Transcript INSTITUTIONAL ECONOMICS AND ECONOMICS OF THE …

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
is divided into two inter-related parts

the first part, Institutional Economics, explains
and illustrates the economic importance of
„institutions“ including legislation

Substantial part of Institutional Economics is
referred to as Economics and Law/Economic
Analysis of Law

the second part, Economics of the Public
Sector, sometimes called Economic Theory of
Public Choice, focuses on the main economic
principles of the public sector and political
decision making
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
the exam is a written one
each student is asked to choose a (preferably
recent and/or controversial) topic studied by
„Institutional Economics“ or „Economics of the
Public Sector“ and analyze it in a short paper

The essay/paper should be at least 6 normal pages
(and preferably not more than 8 pages) in length

Topics of paper are subject to approval, but can be
chosen freely or selected from a list of topics which
will be provided
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Papers should be submitted by e-mail till mid June
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Institutional economics is a relatively new
interdisciplinary field that includes and puts
together aspects of economics, law, sociology and
history.

It is not just „hard“ factors (labor, capital,
technology, natural resources etc.) but also
„soft“ factors or „institutions“ that matter for
economic performance and wealth of nations
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Economic activities or transactions
(i.e. work, consumption, (re)distribution, trading,
saving, investments, education etc.) are embedded
in an institutional environment

Institutional environment is formed
by economically important rules of social
conduct
 can be formal (legal), and thus
formally reinforced,

and informal (social), informally
reinforced, including habits and
traditions, often based on social beliefs.

Institutions, both formal and informal, can either
promote (facilitate, provide incentives to) certain
socially important economic activities
and transactions
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or they can rather hamper (impose constraints to)
certain important economic activities
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In economic terms, an important characteristic
of institutions is they can influence the costs
of economic activities and transactions
(„transaction costs“) for/between individuals,
firms etc.
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Transaction costs belong to „dead-weight costs“,
i.e. they mean loss of welfare
If essentially stable and applicable in repeated situations, institutions
can
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make human behavior more predictable,
create mutual trust (social capital),
provide guarantee to transacting parties (usually
mainly important for the weaker party to a
transaction)
and thus lower the need for costly precautions, which
otherwise might be necessary.

A related economic perspective of evaluting
institutions is their „efficiency“
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Institutions may be „efficient“ or „imperfect“
(inefficient) in the sense that nation or community
may be better off in case of their presence than in
case of their absence, or vice versa
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„Efficient institutions“ promote economic
activities and/or transactions that make the
community better off.
Examples include work, investment, education,
trading, labour and capital flexibility, etc. on the
one hand, and fraud, weak property rights and
expropriation, rent seeking, etc. on the other
hand.
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The contribution of the society's entrepreneurial
activities varies because of their allocation
between productive activities, such as innovation,
and largely unproductive or even destructive
activities, such as rent seeking or organized crime.
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This allocation is heavily influenced by
institutional framework: the relative payoffs
society offers to such activities.

Members of a primitive society living in an area
with scarce water resources may either believe
that water can be gained by giving donations to
gods of rain or by buildings wells, irrigations
etc.
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Similarly, members of a modern society suffering
from high unemployment may either believe that
additional jobs can be created by administrative
regulation (e.g. ban of transfers of companies to
low wage countries) or by increasing labor
productivity and/or decreasing labor costs
 General, universally valid, or specific, governing
certain relationships, e.g. specific bilateral contracts
 Deliberately created or spontaneously emerging
 Public, enforced by the government, or private,
sanctioned by private organizations (e.g. expulsion)
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If
institutions
matter
for
economic
performance, why do societies sometimes
choose or end up with „inefficient
institutions“ that do not promote economic
growth or overall economic welfare?

Inefficient institutions will emerge and persist,
when social groups that prefer the inefficient
(non-growth enhancing) rules, are sufficiently
powerful
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E.g. the „elite“ may pursue inefficient policies
to extract revenue from other groups
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Revenue extraction: the group in power - the elite will set high taxes on producers in order to extract
revenue.
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Because of limited resources of producers, these taxes
impede economic growth.
 Income
manipulation: powerful group can, for
example, impose market entry barriers or suppress
competition in certain markets to increase its
incomes.
 Market
barriers limit competition and hamper
economic and/or technological progress

