ECON 0301 Why Trade Liberalization may not be

ECON 0301 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 Assumption: all of the above is commonly known in the following exercises, and all agents are risk neutral.

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).

Scenario II: No Information • 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 * $30 K + 2/3 * $20 K = $23. 33 K • Expected valuation of a car to sellers = 1/3 * $25 K + 2/3 * $10 K = $15 K • Both good cars and bad cars will be traded!

Scenario III: Asymmetric (Unequal) Information • 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 $25 K (say $26 K)? • No, because there is 2/3 of probability that the car is bad, and the expected valuation to the buyer=1/3*$30 K + 2/3*$20 K= $23. 33 K < the price

Scenario III: Asymmetric (Unequal) Information • Is a buyer willing to pay a price of $22 K to buy a car? • No, at such a low price, only bad cars owners will sell their cars. But bad cars are worth only $20 K to the buyer. $22 K is too high a price. • The market price is even lower, at $20 K 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 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 $25 K if (1 p)x$30 K + px$20 K>$25 K, 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: • • 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 L 2 D, High Demand for Loan L 1 D, Low Demand for Loans R 1 R* S(ρ(R)), Supply of Loan 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.