( international treaties, corporate law = vennootschapregeling,
competition law=mededingingsrecht)
 State-owned enterprise (minisetries, police)

Continuum of governace structures

Market hybrid hierarchy

Market; the market is the governance structure in which parties negotiate in

setting of equal rights about the content of the contract
Hierarchy; supervisors give commands to agents at lower levels of the
organization.
Hybrid; is based on a contract that is the result of negotiations between
equal parties, aimed at some form of collaboration.
Vested interest approach
A powerful minority group succeeds in maximizing their own profit. Economic welfare is thus not
maximized.
 Property Rights; the allocation of property rights reflects the power structure of society and
negotiation among the owners of the right always takes place within that initial distribution of power
 Agency; this theory already takes misuse into account. How can the interests of managers
and shareholders become aligned? (by monitoring devices and setting the right payment).
 Governance structures; actors seek that governance structure which minimized tc (efficiency
approach). Nut governance structures often arise out of power ( think of cartels).

Hoofdstuk 4
Enculuration: Actors make themselves familiar with instituitions. Members of a group give the
(young) members a formal or informal training.

Private and/or governance structures are changed by:

- Culture
Culture is the aspects of human behaviour and society that are shared by all, or almost all, members
of some social group. It includes immaterial and material phenomena and is reflected in laws. Culture
changes over long periods of time. If it changes, the formal institutions also have to change so the
change in formal institutions is driven by an exogenous change in the country’s culture.
- Technology
The exogenous change in technology drives the institutional change in private governance structures,
such as the size and structure of the firm. For example when mass production became possible
through new tc the governance structure that best accommodates large scale production became
dominant. Technology is so-called ‘unruly’; it drives a transformation toward a new gov ernance
structure but wether this happens and which governance structure will be selectet is a matter of
choice by the actors involved.
- State
If the government makes laws, the other actors have to live up to these laws. For example, of
cooperation become forbidden then firms might merger or take over their competitor.

Two motivations of change

1) Efficiency
Why and wen are actors motivated to look for the most efficients solutions. In many theories it is
assumed this comes through competition. H2 represents the static approach. Now should be shown
how agents obtain the right info, how then know about the most efficient alternative governance
structures and so on.
Some circumstances block the efficient choice:
- It must be possible under existing law, or the shared mental maps.
- economic lock-ins; high switching costs
- technological lock-ins; bhe tc requires an integration of activities
- institutional lock-in; changes in complementary institutions do not come about in the same way as
an adaptations of the competition law that permits the new network-type of governance structure.
2) Vested Interest
Competition drives firms so reach for efficient solutions, so from a societal point of view it is positive.
At the level of individual firms it is a burden. Managerial strategies aim the control or elimination of
competition to protect their Vested interest, this can be done by horizontal and vertical merges and
by acquisitions. Networks can be used to increase power.
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The evolutionary approach toward the dynamics of institutions.

In a dynamic analysis are all kinds of interdependencies between variables.(zie 4.3).
You can look and the evolutionary process and the design process.
The point in the evolutionary approach is that under specific conditions, independent actors, who
behave in their own interest, unintentionally create institutions that are durable and that coordinate
the behaviour of economic actors. Other actors are preferred to behave in the same way. This
behaviour reduces uncertainty and so information costs.
Compare it with a footpath witch is spontaneously created by walkers. Everybody follows the path
because it is easier and in their own interest, but it was not intended. No authority was needed and
its maintenance is self-enforcing.

Institutions as an equilibrium.
Three phases of creating instituitons:
1) Externalisation; the rule has to become visible for the externs
2) Objectivization; others have to take it in account
3) Enculturation; see above
This regularity becomes an institution when a large majority internalizes it.

Interdisciplinary research; insights of both game theory and history are combined.(also pluralistic
interdisciplinary approach, because different methods are used, see H2)
Game theory; shows why institutions are self-enforcing. That happens if actors discover that
cooperative behaviour and compliance with the institution create mutual gains.
History; if the institution is not efficient it might come because it was originally created for something
else. Maby the footpath was created to stroll around ipv quickly reaching the overkant, but it is to
costly to create a new one.
Multiple equilibria; depending on different historica conditions, different equilibria(institutions) are
reached.

Darwinian evolution
This focusus more on the selection process instead of the equilibrium.
Tree key elements are(inspired by darwins work on biological evolution).
1) Mutation; a deviation
2) Selection; many mutations are not copied and don’t survive
3) Inheritance and retention; the fittest institutions are inherited and retained by future
generations and create habits.
Path dependence
This concept capture the linkages of the past to the present and the future. History matters. The path
of development is forced by technical or institutional factors and switching is very costly or it is not
part of the mental map.

Gradual change and ‘punctuated equilibria’

So far evolution was slow and gradual. Sometimes evolutions goes radical, ten the shared mental
map is completely replaced along with the corresponding institutions. Another framework is
necessary. A punctuated equilibrium involves long periods of gradual change, punctuated by short
periods of dramatic changes.

Cumulative causation
Changes that reinforce developments in the same direction, bijv multiplier or one firm goes away and
then all firms follow.

Intentional and habitual behaviour

A spontaneous process can also start with an intentional act at the individual level, which ten is
spontaneously copied by others.

The design approach toward the dynamic of institutions

Designing institutions takes places at two levels
1) The level of formal public governance structures of laws and regulations
2) The level of private governance structures
First order economizing; politics designed the efficient formal public institutions
Second order economizing; private actors will design the governance structures that minimize
production and transaction costs.

Efficient public governance structures

Dilemma: actors prefer certainty about stable formal institutions, but institutions should also be
flexible to respond to changes.
Two steps
1) Formulation of the objectives(what is the desired outcome of the institutions)
2) What should the set of public institutions look like?
In NIE, the objective is a competitive market and the sesired public institutions are about competition
law and corporate law.

Designing effective institutions: the OIE approach

Instituitions: a matter of valuation
In H1 we saw that what actors consider to be rational is in fact ´socially constructed´. Vested Interest
and the power structure of society are important. The allocation of rights is not neutral. Institutions
are human constructions and are subject to evaluation and redesign(OIE).

