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Markets and
market failures
Sergei Guriev
1
Plan
• All markets are important for development
– Product markets
– Financial markets:
• insurance and credit
– Labor market, human capital
– Land/real estate market
• How do markets work when they work?
• Sources of market imperfections
• Interactions of market failures
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Neoclassical paradise
• Arrow-Debreu model
– Perfect competition
– No transaction costs
– Symmetric information
• Adam Smith’s Invisible hand
– First Welfare Theorem
• Market equilibrium is efficient (whatever the allocation of
property rights)
– Second Welfare Theorem
• Every efficient allocation can be supported as market
equilibrium if income/wealth is redistributed
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Invisible hand in real life
• Labor mobility
– Nationwide competitive market
• Financial revolution
– Financing ideas and even search for ideas not only investment in
tangible assets
– Raising outside options for skilled employees
• Mortgages
– Reinforces labor mobility
• Insurance
– Encourages adequate risk-taking
– ? Health insurance
• Education market
– Incentives to accumulate human capital
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What are the imperfections?
• Product markets
– Imperfect competition
– Externalities
– Asymmetric information about quality
• Financial markets
– Asymmetric information: insuring/lending to wrong people
– Moral hazard: Securing returns to investors
• Labor market
– Segmentation; mobility depends on financial markets
– Monopsony power
• Human capital
– Externalities and public goods: hard to appropriate returns
– Non-alienable, hence relies on efficient labor market
• Land and real estate
– Relies on efficient financial markets
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Imperfect competition
• Burden of monopoly is not only the Harberger triangle (very small for
the US and even some developing economies)
• Imperfect competition (monopoly or oligopoly) may be sustainable in
the long-run
– Why can’t more efficient perfectly competitive market structure take
over?
• Incumbents lose
• Usually incumbents hold substantial political power
– Why cannot compensate incumbents for losses
• Commitment (time-inconsistency) problem
• Collective action problem
• Implications:
– “Barriers to riches” (Parente and Prescott)
• Adoption of new technologies is blocked by insiders
• TFP does not grow
– Rent-seeking
• Struggle for monopoly rents subverts institutions
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Why need financial markets?
• At each moment, firms and household make plans for
future, taking into account uncertainty
• Need to reallocate wealth across time and across states
of nature
No investment
Success
Market research
t+2
Investment
t+3
Moderate demand
t+1
Failure
High demand
Low demand
t
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Insurance market
• Reallocating wealth across states of nature
• Customer: risk-averse
– Maximizes a concave utility function u(x)
– Agrees to pay for certainty: u(Ex)>Eu(x) increase
wealth in worse states at the expense of better states
• Insurance company
– Large, deals with many customers
• Hence (by the Law of large numbers) is risk-neutral
– Takes on all the risks for a fee
• BUT: some risks cannot be insured even by insurance
companies
• Competition between insurance companies
drives price of insurance down
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Diminishing marginal utility
and insurance
Utility
Net benefit of risk sharing
Cost of
insurance to
the insurance
company
Payoff
Bad state
Expected payoff Good state
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Asymmetric information
and insurance
• Pre-contractual asymmetric information: adverse
selection
– High-risk customers self-select into insurance
– Price of insurance ↑ for low-risk customers
• Post-contractual asymmetric information: moral hazard
– The insured lacks incentives to take a good care of the insured
assets
– The insured’s actions are not observable by the insurance
company, nor by courts, hence cannot be included into contract
• Additional problems: Commitment problem on the
insurance company’s side
– If market is not developmed
• Bankruptcy of insurance company
– If legal environment is very weak
• Strategic default of the insurance company
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Credit/Capital market
• Allocate wealth across time
• A firm has a profitable investment project
but no cash to finance it
– Needs to borrow at a low interest rate
• Households want to get a return on their
savings
• Perfect market: savings rate = borrowing
rate
• Real life: huge wedge between the two
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Principal-agent problem
• Same as moral hazard in insurance
• Example: Shareholders vs Managers
– Enron, Worldcom, Tyco
• Example: Sharecropping
– Why take away incentives from the tenants?
• Problem:
– M chooses effort (inputs) that influences output (market value)
• But market value also depends on other factors
– Inputs are not observable
• Close monitoring may fail because of collective action problem
• External monitors (e.g. auditing firms) may be not collusion-proof
– The contract may reward better performance in terms of outputs,
not inputs
• Outputs are noisy measures of inputs
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Inefficiency of sharecropping
Total revenue
Tenant’s share
of revenue
Cost of production
(borne by tenant)
Crop
Sharecropping
equilibrium
Social optimum
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Example: US corporate
governance scandals
Tyco’s CEO Dennis Kozlovski
• 2001: named by Business Week one of
the 25 managers of the year
– Allegedly tunneled $600 mln from company to
private uses
• 2003: “… The indictment of Mr Kozlowski
and his chief financial officer, Mark Swartz,
lists 15 separate charges of grand larceny
and 67 charges of falsifying business
records.”
