UNIT 1

WHAT IS INSTITUTIONAL ECONOMICS/

INSTITUTIONALISM?
School of Economics, It viewed the evolution of economic institutions as a part of the
broader process of cultural development.
An institution can be defined as - property rights, honest governments, political
stability, dependable legal system and competitive and open markets - creating a right
environment to allocate scarce resources.
Property rights: A property right is the exclusive authority to determine how a
resource is used, whether that resource is owned by the government or by individuals.
Society approves the uses selected by the holder of the property right with
governmental administered force and with social ostracism.
Political Stability: The fact of scarcity, which exists everywhere, guarantees that
people will compete for resources. Markets are one way to organize and channel this
competition. Politics is another. People use both markets and politics to get resources
allocated to the ends they favor. Political activity, however, is startlingly different
from voluntary exchange in markets. In a democracy groups can accomplish many
things in politics that they could not in the private sector. Some of these are vital to
the broader community’s welfare, such as control of health-threatening air pollution
from myriad sources affecting millions of individuals, or the provision of national
defense. Other public-sector actions provide narrow benefits that fall far short of their
costs
Dependable Legal System: Providing a dependable legal system to a citizen, gives
them a better ground to seek redressals, secure justice in a speedy and cost efficient
manner.
Honest Government: A strong government is a premise for any economically stable
state. A Government must be unbiased to its citizens, and dishonest tactics and
treatment to its citizens for eg - gender, caste bias must be strictly refrained.
Competitive and Open Market: The market, then, is not simply an array, but a
highly complex, interacting latticework of exchanges. In primitive societies,
exchanges are all barter or direct exchange. Two people trade two directly useful
goods, such as horses for cows or Mickey Mantles for Babe Ruths. But as a society
develops, a step-by-step process of mutual benefit creates a situation in which one or
two broadly useful and valuable commodities are chosen on the market as a medium
of indirect exchange. This money-commodity, generally but not always gold or silver,
is then demanded not only for its own sake, but even more to facilitate a reexchange
for another desired commodity. It is much easier to pay steelworkers not in steel bars,
but in money, with which the workers can then buy whatever they desire. They are
willing to accept money because they know from experience and insight that everyone
else in the society will also accept that money in payment
 Institutionalism came to be developed during the first half of the 20 century, in the US.
th

 The foundation of the new system was laid by Thorstein Veblen with the publication of
his book The Theory of Leisure Class , and another book Instinct of Workmanship.
 The GD provided a favourable atmosphere for the development of institutionalism as
an academic movement and a tool of public policy.
 The Institutionalists criticized the rational self-interest approach of classical economists
and emphasized the importance of human instincts and habits in moulding economic
activities.
 The stress is, therefore, on man-made institutions and institutional environments.

INSTITUTIONALISM vs CLASSICISM
 Institutionalism has been essentially a movement against the classical and neo-classical
approaches.
 According to classical and neo-classical writers, economic activities are governed by
economic laws.
 As against this view, the Institutionalists hold that economic activities are governed by
institutions, instincts and habits.
 Davenport says that “ Institutions are a working consensus of human thought or habits,
a generally established attitude of mind and a generally adopted custom of action as,
for eg, private property, inheritance, government taxation, competition and credit”.
 The classical economists believed that human actions are always guided by rational,
enlightened self-interest and, therefore, economic activities/institutions automatically
get adjusted with each other.

 Instincts and habits have been assigned no place in the classical analysis.
 Nature was considered to be superior to man and man made institutions were under-
valued in comparison to the laws of nature.
 Institutionalism primarily aims at social reform.
 In contrast to the concept of static equilibrium of the classical writers, Institutionalists
believe in an all out effort towards a planned evolutionary rearrangement of economic
life.
 Contrary to the classical thought, Institutionalists recognize the existence of
maladjustments and advocate their correction by deliberate efforts.
 Institutionalists are not mere theorists, they are reformers.
 Unlike Marxists, they do not believe in the destruction of Capitalism but in eradicating
its evils.