About ´is´and ´ought to be´

Is: Institutional economics explore the interdependencies in de economic system and how it interacts
with the value, political and judicial systems.
OIE=> the nature of the economy is dynamic and the economy should be explored in a holistic way as
part of a societal system. Starting point is the division of power to understand the institutional
structure and from that the performance of the economy.
Ought to be:
Different levels of society should formulate what the performance of the system ’ought to be’., incl
the value judgment.
Comparison:
Which(change in) institutions will provide the actors with the right motivation and incentives so the
outcome corresponds to the objectives at the different levels of the system? Which vallues and
governance structures(private of public) can be instrumental? = instrumental value theory.
Instrumental valuation: values are not absolute. Which institutions are instrumental to societal
objectives?
OIE=> Institutions might protect Vested Interest, but it is a matter of valuation whether such
institutions need to be replaced(costs a lot of time and ‘institutional change agents’ are crucial’).
Valuation determines what is desirable in economic terms.

Settled beliefs
Belief= view of how the system works, for example the Keynesian view.
A belief is settled in a community if there is no doubt that the belief represent reality and that
policies and institutional changes should be based on that belief, but it is never absolute. It
determines choices scientists make and which mechanisms make the system work. Several beliefs
can exist within one discipline.

Ongoing process of artificial selection

Institutional structure is inherited from the past. If ‘is’ and ‘ought to be’ differs science needs to
explain it and do suggestions which are selected by actors from different levels in society knowing
that new institutions change the distribution of cost en benefits.
Artificial selection: designing institutions is a matter of evaluation, political decision-making,
argumentation end procedures. OIE view see 4.4
Chapter 5: Markets.

To enhance the welfare function of markets, some form of design will be necessary. With an
absence of the necessary institutions for a market to operate properly, a market can not
function. For example, property rights and a legal framework are necessary. Besides
property rights, the choice of specific market institutions is important when it comes to
minimizing transaction costs. This is related to (1) imperfect information, (2) Asymmetric
information and (3) externalities. (for example: to reduce asymmetric information, the
market will be assisted by guarantee certificates).

Market process theory:

Aims to understand how the decisions of individual market participants interact to generate
the market forces which compel changes in prices, in outputs and in methods of production
and the allocation of resources.

Table 5.1 at page 169 for different approaches to the market.

Static efficiency approach:

Spot markets:
Sellers and buyers exchange property rights in the market by bidding and asking. A
relationship in here consists of a single exchange, which means that identities of the
partners to the transaction are irrelevant. Prices react immediately to changes in availability
of the product.
Contingent markets:
A physical product is not necessarily the same economic product: products can also be
defined by the time, place and environment of their availability. For example: if you are not
going to be ill, you will not need a doctors services, her services are contingent on you
becoming ill.

Contract law Regime:

1)Identity of partners is irrelevant; 2)nature of transaction must be defined precisely; 3)
because informal agreements can easily be the subject of misunderstandings, more formal
agreements supersede informal agreements; 4) it is not always necessary to specify all
details; 5) classical contracts are supposed to be restricted to the contractin parties.
Property rights (Chapter 3)
Reputation Effects
In the ideal market, this does not play a role. Since the market structure may deviate from
this idealtype, reputations can be important (in the case of asset specificity or sequential
transactions). For example: a low reputation of the transaction partner results in a higher
need for costly bargaining and contracting; also important to safeguard actors from any
opportunistic behavior by the transaction partner. Reputation can be enhanced through
quality marks or certification, rating services or experiences.
Risk:
Private actors perceive risky situations as business opportunities and may offer safeguards in
a variety of forms.

Sometimes, people decide to run the risk of being cheated (for example: when costs of
safeguarding are high in comparison to the price of the transaction.) Besides risks, markets
also differ on the way that buyers are informed about the quality of the product (most of the
times they are displayed, so the buyer can have a look).

Opportunism and externalities:

Ex-ante Opportunism is characterized by hidden(asymmetrical) information.
Ex-post opportunism is characterized by hidden action (after the contract has been signed;
for example: hold-up, p. 179).

Adverse selection: (Lemons) when there are no built in safeguards to protect the trading
partner who has the inferior knowledge (Automobiles).
Moral Hazard: Zie box 5.7, p.181

Externalities
When someones actions affect another party without compensation. Hierdoor: Coase
theorem: when there are no transaction costs, a dispute with regard to externalities results
in an efficient outcome, regardless of how the law assigns responsibility for damages.
Example at table 5.3, p. 182

STATIC VESTED INTEREST APPROACH TO MARKETS

In perfect competition: no market power (no producer with a price higher than marginal
costs). An example is a monopoly, however, there are also less extreme cases. Therefore, in
a situation with many producers, market power is low.
When manufacturers set prices in order to cover all costs and to provide a profit
margin, we can speak in terms of mark-up pricing. To reap higher profits, price
discrimination is also possible. Another option, for a monopolist, is to exclude potential
entrants from the market (for example by engaging long term exclusive contracting with
customers). Or predatory pricing: this implies a short-term pricing policy that is loss-leading
and therefore so unattractive to competitors, that they will leave the market (prijzenoorlog).
In general: market power will not pose a problem if firms are small, but if firms are
large, there is always a possibility of hampering competition.
Three ways to eliminate competition: 1) merge: two or more competing firms become one.
2) When B knows that A raises his price, then so can B, and vice versa. 3) raise prices
together with rivals.

DYNAMIC EFFICIENCY APPORACH TO MARKETS.

Market process theory: Through the process of discovery, the market coordinates sellers’
and buyers’ decisions, not only at equilibrium prices, as is shown in the static partial analysis
of the market, but also at disequilibrium prices.
Role of entrepreneurs: These are prepared to bear the costs of uncertainty. Entrepreneurship
can be viewed as an institutional answer to the problem of uncertainty. The profits that
emerge from entrepreneurial activities are the reward for the discovery of the market
opportunity. Entrepreneurship is embedded in societal institutions (p. 188): 1) social context
of entrepreneurial activities influences their level in a society (stigma of failure). 2) formal
institutions, such as financial institutions and property rights, are also essential for
entrepreneurial activity.

