Transcript Lecture 5

ECON0301
Why Trade Liberalization may
not be good
Market Failures and Trade
• Ricardian model and H-O model predicts that trade
liberalization is beneficial assuming the market functions
well.
• Newer models predicts different outcomes:
– Dynamic Learning, External Economies of Scale (recall the Thai
watch industry in the presence of the Swiss watch industry)
– Infant industry argument: an infant industry needs protection for
it to thrive
• In the presence of market failures, whether trade
liberalization is good is uncertain
• In fact, market failures may be exacerbated under trade
liberalization
External Economies and Market
Failure
Other Market Failures
• A few types of market failures
– Involuntary unemployment
– Credit rationing
– Bad product drives out good product
• These are easily studied by asymmetric
information
Asymmetric Information
• When a person buys medical insurance, the insuring
company does not know whether the person is healthy.
Nor does it know how well he’ll take care of himself after
insured.
• The former type of asymmetry information is called a
hidden type problem, or adverse selection problem.
• The latter type of asymmetric information is called a
hidden action problem, or moral hazard problem. But the
meaning of moral hazard has subsequently expanded.
• Information economics is the study of decision makings
between agents when their information is asymmetric.
Bad Product Drives out
Good Product
Adverse Selection
• Adverse selection refers to a situation where a selection
process (here market) results in a pool of
products/individuals with economically undesirable
characteristics.
• With “hidden type”, either (1) bad products drive out
good products or (2) good products subsidize bad
products (both receive the same price).
• Gresham’s law: bad money drives out good. Or, where
two media of exchange come into circulation together
the more valuable will tend to disappear.
Adverse selection: Used Cars
(Lemons) Market
good cars bad cars
buyers' valuation
$30K
$20K
sellers' valuation
$25K
$10K
number of cars
100
200
number of buyers
infinite
Assumption: all of the above is commonly known in the
following exercises, and all agents are risk neutral.
Scenario I: Full Information
good cars bad cars
buyers' valuation
$30K
$20K
sellers' valuation
$25K
$10K
number of cars
100
200
number of buyers
infinite
• Suppose that every buyer and every seller know
the type of the car they are negotiating.
• Then both good cars and bad cars will be traded.
• There are simply two products (good and bad
cars).
Scenario II: No Information
good cars bad cars
buyers' valuation
$30K
$20K
sellers' valuation
$25K
$10K
number of cars
100
200
number of buyers
infinite
• Suppose buyers don’t know the type of the cars they are
interested. Also suppose no sellers know the type of the
cars they own.
• Expected valuation of a car to buyers= 1/3 * $30K + 2/3 *
$20K = $23.33K
• Expected valuation of a car to sellers = 1/3 * $25K + 2/3
* $10K = $15K
• Both good cars and bad cars will be traded!
Scenario III: Asymmetric (Unequal)
Information good cars bad cars
buyers' valuation
sellers' valuation
number of cars
number of buyers
$30K
$25K
100
infinite
$20K
$10K
200
• Sellers know the types of cars they own. But buyers
don’t know the types of cars they are going to buy.
• Is a buyer willing to pay at a price greater than $25K (say
$26K)?
• No, because there is 2/3 of probability that the car is bad,
and the expected valuation to the buyer=1/3*$30K +
2/3*$20K= $23.33K < the price
Scenario III: Asymmetric (Unequal)
Information
good cars bad cars
buyers' valuation
$30K
$20K
sellers' valuation
$25K
$10K
number of cars
100
200
number of buyers
infinite
• Is a buyer willing to pay a price of $22K to buy a car?
• No, at such a low price, only bad cars owners will sell
their cars. But bad cars are worth only $20K to the buyer.
$22K is too high a price.
• The market price is even lower, at $20K or somewhat
lower. Only bad cars will be traded. Good cars don’t find
a buyer!!!
• Remark: What matters is not the amount of information.
Scenario III: Asymmetric
Information good cars bad cars
buyers' valuation
sellers' valuation
number of cars
number of buyers
$30K
$25K
100
infinite
$20K
$10K
200
• Good cars may still find a buyer, if the probability of bad
cars in the pool is low.