FEATURES OF INSTITUTIONAL ECONOMICS:

 Group behavior and nor price is considered to be the central theme of economists.
 It recognizes that human behavior is constantly changing and that economic laws
should always be relative to time and space.
 Emphasis is given to customs, habits and laws, as the modes of organizing economic
life.
 It holds that important motives governing individual action cannot be measured.
  Maladjustments in economic life under existing institutions are normal occurrences and
are not to be treated as a departure from normal equilibrium.

WHY DO WE NEED AN INSTITUTION? SK and NK

Information Asymmetry, Bounded Rationality and Transaction Costs.
 institutions matter for economic performance.
 Institutions reduce the costs of coordinating human actions and therefore are of
central importance in understanding human interactions.
 Institutions play a crucial role in coordinating individual actions.
 Example:- Barter economy and Money

FORMAL AND INFORMAL

Formal Organization –
 Def: An organization created by management where authorities and responsibilities
are clearly defined.
 Origin: It is established because of the rules and policies of the organization. They are
formed deliberately in a planned manner.
 Authority: Arises on the basis of position in the management.
 Behavior: Standards of behavior are laid down by rules.
 Flow of Communication: Communication flows through a scalar chain.
 Nature: It is rigid and stable.
 Leadership: Managers are the leaders.
 Purpose: Its purpose is to achieve organizational goals by working systematically.
 Structure: There is a well-defined organizational structure which decides the scalar
chain and defies superior-subordinates relationship.
Informal Organization –
 Def: An organization born out of mutual relations is called informal organization and
it emerges automatically.
 Origin: It is established because of social relationships. They get created
spontaneously without any planning.
 Authority: Arises out of personal qualities.
 Behavior: No set behavior pattern. Management has no control over the behavior of
members. But if the behavior of the informal group is bringing negative results, then
the management may intervene.
 Flow of Communication: Independent channels of communication.
 Nature: It is temporary and less stable.
 Leadership: The group chooses the leader by itself.
 Purpose: Its purpose incorporates fulfillment of individual needs too. Psychological
satisfaction is key.
 Structure: There is np well defined structure, no fixed superior or subordinate and no
scalar chain.
 DIFFERENCE BETWEEN OLD AND NEW INSTITUTIONS

OLD NEW INSTI ECO

INSTI
ECO

 NIE began as an attempt to extend the range of applicability of neo

classical theory.
 During the post war period, there was an increasing dissatisfaction
with, and criticism of, the traditional models of production and
exchange.
 NIE desired to change certain key assumptions of mainstream
economics.
 Thus, NIE, while similar in many respects to standard neoclassical
analysis, is distinct and characterized by a significantly different
perspective on micro economic phenomena.
 Bounded Rationality than Full Rationality.
 Opportunism over full honesty.
 Institutions are part of the society's effort to use scarce resources
efficiently.