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How to solve
principal-agent problem?
• Align M’s interests with shareholders’
• Ideal solution: for each $1 earned by
shareholders pay $1 to CEO
– Effectively make the CEO a residual claimant
(virtually an owner)
– But …
• Incentive-insurance trade-off:
– High-powered incentives  higher variability of M’s
income  M has to be compensated for higher risk
– Perfect insurance  same payoff in good and bad
states  no incentives
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Limited liability
The contract “$1 to M for each $1 increase in shareholder
value” must specify NEGATIVE payoffs for M in some
states
Indeed if M buys a firm, has to pay a large transfer to
shareholders 
Will need to borrow to finance it 
But it indebtedness is too high then
– The interest rate is too high or
– Credit is denied (infinite interest rate)
• Personal/corporate bankruptcy
– Creditors get less than the nominal value of the debt
– Interest rates increase further to make up for bankrupt debtors
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Risk-aversion is aggravated
by credit market imperfections
Wedge between interest rates on deposits and loans 
even originally risk-neutral decision makers become riskaverse
Utility
saving
(costly)
borrowing
Initial wealth
Payoff
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Debt overhang
• Why cannot debt finance help?
– Standard debt contract: “Pay back D or give up
control over firm”
• If the probability of bankruptcy is not very high,
quite efficient
• Otherwise: similar to equity
– Debt overhang problem
• M is residual claimant only if cash flows > D
• But probability of this is low
• If cash flows < D, M has no marginal stake
• Hence debt finance also has limitations
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Debt overhang hurts
incentives
Income after repaying the debt
Cash flows
D
D
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Principal-agent problems
ubiquitous
•
•
•
•
•
Investor vs firm
Insurance company vs ensured
Employer vs employee
Public vs bureaucrats
Landlord vs tenants
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Financial imperfections: a
summary
• A solution to principal-agent problem?
– Assets should be owned by those who work with
them
• Complementarity between human and physical investment
– But what if M has no cash
– Why can’t she borrow and launch an LBO
– If need to borrow too much, debt overhang would
suppress incentives
• So nobody would lend at a reasonable rate
• Workable solutions:
– Laws and courts to reduce informational asymmetries
– Reputational concerns
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“Financial revolution”
• Competitive financial markets:
– Higher returns to investors  lower cost of finance
• Developed legal system
– Sophisticated financial contracts and instruments to overcome
asymmetric information and moral hazard
• E.g. buyout options in venture finance
• (de Soto) formalized property rights  collateral  debt finance and
other contracts
– Enforcement of creditor/property rights
• Political support for secure property rights may be low in unequal
societies
• Problematic not only in developing countries (Rajan-Zingales)
– UK: reposessing a collateral in a mortgage takes 1 year and 5% value
– Italy: 3-5 years and 18-20% value
– UK: mortgages 52% GDP, Italy: 5.5% GDP
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Labor markets
• Geographical segmentation
– Local labor market – monopsony
– Reinforced by imperfect housing market
• Which is reinforced by imperfect financial markets
(mortgage)
• Skill segmentation and monopsony
– Financial market
• Need to borrow to quit and startup a firm
– Education market
• Education increases intra/inter occupational
mobility
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Human capital
• Incentives to accumulate skills
– Rewarding increased productivity requires
competition between employers
• Competitive labor market
• Incentives to innovate
– Financing research and development
– Intellectual property rights
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Land/real estate
• Land is complementary to labor in
agriculture
– If agricultural worker does not own land, there
is a principal-agent problem and insuranceincentive trade-off
– Hence need to broaden land ownership
• Land/real estate is also a perfect collateral
– Market for land helps to build financial
markets
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Agriculture, value added
(% of GDP) in 2004
Argentina
10
Low income
22
Belarus
10
Middle income
10
Botswana
3
Netherlands
2
Brazil
10
Pakistan
22
Central African Republic
56
Russian Federation
5
China
13
South Africa
3
Czech Republic
3
South Asia
20
Denmark
2
Turkey
13
Europe & Central Asia
8
Ukraine
12
European Monetary Union
2
United Kingdom
1
France
2
United States
1
HIPC
32
Upper middle income
7
Low & middle income
12
World
4
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Land and sharecropping
• Equity: rural poor are usually the poorest of the poor and the most
numerous of the poor
• “Efficiency vs equity” or “efficiency AND equity (but vs. property
rights protection)”
– Evidence: smaller farms are (much) more productive
• From 16 to 40 per cent
– Hence more equal land distribution is also more efficient
• Why are smaller farms more efficient
– Increasing returns:
• Technology and investment in fixed capital
• Increasing returns can be mitigated through contractual arrangements
(shared access to physical capital)
– Decreasing returns:
• Incentives (principal-agent problem in sharecropping)
• Solving the incentives problems requires, in the end of the day, sale of land
to family farmers
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Reality: land distribution is
VERY unequal
Gini of land distribution (Otsuka et al. 1992, data for
1970s) is much higher than Gini for income
distribution
Bangladesh
0.42
Brazil
0.84
India
Indonesia
0.62
0.56
Colombia
Peru
0.86
0.91
Nepal
0.56
Uruguay
0.82
Thailands
0.45
Venezuela
0.91
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Redistributing land
• Land market?