Blocking technological change: in order to
increase the probability of staying in power the
elite can block technological development/use. The
reason is that technological change may erode its
advantage.
 Blocking
technological change limits growth
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People often do not understand how the pursuit of
private profits can yield public benefits: they can have
an anti-market bias.
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People often tend to underestimate the benefits of
interactions with foreigners: they have an anti-foreign
bias.
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People often tend to equate prosperity with
employment rather than production
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explain and evaluate impact of institutions
(institutional environment) on economic
performance, efficiency and distribution
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evaluate social, historical etc. determinants of
institutions and study evolution of institutions
over time
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to describe how specific economic behavior is
influenced by institutions

show how (why) specific economies develop
institutions
that
produce
growth
and
development, while other develop institutions
leading to high costs, economic problems and
stagnation
Government can—and does—contribute to the
economic efficiency of markets by providing
infrastructure that permits markets to function

 There is a strong relation between infrastructure
quality and economic performance
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 physical infrastructure—bridges, airports,
waterways, and buildings
 institutional infrastructure—laws, courts,
and regulations, stepping in when markets are
not working properly
30

The backbone of a market economy’s institutional
infrastructure is the legal system

Important part of the institutional infrastructure that
supports market economy is regulation
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◦ While criminal law has important moral and ethical
dimensions, its central economic function is to limit
exchanges to voluntary ones
◦ By making most involuntary exchanges illegal,
criminal law helps to channel energies into exchanges
and productive activities that benefit all parties
involved
◦ In this way, criminal law contributes to economic
efficiency
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
Property law gives people precisely defined, enforceable
rights over things they own

When property rights are poorly defined
◦ Much time and energy are wasted in disputes about
ownership
◦ People spend time trying to capture resources from
others (time that could have been spent producing
valuable goods and services)
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A contract is a mutual promise
◦ Often one party does something first and the other
party promises to do something later
◦ Contract law enables to make exchanges that take
place over time and in which one person must act
first
34

Contract law plays a special role in a market
economy
◦ Without it, only transactions involving
simultaneous exchange could take place
◦ In this way, contracts help society enjoy the full
benefits of specialization and exchange
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In countries in which contract law is less well
defined or less strictly enforced, both traders
and investors would worry that they would not
be able to collect their revenue

Because of contract law, people are more willing
to take a chance with a new business
36

A tort is a wrongful act — such as manufacturing
an unsafe product — that causes harm to
someone, and for which the injured person can
seek remedy in court
37
Tort law defines types of harm for which
someone can seek legal remedy and what sorts
of compensation the injured person can expect
When people and business are held responsible
for injuries they cause, they act more carefully

Also
protects against fraud in which a seller of
something—a product, a business, shares of
stock—lies to the buyer in order to make the sale
38
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Designed to prevent business from making
agreements or engaging in other behavior that
limits competition and harms consumers
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Operates in three areas
 Agreements among competitors —prohibits
“contracts, combinations, or conspiracies” among
competing firms that would harm consumers by
raising prices
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Operates in three areas
 Monopolization - it is illegal to monopolize or
attempt to monopolize a market
 Mergers. In a merger, two firms combine to form
one new firm. The result is to increase the danger
of higher prices from oligopoly or monopoly
41

Important part of the institutional infrastructure
that supports a market economy

In addition to protecting public safety and health
regulation is also used to help markets function
more efficiently

Regulation differs from use of legal procedures
in a fundamental way

Under regulation,a government agency has
power to direct business to take specific actions

While legal procedures typically result in fines or
other penalties if businesses do something
wrong, regulators reach deep into the operations
of business to tell them what to do
 Ownership of the regulated firm remains
private.
 Pricing and production decisions controlled
by a government regulatory agency
 Justification for Government Regulation - the
use of private property can be regulated to
serve the public interest
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An efficient regulatory infrastructure must
consider and balance benefits - safer products,
reduced crime - against the costs of achieving
legal and regulatory goals

A legal and regulatory system that ensuring
complete elimination of crime, unsafe products,
and other unwelcome activities would be less
efficient than a system that tolerated some
amount of these activities
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By the 1960s government regulation of prices
and entry was commonplace in the
- transportation (railroads, trucking, airlines),
- communications (telephone services, radio,
television),
- “natural monopoly” utility (electricity, natural
gas) industries

Increased significantly starting late 1960s and
continuing in the 1970s with the emergence of
environmental and consumer movements

Scale & scope of regulatory activity expanded

Governments imposed new controls on
environmental pollution, the safety of the workplace
& consumer products

Cycles of regulation:
◦ periods of heavy regulation
◦ followed by periods of deregulation

Economic and political influences
The last decades of the 20th century saw a wave
of attempts to remove, reduce, or simplify restrictions
on business and individuals with the intent of
encouraging the efficient operation of markets.


