ECON0301

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ECON0301

• Why Trade Liberalization may not be good

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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

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External Economies and Market Failure
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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

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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 hell 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.

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• Bad Product Drives out Good Product

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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).
• Greshams law bad money drives out good. Or,
  where two media of exchange come into circulation
  together the more valuable will tend to disappear.

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Adverse selection Used Cars (Lemons) Market
Assumption all of the above is commonly known in
the following exercises, and all agents are risk
neutral.
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Scenario I Full Information

• 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).

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Scenario II No Information

• Suppose buyers dont 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!

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Scenario III Asymmetric (Unequal) Information

• Sellers know the types of cars they own. But
  buyers dont 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
  buyer1/330K 2/320K 23.33K lt the price

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Scenario III Asymmetric (Unequal) Information

• 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 dont find a buyer!!!
• Remark What matters is not the amount of
  information.

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Scenario III Asymmetric Information

• 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 (1-p)x30K px20Kgt25K, or plt0.5.
• Good cars of 2-3 years old will easily find a
  buyer, while good cars of 10 years old dont find
  a buyer

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Solving the Problems

• 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

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• Credit Rationing

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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.

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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 ?.

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Expected Return and Nominal Rate
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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 ? implies that banks are able to
  give a higher interest rate paid to depositors.
  Therefore, the supply of loans is SS(?(R)) which
  is increasing in ?. This explains a loan supply
  curve as in Figure 2.

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Equilibrium Credit Rationing
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Credit Rationing and Financial Market
Liberalization

• The S(?(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.

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Involuntary Unemployment

• Involuntary unemploymentlabor market failureis
  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

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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

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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 RltR and there is
  no credit rationing.