MAINSTREAM ECONOMICS AND ITS ASSUMPTIONS

 Mainstream economics is a term used to describe schools of economic thought
considered to be orthodox. Many of the underpinning models and beliefs of
mainstream economics are based on concepts that involve economic scarcity, the role
of governmental regulation or other action that affects an actor's decision, the concept
of utility(Utility is a term in economics that refers to the total satisfaction received
from consuming a good or service), and the idea that people are rational actors who
will make decisions that are based purely on available information and not emotion.
 Mainstream economics is not a branch of economics itself, but is used to describe
theories often considered part of the neoclassical economics tradition.
 Mainstream economics follows rational choice theory, which assumes that
individuals make decisions that will maximize their own utility, and uses statistics and
mathematical models to demonstrate theories and evaluate various economic
developments.
 Mainstream economics, the study of rational actors in a world of trade-offs, has faced
several challenges. Schools of economic thought outside of mainstream economics—
called heterodox economics—are more skeptical of the role of the government and the
rationality of actors.
 The main criticism of mainstream economics is the absence of considerations relating
to external factors. For example, this type of economic thought assumes the complete
rationality of actors. It assumes that individuals are selfish and will always act in their
own best interests. There is no place for moral concerns or altruism in mainstream
economics and the invisible hand is expected to move markets without fear or favor.
 But recent economic theorists have become open to the thought that people are not
entirely rational. In fact, an entirely new field of study, known as behavioral
economics, has emerged for this discipline. Markets are also not entirely efficient, and
factors that affect an actor's decision are not always quantifiable. These beliefs seem
to have become more commonplace since the Great Recession (2008 Financial Crisis
- Housing market crash - CDO’s and CDS’s - Short on Mortgage backed securities).
 Mainstream economics also does not focus on economic concerns gaining
momentum, such as sustainability and pollution. Again, environmental economics is a
separate field that studies incentives and policymaking specifically geared toward
promoting sustainable practices and businesses.
 Early theories relating to the development of economics as a field of study are part of
mainstream economics.
 For example, the invisible hand theory that is responsible for moving markets is part
of mainstream economics. In this theory, individual self-interest and freedom to
produce and consume are supposed to collectively maximize the common good (In
philosophy, economics, and political science, the common good refers to either what
is shared and beneficial for all or most members of a given community, or
alternatively, what is achieved by citizenship, collective action, and active
participation in the realm of politics and public service ).
 Governments have little to no role to play in this theory, except for ensuring that the
rule of law is followed. However, recent events, especially those relating to the Great
Recession, have proved that the common good is not always the end result of
individuals pursuing profits.

CORE ISSUES OF NEW INSTITUTIONAL ECONOMICS

 NIE took off spectacularly over the last two decades and is now evolving as a very
progressive research program.
 A coherent set of concepts has been elaborated, with transactions and their costs at
the core, and empirical tests and applications have proliferated at a pace rarely observed
in economics.
 As with any innovative research program, NIE has its flaws and weaknesses, and
critics have mainly focused on methodological issues.

 Heterodox economists attack primarily the assumptions made, particularly the idea that
economic agents are in some way calculative, since they are assumed to have a bounded
rationality, and that they tend to find solutions that minimize costs.
 Mainstream economists criticize the lack of mathematical models to support the
reasoning and contribute to testable predictions.
ISSUES:
 Any representation of the progress of scientific activity depends primarily on 3
factors:
 Theory: It is defined as a set of questions and concepts to answer these questions
 Models: Tools rooted in theory and designed to generate predictions about a
class of phenomena
 Tests: This involves measurements , to determine whether facts behave
according to predictions.
THEORISING:
 One central characteristic of New Institutional Economics is that it is based on a
small set of concepts that are logically coherent and provides powerful tools to
understand a large set of facts and relationships among these facts.
 Insofar as posing relevant questions and providing a pool of resources for
addressing these questions are keys to building theory, then New Institutional
Economics is well on its way.
 Transactions and their related costs are at the core of the theory and constitute
the force that unifies the subfields that have developed.

 Coase theorem - (The Coase Theorem argues that under the right conditions
parties to a dispute over property rights will be able to negotiate an
economically optimal solution, regardless of the initial distribution of the
property rights, In the real world, it is rare that perfect economic conditions
exist, making the Coase Theorem better suited to explaining why inefficiencies
exist as opposed to a way to resolve disputes.) rightly emphasized the
importance of transactions and their centrality in the research program promoted
by neo-institutionalists.
  Without transactions and their relevant organizations, it would be impossible to
take advantage of division of labor or of innovative technologies
 In that sense, there is a primacy of transactions over conditions of production.
 The second key feature of the theory is that organizing transactions involves
costs.
 In a world of positive transaction costs, the allocation of resources and the
development of new technologies depend on the prevailing governance
structures, i.e., the modes for organizing transactions, and on the characteristics
of users’ rights, particularly property rights.
 This may be why transaction cost economics, another name for New
Institutional Economics that emphasises its analytical core, is often viewed as an
alternative theory.
 Note that an alternative theory need not render existing theories obsolete; but
it does “regionalize” them into a more complex scheme, and may restructure
them.
 Thanks to Ronald Coase, Douglass North and many others, we have an
increasingly precise identification of the institutions that matter most in the
development of transactions (e.g., the regime of property rights and contract
laws).