Creative Destruction (Schumpeter): new capital and production processes replace existing
ones. This also means that changes in the economic structure (through innovation) not onlay
result in structural change in the economy, but also in new institutions. Institutions have to
adapt.
Entrepreneurs who help to set up market institutions are called institutionale
entrepreneurs. They not only integrate resources, but may also have to overcome
institutional restraints. Four possible strategies to change the rules: 1) campaign openly; 2)
lobby privately; 3) argue to be exempted from prevailing rules, because he is a special case;
4) start a business without complying with existing rules.

THE DYNAMIC VESTED INTERESTS APPROACH TO MARKETS (p. 192)

Bargaining occurs between parties who are equal before the law, but who are not
necessarily equal in social and economic power.
In conventional market analysis, consumers are sovereign and their decisions govern
economic life. In the privately planned approach, large firms do not satisfy consumers
demands, it is the executives who try to persuade the consumer to buy by spending money
on advertisements et cetera.

Counterveiling power: private economic power is sometimes held in check by power from
the opposite side of the market (in the form of trade unions, or consumer boycotts).
Idealtype Labormarkets (Anglo-Saxon vs. European, table 5.4 @ p. 195)

Conclusion:
Markets can be efficient, benefits however sometimes disappear. Different institutional
arrangements are generated in order to deal with problems that arise in markets, such as
external effects or market power. Central role for entrepreneur in coordinating the
economic process. They are capable of discovering new market opportunities thanks to their
alertness.

See table 5.5 at page 199 for different types of auction (ook in sheets!)
Hoofdstuk 7 Cooperation between firms

1. Introduction
Strategic alliance: an agreement between firms to pool specific resources and effort to achieve
mutual gains.
Hybrids: neither markets, nor hierarchies. Hybrids are the governance structures of collaboration,
combining elements of both market and hierarchy. Definition H3: governance structures in which
cooperating firms preserve their autonomy in many respects (strategic decision making, daily
business activities) but allow some hierarchical intervention in affairs concerning cooperation (pooled
resources and efforts with respect to coordinating joint activities).
Trust plays an important role in the way that cooperation between firms is formally arranged.
For different approaches to hybrids  table 7.1 page 236.

2. Cooperation between firms in theory and practice

Different theoretical approaches to cooperation between firms
A prisoner’s dilemma easily explains the need for cooperation. In a prisoners dilemma the optimal
result cannot be achieved if there is no possibility of cooperation, and market transactions and
hierarchy are not feasible or efficient alternative. In this game the two players con cooperate or not,
assuming that each individual player is maximizing his own payoff without taking the other player’s
pay off into consideration. The result will be that no optimal cooperative result is reached. To reach
on optimal result, cooperation or some degree of monitoring of behavior and institutional incentive
mechanisms are necessary. See box 7.1 for an example of a prisoners dilemma!
In the prisoners dilemma in box 7.1 free riding will show up. This problem may encourage welfare
enhancing solutions such as contracts in markets, monitoring within firms or cooperation.
There are also forms of cooperation that enhance the cooperating firms welfare at the expense of
consumers. Cartel is the clearest example  competition is eliminated between firms through an
agreement to raise prices collectively. Consumers are worse off, but the profits of the cartel
members rise. Interesting feature with this is that although there is an agreement, it doesn’t mean
the firms will stick to it. The cartel isn’t self enforcing. See box 7.2 for further explanation of this.
A situation with the characteristics of a prisoner’s dilemma can only be avoided if effective
institutions have been developed to make agreements possible and enforceable. Effective sanctions
induce people to keep to agreements and as a result make them possible and profitable for trading
partners. Effective sanctions could be an independent authority (third party) or a tit-for-tat strategy.
These days we generally agree that cartels have a negative effect on consumer welfare. Therefore
there is a competition law that says that the principle of contractual freedom has been restricted to
cooperation that enhances (consumer) welfare and is no longer applicable to cooperation that
restricts competition without gaining welfare. There are three types of agreements to cooperate:
- Noncompetition restricting agreements: agreements that don’t have an effect on the
competition between firms
- Competition restricting agreements that increase total welfare: those are allowed
- Competition restricting agreements that decrease total welfare: those aren’t allowed.
In the rest of this chapter: cartel or collusion is used in the sense of welfare decreasing.
Real life examples of hybrids
Possible reasons for hybrids: 1. Firms want to share costs by pooling resources to gain access to new
markets. 2. Partnerships: common form of cooperation in professional service industries based on
proven professional knowledge. 3. Firms seek cooperation in order to obtain economies of scale 4. to
diversify risk 5. to develop new products 6. to acquire means of distribution or a new technology 7.
or to restrict completion.

Japanese supply networks (keiretsu)

Keiretsu: a cluster of independent, autonomous organizations that coordinate their transactions
without any one of them being the central player, they work together to further the groups interest.
There are two types:
- Horizontal business groups (bijv. Mitsubishi): autonomous industrial enterprises centered
around a major bank and a general trading company. There is cross shareholding,
interlocking directorates and regular meetings of the presidents of the member firms.
Relations between member enterprises: equailly, and they have the freedom to borrow from
other banks, or to use the trading services of firms from another keiretsu
- Vertical business groups: groups of enterprises of subcontractors and trading firms.
Relationship  unequal: the leading enterprise dominates the other enterprises.
Management of the firms is controlled by a ‘core’ firm, so that the parent enterprise can
create subsidiaries each with its own decision power.
For an example of a keiretsu: page 242.

Cooperatives
Cooperative: an association of autonomous individuals or firms who seek their common goals
through a jointly owned and democratically controlled enterprise. Here you should think of the
example of the dairy producer in the lecture.