The stated rationale for deregulation. i.e. greater
reliance on market forces, was often that fewer and
simpler regulations will lead to a raised level of
competitiveness, therefore higher productivity, more
efficiency and lower prices overall.

Removal of many price and entry restrictions in
regulated industries (Telecommunications,
Electrical Utilities, Banking/Financial Services
etc.)
 For example, deregulation of the air industry in
Europe in 1992 gave carriers from one EU country
the right to operate scheduled services between
other EU states.
addition, there have been regulatory
innovations, usually suggested by economists,
such as emissions trading

In
 While
economic regulation declined, social
regulations (e.g., environmental, product and
workplace safety,, equal employment opportunity,
increased min. wage) remained
 Interest
groups and general public support
remained high for social regulation

What is the rationale for economic regulation ?

Whose interests are represented in regulation?
Sometimes regulatory bodies protect the
interests of companies they are supposed to
regulate.
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◦ What is the desired outcome of regulation
(behavior of regulated subjects)?
◦ Can we design a regulatory mechanism that
induces the regulated firm to act in a way that
results in the optimal outcome?
◦ Can we balance the benefits of regulation with its
costs (compliance costs) and risks, e.g. regulator’s
capture?
◦ Intervention
in the market is often required (in
situations of „market failure“)
- to ensure that the pursuit of profit does not
conflict with social welfare
- to ensure socially desirable outcomes when
competition cannot be relied upon to achieve
them.

(Natural) monopoly is the classic case.
 Monopolies and natural monopolies,
anti-competitive behaviour and predatory
pricing
 Externalities
 Information inadequacies and
asymmetry
 Unequal bargaining power
 Moral hazard
 Continuity and availability of service
 Scarcity and rationing
 Distributional justice and social policy
Industry/areas of specific regulations cover
mainly:
 Air Transportation
 Electricity
 Gas
 Telecommunications
 Environment
 Financial and capital markets

Consumer protection

Health care

Employer-Employee relationships

Energy use
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Parliament
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Government institutions (ministries)
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Independent regulatory bodies (central
banks, specialized agencies)

European Commission
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Courts

Self-regulatory (private) bodies

If regulation is implemented through
independent commissions and agencies,
regulatory statutes and practices can be
appealed to the courts to test their
constitutionality and to ensure that agencies
satisfy due process in their decision making
- direct intervention (bans, requirements,
e.g. price regulation, rate of return regulation)
- or indirect intervention (taxes, subsidies)


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A market with just one seller, or a few
oligopolists who cooperate and behave as a
monopoly, is a serious market failure justifying
government intervention
A firm has monopoly power when it can
influence the price that it charges for its
product
Monopolies (imperfectly competitive markets)
are economically inefficient: price is too high,
output is too low
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
Government responds to the problem
of monopoly in one of three ways
◦ Making monopolized industries more
competitive.
◦ Regulating the behaviour of
monopolies.
◦ Turning some private monopolies
into public enterprises.
 Legislation
designed to encourage
competition and discourage/ban the use of
monopoly practices
 can
curb the inefficiencies resulting from
market power in general and monopoly in
particular



To promote economic efficiency, anti-trust law
attempts to ensure entry and competition in
industries with barriers to entry and anticompetitive practices
Anti-trust policies (as with all govt regulations)
change over time and are strongly influenced by
economics and politics
Broad language of anti-trust law leaves
considerable room for interpretation for
courts/judges
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(1)
-
-
Horizontal Restraint of Trade
a division of market, which reduces
competition and creates monopoly
a single company dominates a market
and/or industry
(2) Vertical Restraint of Trade
examples:
-
-
resale price control (manufacturer tries to
control the retail price)
a single firm controls the „supply chain“
(3) Predatory Pricing
-
-
firms price their products below cost until
other firms get driven out of business and
then they price as a monopolist
most relevant in industries with high barriers
to entry (e.g., airlines)
-
what is the relevant market?
elevant market defines the market in which
one or more goods compete. i.e. it defines
whether two or more products can be
considered „substitute goods“
-
what is the market share of competitors?
- are there barriers to market entry (capital
costs, distribution chains, software
platforms)?
-
-
-
-
is there international competition?
what is the cost structure of industry (is it
subject to increasing returns to scale?)
are there incentives to innovate ?
what is the effect of tech change
on relevant market?
Breaking up a monopoly would not make
sense when the market would perform even
worse with more competition
Monopolies that arise from patents and
copyrights, provide an incentive for artistic
creations and scientific discovery