MODELLING:
 Lack of adequate models is the main critique levelled by mainstream economists
against New Institutional Economics.
 Models are necessary intermediaries between the development of a pure theory and
its application to the analysis of empirical facts.
 The central core of New Institutional Economics does lack adequate models
 Certainly, developing more adequate models is a priority in New Institutional
Economics
 Most New Institutionalists are optimistic about the possible contribution of game
theory, in analysing the nature of complex governance structures or economic
behavior.
 Another possibility lies in the development of experimental economics
 So far, the field seems to have expanded largely in testing rationality hypotheses and
in elaborating complex schemes for resolving the resulting paradoxes.
 Further developments may provide new insights better adapted to the understanding
of how institutions actually shape beliefs and choices.
TESTING:
 When it comes to empirical testing and analysis, New Institutional Economics is a
“success story”, as noted by Joskow (1991) and emphasized continuously by
Williamson.
  Indeed, there have been hundreds of tests of transaction cost economics over the last
two decades.
 This is quite paradoxical, if we consider the small number of models available
 Availability of data was a major challenge for NIE in the 1980s.
 The development of a new theory always requires the collection of new data that will
be adequate for new tests.
 New Institutional Economics is no exception and the pioneers of empirical studies
(Anderson, Demsetz, Joskow, Palay, Masten, North and Wallis, and others) had to
build new sets of data from scratch.
 A body of evidence for NIE is progressively building but there are 2 major issues.

 One is the collection of data, since so much is required both at the micro and
institutional level.
 Second is the collection of relevant data relating to the analysis of contracts, for
measuring the degree of specificity of assets involved in transactions, for
determining the degree of uncertainty surrounding transactions etc.
 NIE is evolutionary, with rapid changes occurring, and it is progressive.
 The building blocks have a cumulative effect, with each part helping to better
understand other parts.
 Like any new research program, it confronts difficult methodological issues.
 This is because it “de-isolates” questions that were set aside by mainstream
economics ( e.g. the concept of the firm as a governance structure rather than a mere
production function, and the concept that the institutions of exchange have positive
transaction costs).
 Another difficulty arises from the search for more realistic assumptions about
economic behavior, which makes model building much more difficult.

MARXIAN ECONOMICS
https://www.economics.utoronto.ca/wwwfiles/archives/munro5/MARXECON.htm
“Workers of the world, UNITE; for you lose nothing but your chains”- Karl Marx

 It is a school of economic thought based on the work of 19th-century economist and

philosopher Karl Marx. Much is drawn from his seminal work "Das Kapital,"
 Flaws: Marx claimed there are two major flaws in capitalism: the chaotic nature of
the free market and surplus labor. The specialization of the labor force + a growing
population = pushes wages down (the value placed on goods and services does not
accurately account for the true cost of labor.)
 His Prediction: Capitalism will lead more people to get relegated to worker status,
sparking a revolution with production being turned over to the state.
 “Surplus value” of labor and its consequences for capitalism: it was not the pressure
of labor pools that drove wages to the subsistence level but rather the existence of a
 large army of unemployed, which he blamed on capitalists. Within the capitalist
system, labor was a mere commodity that could gain only subsistence wages.