Licensing and franchising

License: involves the transfer of a property right, for example the right to use a brand name,
trademark of a type of know-how. In exchange for the use of this right, the license-see pays a fee to
the licensor. A license contract involves things as, the brand name the license covers, the quality
standards, the period of the license, the geographical area in which the licensee is allowed to sell, the
minimum fees and how the relationship will be concluded when the license ends. Examples: Walt
Disney and the body shop. Licenses are a way to assign and protect property rights.
Franchise: the licensing of a business concept of a franchisor to a franchisee., for example the
acquisition of the right to use a well-known brand name or trademark, specified procedures and
marketing strategies. The difference between license and franchise is that the latter includes much
more rules (see the points on page 244). With a license the lincensee stays much more autonomous
than they would with a franchise contract.
The franchisor benefits because she saves on transaction costs when entering and exploiting
(foreign) markets  franchisee strengthen the brand through advertising, and has better access to
the local labor market. The franchisee benefits because he gets substantive assistance in replicating
the original business model and because the franchisor advertises the brand or trademark.
Islamic banking
One of the organization forms is that of a Special Purpose Entity: a limited partnership to fulfill a
Particular or temporary objective. The bank contributes financial assets and the firm contributes
productive assets. This construction may give a bank the right to share in the profits. This is because
under Islamic law lending and borrowing with interest is forbidden. The mechanism that replaces
interest is profit sharing: capital will be invested in those sectors that offer the highest profit-sharing
ratio to the lenders.

3. The static efficiency approach to hybrids

TC approach: independent partners may gain from cooperation if total transaction costs are lower
than in the case of noncooperation (market contract) or of complete merger (firm).

The TCE approach to hybrids

If investment is semi-specific to highly specific the hybrid is more effective than private GS. With
rising asset specificity hazards increase  it may become profitable to invest in a relationship
especially in the case of recurrent transactions, in order to enforce compliance.

Contract law regime

Hybrid  mode of cooperation with rules that establish monitoring and enforcement of the contract,
which is set out as clearly and as completely as possible. Parties preserve autonomy but are
dependent on each other to a significant degree. Contract regime that applies here  complex
contract law: This regime allows contracts to be mediated by arbitrage (flexible enforcement
mechanism) rather than by courts. It only applies when deviations from the contract are serious
enough. As long as disturbances don’t occur to frequently, it’s less costly than going to court because
the appointed arbitrator acts in a much more informal way, and is an expert in the field. When
disturbances become the costly and frequent you have to go to court and maybe chose another GS
like a merger.

Property rights
In case of hybrids actors may decide to pool only a proportion of their property rights while retaining
full autonomy over the remainder. They reap the benefits of the cooperation but avoid the
bureaucratic costs and maintaining market incentives. Apart from the cooperation part, they stay
autonomous in their actions. Depending on the degree to which the pooling af ssets creates mutual
dependencies, the signed agreements will be specifies to a greater or lesser extent (have more or
fewer built-in safeguards).

Reputation effects
The more specific a mutual investment, the higher the risk of opportunistic behavior and the higher
the need for safeguards. Brand names require the implementation of modes of control between
partners to secure the reputation of the brand. This reputation can be endangered if actors who are
involved in selling it behave opportunistically (like cutting costs and therefore not meeting quality
standards). Improvement in reputation weakens incentives for opportunistic behavior and will
therefore reduce the costs of contracting between firms  transaction cost function (page 246)
shifts to the right and the intersection between hybrid and hierarchy does so too.
Risk
The higher the level of risk in a market situation, the higher the need for cooperation and thus shift
to a hybrid. Risks that could make decide to go into a hybrid: if producing requires high investments
which are to large for one company, firms could decide to cooperate and thus spread the risk. Risk of
burglary: if there’s a high risk of burgling, firms that are working in the same area may decide to
jointly hire a security guard.
Of course there are also risks in cooperation:
- A clash of cultures: can occur of firms within the same country or when collaboration extends
beyond national boundaries (like language barriers and specific cultural situations)
- A lack of trust: Partners must trust each other’s commitment, otherwise they will constantly
run into disputes about another’s contribution to the cooperative effort. The less partner’s
trust each other, the more has to be stipulated in contracts
- Lack of coordination of middle management groups which may be expressed by managers
pursuing goals that are not congruent with the goals of the CEO’s.
- Performance risk: the danger that an alliance may fail despite the full commitment of the
partners. Includes external forces such as actions of competitors and demand/input risk.

Summary; information problems and opportunistic behavior

Hybrid: governance structure in which parties remain legally autonomous, despite being mutually
dependent for important decisions. The mutual dependency makes a hybrid sensitive to hazards that
stem from information asymmetries, measurement problems, weaknesses in the institutional
environment and changing conditions over time. Hazards can be prevented by carefully selecting
partners. Selection is mainly based on past experience and/or reputation.
It can also be prevented by including clauses in the contract that constrain opportunistic behavior
efficiently. But most of the time this is to costly and contracts referring to hybrids are standardidized.
It is difficult to arrange the protection and distribution of the gains of cooperation. Ex-post
opportunism is difficult to handle. Solutions: franchising, equity principle (share everything equally).

4. The static vested interest approach to hybrids

Sometimes cooperation between firms is not aimed at increasing overall economic welfare but
people might strive after their own interest at the expense of others. Two examples below:
The green lobby
To guarantee the supply of food and to stimulate productivity governments are involved in the
organization of agriculture. This growing involvement has been accompanied by lobbying by vested
interests to benefit the agricultural sector. The agricultural sector in many industrial countries has
significant power and therefore many benefits with regard to other sectors. These benefits could be
an own ministry, tax benefits, subsidies etc. which other sectors won’t get.
Cartels
Cartels, doesn’t matter in which form, also result in a higher price. In terms of institutional
economics, cartels are typically hybrids. Because they are forbidden by law, they have to be enforced
by the firms involved  requires not to many firms, a mutual monitoring and a disciplining device.
 5. The dynamic efficiency approach to hybrids
Dynamic approach  emphasizes corporate strategy as the reason for changing the
structure of governance and institutions. For example: firms are confronted with an external
shock and decide to develop a new governance structure because the existing one isn’t
working properly anymore. Governance structure can also change by building on trust.
When the one party trusts the other more, the less do contracts need to be specified in
detail  less contracting costs.