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
A natural monopoly exists when, due to
economies of scale, one firm can produce
for the entire market at a lower cost per
unit than can two or more firms
◦ If government steps aside, such a market will
naturally evolve toward monopoly
76
Natural monopoly arises from networks
which offer benefits that would be hard to
achieve under more competitive conditions

When a monopoly arises as a natural
monopoly, using anti-trust law to break it up
or even to prevent its formation is a poor
remedy

◦ One option is public ownership and
operation
Public takeover of private business is rare
◦ The other option is regulation
78


Under regulation, a government agency
takes some of the firm’s decisions under its
own control
In the case of a natural monopoly,
regulators are interested in achieving
economic efficiency, which they do by
telling the firm what price it can charge
79


Natural monopoly regulators do not have an
easy job
There is the matter of information:
regulators often depend on information
obtained from monopolies
80
Regulators determine a price that gives
owners a “fair rate of return” for funds they’ve
put into the monopoly
This price should give monopoly what
economists call normal profit, i.e. profit just
high enough to cover all of the owners’ costs,
including the foregone interest of their own
funds


Since the government is guaranteeing
a specific rate of return, the firm is not
motivated to economize on costs.
Regulated firms thus have little incentive
to hold down costs.
 There is a tendency of regulated natural
monopolies to overinvest in capital
82
 Regulatory
boards are often made up of
individuals from the industry being regulated.
 Industries
that could very well compete desire
to be declared natural monopolies.
In practice, there are two views of
competition:
judgment by performance and judgment
by structure
: 84

Judgment by performance – we should judge
the competitiveness of markets by the
performance (behavior) of firms in the
market.
A firm’s size within an industry is
insufficient evidence for the court to rule
against it in an antitrust suit. Issue is
behavior not size.
Evidence must show that the firm
actually used its size to violate antitrust
laws.
: 86

Judgment by structure – we should judge the
competitiveness of markets by the structure
of the industry.
A firm’s size within an industry is
considered sufficient evidence for the
court to rule against it in an antitrust suit.
Does not differentiate between good and
bad monopolies.
: 88

A trust or cartel is a combination of firms
in which the firms have not actually
merged, but act as a single entity.

A trust sets common prices and governs the
output of individual member firms.

A trust can, and often does act like a
monopolist.

In 1911, the U.S. Supreme Court determined
that both Standard Oil and American Tobacco
were structural monopolies in that each
controlled over 90 percent of their markets.

In spite of this, they were not judged to have
violated the antitrust legislation because of
their structure, but because of their “unfair
business practices.”


This judgment on performance, not structure,
is often called the abuse theory
A firm is legally considered a monopoly only
if it commits monopolistic abuses.

Judging by structure may seem unfair since
the alleged wrongdoer is doing what it is
supposed to be doing—producing the best
product at the lowest possible price.

Supporters of this position recognize this
problem, but they nevertheless favor the
structure criterion because of its
practicality.

Judgment by performance requires that each
action of a firm must be analyzed on a caseby-case basis.

This is enormously expensive and timeconsuming.

Courts must find a way to limit the cases they
look at.
 Some
argue that structure is a predictor of future
performance.

A monopolist may be charging low prices now.

Once the competition is removed, the offending
firm increases its prices.


The structural approach is not without faults.
Choosing the relevant market when
evaluating competitiveness is difficult to do.

In the famous du Pont case (1956), the
relevant market for cellophane was the
„flexible – wrap“ industry not the cellophane
market of which du Pont owned 100 percent.

Therefore, du Pont was not considered a
monopolist.

Both structure and performance criteria
have ambiguities, and in the real world
there are no definitive criteria for judging
whether a firm has violated the antitrust
statutes.


In recent years, antitrust law has worked
mainly through its deterrent effect
Many potential mergers are never even
proposed because firms know the merger
would not be allowed.

Technology was changing so fast that
by the time litigation reached the
courts, the issues were no longer
relevant.