• Let p be such prob. A buyer is willing to pay $25K if (1p)x$30K + px$20K>$25K, or p<0.5.
• Good cars of 2-3 years old will easily find a buyer, while
good cars of 10 years old don’t find a buyer
Solving the Problems:
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Guarantees & Warranties
Liability Laws
Reputation of a store or the manufacturer
Experts--a disinterested party
Standards & Certifications
Long term relationship
Bottom line: Proper functioning of the market
requires proper development of other institutions
(law enforcement, etc.)—a substitute for these
institutions are long term relationship
Credit Rationing
Equilibrium Credit Rationing
•
Equilibrium credit rationing occurs whenever some
borrower's demand for credit is turned down, even if this
borrower is willing to pay all the price and non-price
elements of the loan contract.
– The interest rate charged is not constrained or regulated by the
government.
– "nonprice elements" such as collateral requirements, etc.
• Two types of (equilibrium) credit rationing:
– Type I: for a category of borrowers (i.e., all observable
characteristics of these borrowers are the same), each of them
gets a fraction of what he wants to borrow.
– Type II: some of them are able to borrow all they want to borrow,
and other cannot borrow any.
Expected Return and Nominal Rate
• equilibrium credit rationing can appear when the
expected return on a bank loan (for a given category of
borrowers) is not a monotonic function of the nominal
rate of this loan.
• A loan contract would state a payment of R that the
borrower should repay at some specified time later.
• In case the borrower defaults (or simply runs away) later,
the lender cannot get back all of R. Taking this into
account, we calculate the expected rate of return and
call it ρ.
Expected Return and Nominal Rate
ρ, Expected
Return for the
Bank
ρ(R)
R, Nominal Rate
of the Loan
R
R*
Figure 1: Expected Return for the Bank as a Function
of the Nominal Rate of the Loan
Competitive Banking Sector
• Assume perfectly competitive banking sector--each bank
is too small to influence R, and hence take R as given;
no barrier of entry into or exit from the sector, and hence
each bank is earning zero profit.
• Assume the supply of loans by this banking sector is
determined by the supply of deposits into the banking
sector.
• A higher bank's ρ implies that banks are able to give a
higher interest rate paid to depositors. Therefore, the
supply of loans is S=S(ρ(R)) which is increasing in ρ.
This explains a loan supply curve as in Figure 2.
Equilibrium Credit Rationing
Volume of
Credit
Equilibrium
Excess
Demand
L2D, High
Demand for
Loan
S(ρ(R)), Supply
of Loan
L1D, Low
Demand for
Loans
R1
R*
R, Nominal Rate
of the Loan
Figure 2: Equilibrium Credit Rationing
Credit Rationing and Financial
Market Liberalization
• The S(ρ(R)) must have its peak at R∗. When the
demand for loan is high enough such as L₂D, the
equilibrium is at rate R∗ and there is equilibrium
excess demand (type II credit rationing)
• In most cases, international banks that displace
local banks no longer grant loans to the small
local businesses as local banks did.
• That is, financial market liberalization worsens
the local financial market.
Involuntary Unemployment
• Involuntary unemployment—labor market failure—is
said to exist if some unemployed are willing to accept
the current wage package (or even an inferior one) of
those employed workers who have exactly the same
qualifications.
• Does involuntary unemployment exist? If yes, why wage
does not go down to absorb the unemployed?
• Asymmetric information can explain this as well
Market failures and Trade
• A more open economy is susceptible to market
failures due to asymmetric information
• Long term relationship within community is
broken
• It stops the process through which auxiliary
institutions that support market are developed
Monopolist bank
• A monopolist bank facing the return schedule of Figure 1
will never offer an interest rate above R∗. When the
quantity demanded for loans exceeds the quantity
supplied of loan by that monopolist bank at R∗, there is
equilibrium credit rationing.
• It is "equilibrium" because no further changes that
resolve the excess demand will happen given the market
conditions.
• Of course, if at R∗ the quantity demanded for loans is
less than the quantity supplied of loans by the
monopolist bank, then there will be an equilibrium at an
interest rate R<R∗ and there is no credit rationing.