Trust
TCE approach  people may have a propensity to act opportunistically, this underlines the necessity
to take precautionary measures with rising asset specificity (control mechanisms: sanctions from
authorities, self-interest & reputation effects. These will limit opportunistic behavior).
Parties, ex-ante, almost never have all the relevant data  contracts are incomplete  monitoring
the other party to the contract is never perfect. More details in the contract will rise the costs and
therefore form serious barriers for cooperation. When transactions are repeated often, parties will
get to know the likeliness that the other party will behave opportunistic. If the other party is trusted
this will save contracting and monitoring costs and maybe cooperation can build on informal
agreements and trust instead of formal contracts. Conclusion: trust reduces transaction costs and
therefore it pays to invest in building trust.  trust is a substitute for contracts.
Trust: the belief that all aspects of a partnership that are not stipulated in a contract will be
successful.
Trust and contracts can be substitutes but also complements: contracts are not always used and
interpreted in a formal way. See table 7.3

Learning
Trust is adaptive  it may be strengthened or weakened according to the experience with a
partner’s commitment to the relationship. As the partnership progresses, the counterparty’s
commitment is increasingly taken for granted and similar loyalty expected in the future.
Reputation mechanism: one’s reputation reveals that other parties have the same experience with
the transaction partner in question. This may influence the choice of expanding or tightening existing
networks: when risk is high, firms will want to tighten their existing network rather than enter
relations with partners they don’t know.
When trust rises  transactions costs (contracting/monitoring) go down. This shifts the transaction
costs function in figure 7.1 downward  intersection between hybrid or hierarchy shifts to the right.
Asset specificity has to become higher before a firm decides to produce the product on its own.

6. The dynamic vested interest approach to hybrids

Dynamics of the vested interest of firms  focus on the strategies of firms to strengthen their
power. Firms may strengthen their power through cooperation with other firms.
Market power theory
Tit-for-tat strategy: a self-enforcing equilibrium: because parties can punish each other in the case of
repeated interactions, complying with cooperation becomes a serious option.
Implicit cartel/implicit collusion: if a cartel is self-enforcing in the sense of the repetitively played
prisoner’s dilemma game. Read box 7.6 to learn how implicit collusion comes about!
Market power is determined by five fundamental forces:

Threat of entry
There are a lot of entry barriers like: economies of scale, product differentiation, capital
requirements, switching costs, access to distribution channels, cost disadvantages independent of
scale and government policy.
Through cooperation firms may secure distribution channels and exclude new entrants form the
market, through cooperation firms also may achieve economies of scale.

Threat of substitute products

For most products substitutes exist, these products compete with each other not only in price but
also in quality. For some consumers price is more important when buying a product (like choosing
mp3 instead of cd’s) and for some consumers quality is more important (like buying an lcd tv instead
of a tube television). The existence of substitutes limits the power of firms to raise prices

Bargaining power of buyers

Buyers compete with suppliers by forcing down prices or by negotiating higher quality or more
services. By doing this they may play firms off against one another.
- Buyer power is high if: they are strongly organized (cooperating), it is a concentrated market
(few large buyers in terms of market share), the buyer purchases large volumes, the buyer
has alternatives in the form of substitute products and the buyer has the credible threat of
integrating with supplying firms
- Buyer power is low if: the produces has a credible threat of integrating with buyers, buyers
are small, and buyers are locked-in (high assets specificity), hence have high switching costs
-
Bargaining power of suppliers of intermediate products
Suppliers of products and production factors may decide to raise prices or reduce quality. This is
when: the industry is dominated by only a few firms while buyers are dispersed, the product is an
essential input to the buyer’s industry or the supplier doesn’t has to fear substitutes.
Labor may also exercise power: the greater the percentage of works organized in labor unions, or the
greater the scarcity of their skills, the stronger the probability that workers will gain higher wages.

Rivalry among existing firms

Firms also heave to negotiate with other firms in the same industry. This competition is the dynamic
driver of economic development. Cooperation between firms may restrict competition and enhance
the power of the cooperating firms, like the OPEC which will be discussed next.
The OPEC and the development of substitute products
OPEC is a standard example of a cartel that decides on price and each partner’s contribution to
output. They meet regularly, and in 1973, 1977 and 2008 they decided to cut the oil production
dramatically in order to stop the fall in oil prices. But even the OPEC faces limits in price setting:
- If OPEC restricts production enough, higher prices may make it profitable for oil producers to
exploit small or difficult oil wells
- OPEC can never be sure every member sticks to the agreement to cut production
- Not all fossil-energy producing countries are a member of the OPEC
- Not all buyers on the oil market are able to pay any price demanded  diminishing demand
for oil
- High oil prices provide incentives for the development of energy-saving products
- High oil prices provide an incentive to search for alternative sources of energy.
In short: the vested interest of the OPEC countries is not sure.

Concluding remarks
Hybrid is a governance structure between market and firms.
Static approach  the hybrid is choosen for reasons of efficiency
Dynamic approach  cooperation may be explained through the strategic choices of firms that strive
for long-term profits.

Hoofdstuk 8

– introduction
Role of government: 1) Efficiency =(holistic) government seeking to improve overall welfare
2) Dynamic = (pluralistic) government swayed by interest groups
# Protective functions of the government:
1. Clearly defined property rights
2. Reliable law system
3. Central bank to control money supply
4. Police force to maintain public order
5. Army to defend the country

 Public interests:
1) Efficiency = welfare of total pop that can't be achieved by private initiatives alone
2) Dynamic = public interest defined by actors that are in control

 Social welfare: distribution of wealth can be improved (this is subjective)

 2 categories of public ordering

1) Regulation = state intervention in free play of market to change behaviour
2) State owned enterprise = provides certain products (ownership rights with government)
 'Regulatory state': sets general rules to influence economic process

 'Developmental state': influences economic activities by giving many more directives to

private actors.

State intervention is often linked to restrictive government. However, it enables opportunities and
fair competition.