The modern era of antitrust policy has
been marked by important cases in
the computer and telecommunications
market.

Microsoft is the dominant player in the
software industry, controlling over 50 percent
of the world market for software and between
80 and 90 percent of the operating systems
market worldwide.

Since all software must be compatible with an
operating system, Microsoft has an enormous
competitive advantage for its other divisions.

The U.S. Justice department charged
Microsoft with an antitrust violation:

Possessing monopoly power in the market for
personal computing operating systems.

Tying other Microsoft products to its Windows
operating system.

The U.S. Justice department charged
Microsoft with an antitrust violation:

Entering into agreements that kept computer
manufacturers that install Windows, from
offering software that competes with
Windows software.

Monopolists need barriers to entry.

The computer software industry has two
sources of monopoly power – network
externalities and economies of scale.

Network externalities exist because
as the number of applications
supported by a single platform
increase, the value of the platform
also increases.

Economies of scale exist because of the cost
of developing a new platform and new
software is significant while the cost of
producing it is minimal.

With its stable 90 percent market
share, it certainly is a monopoly.

By directing the development of in-house
software to favor Windows, Microsoft
strengthened the barrier to entry created by
network externalities.

Microsoft also penalized computer
manufacturers that installed Windows
if they installed competing software.

Microsoft packaged Internet Explorer as
part of Windows at no additional cost to the
buyer which froze out Netscape Navigator.

In late 1999, a federal judge ruled that
Microsoft violated the Sherman Act by
attempting to maintain its monopoly power
by anti-competitive means.

The term merger means the act of
combining two firms.

The law allows firms to break up any way
they like.

Mergers, on the other hand, must fall
within the law's antitrust guidelines.

There are five reasons why unrelated firms
would wish to merge.
To achieve economies of scope.
 To get a good buy.
 To diversify.
 To ward off a takeover bid.
 To strengthen their political-economic
influence.

 If
the competition laws are to raise social
welfare, the government/court must
determine which mergers are desirable
and which are not.

If the merged firms are able to limit access of
other buyers or sellers to the market, the
merger would be in violation of the antitrust
law

Acquisitions and takeovers both result
in the combining of firms.

There are three types of mergers:
horizontal, vertical, and conglomerate.


A horizontal merger is the merging of two
companies in the same industry.
Most antitrust policy has centered on
horizontal mergers.

A vertical merger is a firm merging with the
supplier of one of its inputs.

A conglomerate merger is the merging of
two companies in unrelated industries.


Globalization leads to mergers because firms
can gain instant foreign distribution,
knowledge of local markets, and lower the
costs by redirecting production to low-cost
areas.
Deregulation has caused mergers to occur
among banks, electricity, and
telecommunications companies.

Technological change has created
takeover targets.

If a firm wants a new technology it
could buy the firm that owns it.


Regulators sometimes will not let mergers to
go through without a deacquisition program.
Deacquisitions occur when a firm sells parts
of another company it has bought or parts of
itself.


Antitrust policymakers now view that the
relevant market is the international market.
Some countries oppose antitrust laws
because of economies of scale, lack of a
strong ideology supporting competition, and
strong cultural ties between government and
business.
 Competition
laws have costs and benefits.
 Sometimes companies merge not to reduce
competition but to lower costs through joint
production.
The benefits of greater efficiencies through
mergers are called synergies.

Almost all economists agree that antitrust
enforcement has not reduced the size of
firms below the minimally efficient level, i.e.
the level at which a firm can take full
advantage of economies of scale.

Performance advocates generally believe
enforcement was not needed while structural
advocates generally believe that it was.

They are also mixed on their judgment about
whether any type of antitrust action is
feasible in a rapidly changing technological
arena.

Price discrimination is the business
practice of selling the same good at
different prices to different customers,
even though the costs for producing for
the two customers are the same.


Price discrimination is not possible when
a good is sold in a competitive market
since there are many firms all selling at
the market price.
In order to price discriminate, the firm
must have some market power.


Perfect Price Discrimination refers to the
situation when the monopolist knows
exactly the willingness to pay of each
customer and can charge each customer a
different price.
There is no arbitrage, the process of buying
a good in one market at a low price and
selling it in another market at a higher
price.

Three important effects of price discrimination:
◦
It can increase the monopolist’s profits.
◦
It can reduce deadweight loss of monopoly