– But tenants are cash-constrained
• Most often don’t have access to finance
• Even if buy land through a debt contract
– Debt overhang will suppress incentives
• Hence “land reform”: certain govt intervention to
promote small farms and farmer ownership
– Expropriate land
– Subsidize land purchases by tenants
– Tax large farms
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Land reform: Korea
• Land Reform Act 1949
– Transferred land to Korean peasants/tenants (at a low
price)
• From Japanese owners (little compensation)
• From large Korean owners (with compensation)
• By 1964, 72% land was cultivated by owners
(compared to 17% before reform)
– Only 5% by tenants (compared to 42%)
• Large positive effect on productivity
• Political economy:
– Large Korean landlords cooperated with Japanese
during the war; both large Korean landowners and
Japanese landowners were stripped of political
influence
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Land “reform”: Soviet union
• Revolution 1917: Communists (mostly industrial workers party)
promised land to landless workers
• 1918: expropriation of aristocrats (large landowners, not farming)
• 1920s: expropriation of kulaks (large farmers), redistributing land to
poor peasants, formation of collective farms
– Effectively, destruction of private property (on ideological grounds)
• Over Soviet time: disastrous performance of agriculture, from
exporting grain, Russian became a large net importer
– (only changes back in 21st century)
• Somewhat similar experience in Mexico after 1917 revolution
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Chinese land reform: incentives
without private ownership
• Before 1978: planned inputs and outputs
• Since 1978: “contract responsibility system”
– Have to fulfill the plan (buy planned quantity of inputs at controlled
prices, sell planned quantity of outputs at controlled prices)
– Whatever is produced on top of the plan can be sold in the free market,
profits appropriated by farms
– Collective farm allocates shares of the village-level plan to families
• Reform
– Provides incentives
– Reform can only improve peasants’ welfare
• Political economy:
– Credible commitment from long-term-oriented benevolent dictator
(Communist Party)
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Market-assisted land reform
• “World Bank model”
– Qualified grants/subsidized loans to landless to
purchase land
• (Plus substantial red tape to sort out frivolous attempts)
– Elasticity of land “supply” matters
• Compare to National Project Housing in modern Russia
• South Africa:
– Goal to redistribute 30% of land in 1994-99
– Fell substantially below the quantitative goals
– But productivity and equity improved
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Market-assisted land reform,
Brazil
• 1985: Constitution allows expropriation of large land holdings that
are idle or do not perform “social” funciton
• Until 1998, no action
–
–
–
–
Some estimates: 60% land idle
37 largest landowners own more land than 2.5 million smallest ones
20% wealthies own 90% of land
MST (Landless Rural Workers Movement): land occupations “Occupy,
resist, and produce”
– Violence on both sides
• 1998: Cardoso’s Novo Mundo Rural
– Mixed results: great idea but implementation is still problematic
– MST objects high debt costs
• 2002: Lula comes to power committed to land reform but lack money
to subsidize land redistribution
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Brazil, continued
• Lula’s Promise: to give land to 400,000 families and give
titles to 500,000 squatters
• Delivered only 245,000
• MST is very unhappy
– Continues to squat
– Established 1800 schools and even a university (2005)
• Lula has not won the first round of elections
– But will probably win the second
• Political economy:
– Substantial weight of Ruralista party (large landowners)
– Even-market assisted reform is similar to expropriation – the rich
pay taxes to fund government subsidies to the poor
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Tenancy reforms
• Constraints on tenancy contracts
– Tenants become more expensive
– Both poverty reduction and efficiency gains
• India: Besley and Burgess (2000) vs Banerjee,
Gertler and Ghatak (2002)
– BB: poverty reduction but no productivity gains
– BGG: substantial productivity gains
• Concentrate on reform in West Bengal where really worked
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Land reform: Summary
• Agriculture is still VERY important in developing
countries
• Land distribution is very unequal
• Principal-agent problem is so important that
small farms outperform large farms
• Financial and land markets are underdeveloped
hence the case for land reform
• Land reform:
– if implemented well, promotes both efficiency and
equity
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