Influences shaping Marx’s ideas

 Classicism
 Hegelianism
 Materialism
 Contemporary history
 Socialism

Chief Tenets of Marx

Dialectical Materialism
 Marx modified the Hegelian philosophy of ‘dialectic idealism’.
 According to Hegel, the world is in the process of continuous development
and the development takes place according to the dialectical formula.
 Development or change occurs in the society because of the conflict of
antagonistic elements which are ultimately synthesized.
 Owing to their fusion, the opposite elements are transformed into a new and
better concept
 The initial state is called ‘thesis’, its successor is called ‘antithesis’, and the
third stage is called ‘synthesis’.
 For Hegel, the motive force behind change is a mystical entity, ‘spirit’.
 Marx, on the other hand, considered matter, and not spirit as the driving force
of historical development.
 In other words, Marx put Hegel’s dialectic on a material basis, and made
social evolution a matter of material and economic forces.
 The dialectical process entails the following steps:
 The unity of opposites
 The negation of negation
 The change of quantity into quality

Materialistic Interpretation of History:

 Marx considered man’s material production as the basis of history and his
mental production(intellectual and cultural life) as its effects.
 According to him “ the mode of production in material life determines the
general character of the social, political and spiritual processes of life”.
 Marx, unlike the classical economists, considered the capitalist system as
variable, and treated it as a transitory phase.
 He considered economic laws as relative laws, valid only for a particular stage
of historical development.
 Underlying all social changes, there is a fundamental and continuing
development of the productive powers of the society.
  According to Marx, people make social decisions solely in response to their
economic needs, Thus, over time, the characteristics of a society are
determined by its economic structure.

Class Struggle
 Marx believed that the basic disparity between the evolving powers of
production and outdated institutions would express itself in “class struggle”.
 While classical economists believed in the harmony of interest, Marx made
class conflict the dominant feature of social life.
 In Marx’s view, “All history is the history of class struggle”.
 In ancient times, there was the struggle between the master and the slave.
 Under feudalism, it was between the lord and the serf
 Under conditions of modern capitalism, the struggle is between the capitalists
and the workers.
 The capitalists control the means of production and the workers depend on the
capital for work.
 Exploitation is inherent in the capitalist system.
 As exploitation increases, the society is polarized into 2 classes- the capitalists
and the proletariat.
 In course of time, the conditions will become ripe for the overthrow of
capitalism by the united proletariat.
 In fact, capitalist itself will sow the seeds of its destruction.

Labor Theory of Value

 The labor theory of value expresses a social relation in a capitalistic society.
 A basic form of this relation is commodity.
 A commodity contains use-value as well as exchange-value.
 A useful thing has value because human labor in the abstract has been
materialized in it.
 The exchange value of a commodity, according to Marx, depends upon the
labor time socially necessary for its production.

Theory of Surplus Value

 Ideally, the wage of labor must be equal to the productivity of labor.
 But this does not happen under capitalism.
 In such a system, the exchange value of labor is less than its product.
 Marx observes that labor is paid only a subsistence wage in capitalism which
can only purchase subsistence goods(wage goods) necessary for the
maintenance of the labor.
 Suppose a laborer requires 4 hours of labor to earn his subsistence, then,
assuming a 12 hrs manday, the value of the product created by the laborer for
the remaining 8 hours can be regarded as surplus value.
 Marx says that under capitalism, labor power is the source of surplus value
which is pocketed by the capitalist.
 The working day of the laborer can be divided into ‘necessary labor’ and
‘surplus labor’.
  Necessary labor produces subsistence and surplus labor produces surplus
value.
 The magnitude of the rate of surplus value or exploitation is determined by the
following factors:
 The productivity of labor
 Real wage
 Length of the working day.
 - All of the above 3 factors may also be used in combination by the capitalists
to enhance the surplus value.