• Types of intervention
1) Rules/directives for quality = liability system
2) Rules/directives for price = maximum price / minimum wage
3) Taxation = 'accijns' and income tax (state funding) (regulation)
4) Subsidies = Social security + supporting (positive) behaviour
5) Monitoring = health inspection / competition authority
6) Legal monopolies = gas / water / electricity
--------------------------------------------------------------------------------------
7) Public provision = oil / health care / broadcasting (radio/TV) (state-owned enterprise)
8) Public monopolies = prisons / central banks

CHAPTER 8

• Market imperfections:
1) Imperfect information = quality not observable from price -> leads to less trading
2) Market power = natural monopolies / cartels lead to reduced competition and can lead to
higher prices
3) Externalities = affects welfare and public interest
4) Pure public goods = non excludable / non rival -> leads to no private market

• Static efficiency: actors look for optimal coordination mechanisms => trading property rights
at the lowest possible transaction costs

1. Imperfect information
Knowledge is unevenly distributed, leading to opportunistic behaviour. Relation price and quality is
not always visible and there are situations where information is imperfect for all actors.

- To protect themselves against 'lemons', safeguards are used by actors and consumer associations
inform about products
- Furthermore, due to competition, producers may be motivated to disclose the information
themselves

However, there are high transaction costs involved, which may cause this to falter
- Uncertainty leads to less transactions and some transactions disappear completely.

• Generic state intervention: if actors are more secure there is more trading
- Regulatory: producers must provide information about products or themselves
- Inspection: (public law) leads to lower chance for opportunistic behaviour.

• Sector specific intervention:

- Credence goods = you have to trust that the service offered is of good quality
- Experience goods = you discover the quality after buying the product
Principal-agent problem = (for example) Attorney is vital to defend your interests in court.
Therefore he is subject to strict legal requirements. Inspection can be done by both privates
and the state.
 Private inspection: benefits / disadvantages
+ specific knowledge to monitor specifically
+ can act swiftly to changing circumstances
+ monitoring costs borne by profession itself
- due to knowledge, may block entrance for newcomers
- 'supplier invoked demand' by making people believe they need extra assurance

Government sets minimum standards and oversees the quality by issuing licences.
Sector-level intervention done to protect individuals, i.e. pharmaceutical industry because
population health influences economic growth.

• Intervention in financial sector

- To create transparency and financial security
- During crisis, state may interfere with management to protect entire economy

2. Market power
1. Monopolistic competition = some price control but mostly competition done with differentiation
and quality to gain more market power
- Interference would lead to higher social cost and incentive for entrepreneurship undermined

2. Monopoly = also competition based, does that mean you should punish?
- Is not bad in itself, although abuse of power is
- Monopoly as reward for being risky, innovative and competing fairly
- Patents protect from free-riders
- Monopoly price important for others to enter markets, which means monopolies might create
competition themselves
- Interfering would create welfare losses

• Fixed costs (fixed costs arguments)

- High fixed costs => expansion of production decreases average costs (MC smaller than AC)
- If you have no market power, P=MC and AC>MC, therefore AC>P and it means that when
you produce you make a loss.
- No intervention needed though, as it's part of competition even if it involves deadweight
losses (except if the competition process itself is endangered)

• Competition policy = most countries have a cartel policy (only if agreements hamper
competition). Additionally, most countries screen merging companies.

• Competition authority
- Most firms usually just react to each other, there is not always an agreement.
- 3 situations in which the government can interfere:
1) when market power is being abused by an existing dominant firm
2) to prevent future of abuse of position in a merge
3) market power exerted as result of a cartel
Authority can: - Investigate digital material or do house searches
- Fine and imprison

3. Natural monopolies (= most technologically efficient, doesn't have to the only firm)
- Has decreasing AC when production increases.

• Deadweight loss explained: 2 Firms. Both have fixed costs of 500 and an output of 50
each (100 total). Both firms have average costs of 10 (500/50). However, if there only
 had been 1 farm it would have had average costs of 5 (500/100). The difference between
these situations is called deadweight loss.

A newcomer to the market with the same fixed costs will have higher average costs. This
could be seen as an entry barrier.

• Regulation of natural monopolies

- Through regulation, the price must be set at an efficient level (where P=MC) but
due to decreasing AC, this price incurs losses. Government can compensate this loss
through subsidies.

• Creation of competition for the market

- Government decides which supplier can join the market (usually through state
organized auctions)
- Government wants lowest price for consumers, therefore the most efficient (lowest
MC) firm will be granted access.

3. Externalities
- In many cases, people responsible cannot be called to order:
1) Offenders are large in number and located worldwide
2) People are not aware of actions or do it unintentionally
3) They are aware but continue because they have the power to do so
4) Offenders are usually powerful while third-parties and victims are not well-organized

• Government combats this by introducing awareness programs financial incentives or

product-bans.

• Determined polluters (powerful actors) can only be combated if public authority is

independent from provoking party (and doesn't accept bribes)
- If so, corrective taxes and regulatory limits
- If this fails, fines and bans

• Positive externalities (examples

1) Vaccines (cost is lower than if patient had to be treated + lower contagion risk)
2) Education (higher education -> higher productivity -> higher income -> economic growth

4. Public goods
- If consumers are not willing to pay the price, producers are not willing to produce
Therefore, the state has to provide these products
- Some people may spread information for free (environmentalists), in this case they provide a public
good.

• TCE approach to public ordering

- Perfect competition -> max economic welfare, information and competition, therefore
transaction costs are 0 (market are never perfect though)

• When transaction costs become to high for individual solutions, intervention is needed.
Overview of progressive government intervention:
1) Indicative rules with respect to information enclosure, which is the mildest form and
specifies how much information needs to be available
2) Monetary incentives = taxes/subsidies to steer behaviour
3) Constraining rules = limit options actor, permits for quality control, which are only
obtainable after expertise is demonstrates (quota's against pollution as example)
4) Strict requirements = state decides output numbers and price, which lowers firms
 autonomy
5) Complete control = state-owned enterprises, state is in control of production

Dynamic Approach to State Intervention

• Planning in a market economy
- Macro level: GDP growth, inflation, employment
- Meso level: growth of investment in specific sectors, impact on the level of imports,
implication for the quality of labour.