Falling Rate of Profit

 Under capitalism, there was a tendency for the rate of profit to fall in the long
run.
 Marx thought that there was a tendency for the employment of constant
capital(machinery etc) to increase in relation to variable capital(labor) in the
long run.
 Increase in the employment of C takes place mainly because of the desire of
the capitalist to accumulate more and more capital.
 The capitalist also uses it as a method to keep the wages low.
 If the capitalist employed more , wages would rise.
 To prevent this, they introduced more and more machinery.
 Thus they created a huge industrial reserve army and kept wages down.
 The introduction of machinery on a large scale causes unemployment and
misery for the working classes.
 And the capitalist, it results in a falling rate of profit.


Concentration of Capital
 Marx believed that there was a tendency for capital to be concentrated in large
scale production.
 Competition compels the capitalist to cheapen their commodities and this is
done by using capital intensive technology.
 Capital would be concentrated in the hands of a few persons and the large
scale units will have superior competitive ability.
 Small scale capitalists are now driven out of business and they join the ranks
of the proletariat.
 Polarization becomes sharp and the society gets divided into two classes.

Economic Crisis
 Cyclical fluctuations in the form of prosperity and depression were inherent in
the capitalist system.
 Marx gave 3 reasons for the economic crisis: disproportionality in the level of
production, under consumption & falling rate of profits.
 All of the above, mechanization, misery of labourers, falling rate of profit,
crises and concentration of capital, intensified the class struggle.
 The laborers would unite into a force capable of revolutionary action.
  The capitalists, on the other hand, forced by falling rates of profit and
economic crisis try to exploit labor as much as possible.
 Then comes revolution - overthrowing the capitalists using force.

UNIT 2
Behavioral Economics
 it is a combination of psychology and economics that investigates what happens in
markets in which some of the agents display human limitations and complications. As
can be seen from both given definitions behavioral economics is concerned about the
human aspect in decision making as well as economic issues which are relevant.
 The father of behavioral economics - Richard Thaler, the University of Chicago
professor who just won the Nobel Memorial Prize in Economic Sciences.
 Combines insights from psychology, judgment, and decision making, and economics
to generate a more accurate understanding of human behavior.
 Explores why people make irrational decisions, and why and how their behavior does
not follow the predictions of economic models.
 Because humans are emotional and easily distracted beings, they make decisions that
are not in their self-interest and are not the result of careful deliberation.
 According to BE, people are not always
 self-interested,
 benefits maximizing,
 costs minimizing individuals,
 with stable preferences.

 Thinking is subject to insufficient knowledge, cognitive bias, emotions, social

influences, feedback, and processing capability.
 We are influenced by readily available information in memory, automatically
generated affect, and salient information in the environment. We also live in the
moment, tend to resist change, are poor predictors of future behavior, subject to
distorted memory, and affected by physiological and emotional states. We are social
animals with social preferences, such as those expressed in trust, reciprocity and
fairness.
 The Theory of Moral Sentiments, which has been written in 1759 by Adam Smith,
examines “psychological principles of individual behavior that are arguably as
profound as his economic observations” (Camerer and Loewenstein, 2002).
 Back in the 1990s, Thaler began challenging that view by writing about anomalies in
people’s behavior that could not be explained by standard economic theory.
 Upson (2010) mentioned three basic ideas in behavioral economics: First the rule of
thumb principle, second the framing problem, and third market inefficiencies.
 Rule of Thumb: People act according to the principle that you get what you
paid for. Even though cheaper products can often be as good as more
expensive ones, people perceive it as superior and buy the more expensive
goods.
 The framing problem: When people face a problem, their thoughts are affected
by the presentation of the problem.
  Market Inefficiencies: Market inefficiency is concerned about happenings that
doubt the idea of market efficiency. (Market efficiency - prices which reflect
all information available about a stock.)
 The main target of BE is persuasion which increases the fortification of economic
analysis improving theoretical insights, indicating better policies and providing
appropriate predictions of field phenomena.