• Problems in centrally planned economy

1) Principal-agent problem of asymmetric information: central planner does not know what
the efficient production method is and how much input is needed. Managers of firms can
therefore give distorted information in order to receive a bonus.
2) No innovation incentive
3) Property rights theory indicates less efficiency

• Coordination problems
- Market uncertainty: what will market do in future circumstances
- information usually available in the system
- however, in environment case -> uncertainty about developments

Economics state that price mechanism gives right info at the right time
- the question is: How necessary information and knowledge are acquired and communicated?
Two issues:
- Actors need to have similar expectations about exogenous variables (consumer preferences,
technologies and political institutions)
- Actors need to make their own individual plans for each of the possible states in the future

• Theoretical general equilibrium model

- Markets also exist for all products consumed in the future
- In reality, not enough futures markets and insufficient information supplied through
price (indicative planning fills these gaps)

• Sources of information:
1) Price indicates changes in scarcities and causes changes in behaviour. Futures markets
reduce uncertainty because they can conclude contracts about future prices and
deliveries
2) Own capability to produce information, like market research. These cost money,
therefore decisions sometimes made on basis of little information. To fill this information
gap, there are consulting firms, trade organizations and consumer organizations, these
have access to a large database and efficient labour to find information.
3) Free of charge information by building up trustworthy relationships.

• Information paradox of Arrow: Customer wants information and knows which price he
wants to offer, but only after info has been revealed.
- Supplier of information must be careful because the customer might show
opportunistic behaviour.
- Customer might resell the information, which means the supplier must safeguard,
generating extra costs
- Information can also be revealed through behaviour as externality. By monitoring, other
competitors can pick up this information.
• Embeddedness of indicative planning:
- type of indicate planning dependent on (in)formal institutions.
- In the case of a more interventionist plan, public agencies should be well supplied with
information. Actors and government should align strategies.

• Industrial and technology policies.

- Distinction between cyclical and structural development.
1) Cyclical = Aggregate demand, firms, government and exports. Government can
stimulate if AS and AD are not in harmony (since that creates inflation and
unemployment)
2) Structural = economy divided into sectors
- concern the composition of economic activities
- change in composition due to (dis)investments

Different types of government structural policies

• Technology policy: introduction phase (first step in life cycle product)

- inventions are translated into innovations
- Problems: financing R&D / insufficient knowledge
- Government has to intervene and support firms by means of a technology policy

• Financing innovations:
1) Issue shares on the stock market
2) Issue bonds (obligaties, vergelijkbaar met shares, maar bonds hebben vaste rente,
dus niet winstafh)
3) to borrow from a bank
4) to draw on internal reserves (from profit made in past)

R&D investments are usually risky, banks and private actors therefore hesitant
- Principal-agent problem of asymmetric info and different objectives, causing risk of
opportunistic behaviour

• Capital transactions
- If costs are too high then investment would be too large for a single firm to
bear the burden. Solution lies with hybrids -> consortia and strategic alliances
(ch.7)
- if market can't raise capital, government intervenes and sets up concrete
objectives and can give subsidies

• Lack of sufficient complementary knowledge

- to innovate, different domains of knowledge are needed. Often two domains
have to be connected, which is often costly and not readily available
- Government provides domains and provides framework for large technology
programs.

• The expansion, maturity and stagnation phases - industry policy (happens after
introduction)

In this stage, firms invest according to future ideas (no government needed)
Market then continues to expand -> investments in larger production units
(economies of scale)
However, when there is no central coordinator supervising individuals investment
plans, firms do not know what aggregate demand and supply will be. This often leads
to overcapacity and stagnation.
- Often aggressive price competition ending in price wars
- Capacity reduction inevitable and concentration occurs
- Government can take responsibility of an 'orderly retreat' with an industry policy.

Solution: reduce overcapacity so profits are made again and can be invested in new
directions, the most efficient firms are then able to survive.

Governments may also allow 'crisis cartels' to better develop during crisis. There
needs to be constant monitoring, though.

• Institutional competitiveness
- States compete by setting attractive rules such as different tax rates or
residence permits on a national but also regional level.
Chapter 9 Government Failures
Introduction
Public interference has costs, so that on balance an intervention might not improve welfare. When
this is the case, government failure occurs. Public interference leads to both enforcement costs and
monitoring costs, these costs are financed out of taxes and this leads to administration costs.

Static approach
There is a division between problems and costs in situations of perfect information, and in situations
of imperfect information. When the government is aware of the harmful effects it can attempt to
introduce additional measures to combat these negative consequences. When it is unclear or
unnoticed that state interference is producing unwanted effects, it may become more difficult to
prevent welfare loss.
The best any government can do is to weigh the costs and benefits of its interference and make
decisions that create the highest possible overall welfare (efficiency approach) or serve the welfare
of specific groups in society in particular(vested interest approach). In both cases some groups can be
worse off after the governments intervention.

The arrow paradox

This theorem is about the question if it is possible to have a social preference function that
represents individuals‘ preference functions. The answer is in general, negative.
Explanation:
Ranking Individual 1 Individual 2 Individual 3
1st A B C
nd
2 B C A
3rd C A B
There are 4 assumptions:
Society is made up of at least three individuals and choices consist of at least 3 alternatives.
When A is preferred socially to B and B is preferred socially to C, then A must be preferred socially to
C.
Any pairwise choice between alternatives is independent of any other alternative. So if A is
compared to B it does not matter what the preferences are with respect to C.
Social preference should not be defined by any specific individual’s preference.
This shows that transitive individual preferences can coincide with intransitive social preferences.

Cost-benefit analysis and compensation

Pareto versus hicks-kaldor
A social cost-benefit analysis should be able to show that on balance a choice is optimal if this choice
generates the highest overall profits. Subsequently, ‘losers’ could be compensated by ‘winners’ in
such a way that in the end nobody is worse off. This criterion is also called the Hicks-kaldor criterion.

Property rights problems

Privately owned goods usually lead to optimizing behavior. In the public sector, lack of competition
leads easily to efficiency losses, because managers cannot be punished. State owned enterprises
often lack the urge to minimize costs.
The absence of the right incentives in state-owned enterprises leads to efficiency losses, which
ultimately implies that citizens will have to pay more tax to cover these expenses.
Public versus private provision
Pure public provision of goods is when the government produces and finances a product, such as
national defense.
They could also finance a private firm with public money. Another possibility is private parties who
finance a public good, in this case the government takes the decisions, but the private firm finances
and produces the product.

Ways to motivate government officials

Accountability
Countries worldwide have set up independent public agencies tasked with monitoring and evaluating
the effectiveness and efficiency of all public sector departments and agencies.
Renumeration
Building in positive incentives such as a pay increases or variable pay instead of a fixed salary.

Not only does state provision of public goods easily encounter efficiency losses resulting from
insufficient incentives on the part of civil servants; citizens’ behavior will also generally lead to
efficiency losses. When a product or service is free or has a fixes price, irrespective of how much is
consumed, demand increases; possibly enormously.
Solutions:
The state could set up an excess risk system in which the user is obliged to pay a stipulated sum of
money for the first claim made.
A certain amount can be used free of charge, additional consumption has to be paid for.

Government failures in situations of imperfect information

It is practically impossible, or extremely costly, to inquire about the preferences of all individuals
citizens. Because of imperfect information the government’s policy measures cannot benefit all. They
can also lean towards specific vested interests, in which case information asymmetry can be
exploited.
Even if representatives from both the executive power and the legislative power aim to enlarge the
welfare of the public, they may still fail to do so because of unintended side effects. Also, several
actors in the public sector may abuse their information which leads to a disadvantage for the general
public: the bureaucracy that is supposed to implement governmental policies may not always do so
entirely according to the wishes of the politicians who made these decisions, and politicians
themselves who may not act according to the wishes of their electorate to protect their own vested
interests.
Unintended side effects
Unintended side effects can partly be prevented by making use of specialized agencies that try to
assess the economic effects of any policy implementation.
Several unintended side effects of
- Tenders
Governments often tender large projects. The government ‘sells’ the project to the company
with the highest bid. State-organized tenders or auctions are not always efficient as they may
lead to cartelization.
- Licensing
When the government is not completely informed about changed market conditions, the
number of permits are maintained at a level that is either too high or too low. Another
shortcoming is that the assignment of licences is usually quite restrictive, which blocks high
quality suppliers who are not able to signal their quality with appropriate qualifications.
 - Taxation and subsidies
Citizens could make improper use of taxes and subsidies. Opportunistic individuals try to
collect as much money from the government as possible and pay as less as possible. Also
firms may decide to transfer their business to a jurisdiction with less taxation.
- False positives and false negatives
A false positive is a situation in which somebody or something has been found guilty of
something that he did not do. A false negative is a situation in which somebody or something
has been found innocent of something he did do.

Agency problems
Principal-agent relationships only form a problem in a situation of asymmetric information.

The principal-agent problem between politicians and the bureaucracy.

Civil servants are supposed to carry out the decisions made by politicians. From the efficiency
perspective policy makers are expected to strive after the improvement of the public interest. From
the vested interest approach, they might put their own personal interest first. This usually relates to
vote-maximization, this need not coincide with public interest. Civil servant strive after budget
maximization, this corresponds with the bureaucracy theory. Public officials will receive a higher
budget than is strictly necessary and thus cause an efficiency.
The huge diversity of manifestations of public agencies makes clear that the bureaucracy theory of
Niskanen is too simplistic.

The principal-agent problems between voters and politicians

The decisions or politicians are likely not to be implemented precisely, so they could be seen as the a
victim. On the other hand, in a democration the voter should be ultimate principal, so they are also
seen as agent, and then the question is if they will do as they have promised during election time.
Opportunistic behavior by politicians can occur both before (ex ante) and after (ex post) elections.
They must make a good impression right before elections and right after election they can easily raise
taxes for example, even though they promised not to.
Fiscal illusion: politicians carry out solutions that seem to be beneficial but in fact reduce social
welfare. By the time the consequences appear, the politicians responsible are probably no longer in
government.

The process of liberalization, privatization and regulation.

Privatization of a vertically integrated natural monopoly implies that it becomes privately owned but
otherwise remains the same. This gives a higher power incentives with respect to cost efficiencies. In
order to avoid monopoly pricing, privatization implies regulation. Most often access to the network is
aloud, to stimulate competition.

Other legal monopolies exist that are characterized biy the fact that their activities can be offered
competitively by others through rival networks. In this case a similar process of privatization and
liberalization as above can be followed, but here it is also important to stimulate competition at
network level.

The transition from a state-owned to private natural monopoly.

The general tasks of a regulator is to guarantee access to the network on reasonable terms in order
to induce competition at the level of the provision of the product to consumers, and also to stimulate
competition at the lever of the network. Competition for the product delivered to consumers using
the network implies that the terms and conditions of access to the network must be regulated and
include a (nondiscriminatory) access tariff. (goed idee om pg. 360+361 even door te lezen, ik snap
het niet helemaal)
Rent-seeking in public agencies: commitment and regulatory capture
The dilemma is how to keep prices as low as possible, while at the same time guaranteeing sufficient
incentives for investment and innovation. The challenge of regulators is to align long-run and short-
run interests, the short-run interest being that prices will be low enough to have consumer benefits.
This will both lead to a ‘commitment’ problem and to regulatory capture.
The commitment problem is a consequence of the possibility that short-term interests may be
overemphasized by the regulator and/or by politicians and /or consumers or other pressure groups.
Consequently, prices may be forced to be so low as not to guarantee the future quality of the
product, because all incentives to innovate or invest are being removed. To enable the regulator to
commit itself also to safeguard the long-run interests, measures need to be taken. One can think of
making the regulator independent from politics or one can think of legislation that precisely defines
the objectives and tasks of the regulator.
Another problem is regulatory capture: the regulator becomes too involved with the regulated firm,
and this dependence might imply that the regulator becomes a plaything of the firm. The regulator
might then neglect its official duties: the firm’s interest will be served at the expenses of the public.
The data that the regulator needs might easily be manipulated by the firm to its own benefit. Also
the regulator might be persuaded to overemphasize the long-run interest, which leads to higher
prices now. Consequently the regulator might further the interests of the regulated firm, rather than
the public interest. Regulatory capture and the commitment problem are related and may be solved
by the same kinds of institutional arrangements.