Standard Economic Model and its Shortcomings:

Mainstream economics is defined as the maximization of an individual’s utility function,
whereby utility is a function of quantity of goods or services (McDonald, 2008), the basis of
this concept tries to explain human behavior on the fact that people’s consumption is
important to them.
Conventional Economics, Mainstream or Standard Economic Model is defined as the
principle of an individual who tries to maximize a utility function, in which utility is a
function of the quantity of goods and services consumed by that individual (McDonald,
2008). It provides explanations of behavior and is based on the fact that people’s own
consumption is very important for them.
The standard or also called neoclassical economic analysis assumes that humans are rational
and behave in a way to maximize their individual self-interest (Dawnay and Shah, 2005). As
this rational assumptions lead to powerful analysis it also has its shortcomings which can end
up in an unrealistic analysis or policy-making.

Standard Economic Model Vs Behavioral Economic Model

For the comparison between behavioral economics and mainstream economics, seven
principles of Dawnay and Hetan (2005) will be used, which is the most understandable and
easy applying criteria. These are as follows:
 Behavior of other people matters which can be influential;
 Habits: hard to change;
 Doing the right thing: we are disappointed at failure;
 Expectations: including perceptions of how others should behave;
 loss aversion: humans try to avoid losses;
 computation problems: probabilities are hard to calculate by hand;
 involvement and effectiveness: people who are involved in different activities are
more motivated.
The dimensions to distinguish BE and ME are as follows: Narrowness, rigidity, intolerance,
mechanicalness, separateness and individualism.
Dimensions Behavioral Mainstream Economics
Economics
Narrowness: If a method or its These three According to Thaler (1996)
scope of substantive inquiry is assumptions are rationality, self-interest and
restricted by an economic taken into account. self-control should be included
discipline one can say that the Low in narrowness. when dealing with economic
economic discipline is narrow. aspects which are not discussed
in mainstream economics. So,
it’s narrowness is an
unquestioning acceptance of
these three assumptions.
Rigidity: Rigidity is high when it It is not rigid. mainstream economics does not
has a strong attachment to a include findings of BE and is
particular form of narrowness. therefore inflexible or rigid.
Intolerance: The unwillingness Not intolerant. McCloskey stated on the matter
to recognize and respect of intolerance that mainstream
differences in opinions or beliefs economics is very arrogant.
Mechanisms: The extend Less mechanical. Veblen (1898) stated that
someone leads his principles. perspectives which are human
Disciplines are high in and evolutionary in mainstream
mechanicalness if they behave economics are lacking. So, it is
as machines. mechanical.
Separateness: Whether Very low According to Hausmann (1992)
discipline can stand alone and is separateness. mainstream economics has a
not dependent on other high degree of separateness
disciplines. from other social science
disciplines.
Individualism: Low Attention is given to mainstream economics is more
individualism implies that the social and group concerned with self-interested
aspect is laid on individuals behavior and individuals.
which are part of a collectivity motivators. Much
or social group which behavior less individualistic.
and motivators differ from an
individual one.
Habits: No cognitive effort is BE takes this into According to ME people try to
needed if we do something out account. maximize their utility
of habit. We do not change rationally. Thus, this principle
because of potential barriers of is not valid for the neoclassical
changing habits and hassles economic approach.
which are associated with that
changing.
Expectations: Behavior is BE relies on the fact Neoclassical practitioners
influenced by people’s self- that our behavior is would not include any concept
expectations. If the behavior influenced by others. of self-expectation or
does not fit to beliefs, attitudes commitments.
and values, people might adjust
these before changing their
behavior.

Loss- Aversion: Two biases are BE practitioners In ME, human’s willingness to

known. First, people will try to include the fact that pay is assumed as being the
avoid losses which can be people will put more same as willingness to accept.
attached to high risks but to gain effort into preventing
something, only small risks are a loss than willing to
 taken. Secondly, if people gain.
understand something as their
own it will gain some extra
value.
Computation Problems: BE considers that not For ME computation problems
Probabilities are hard to be all people have are not relevant as it is assumed
computed by hand and therefore complete information that people have enough
can influence the decision on a about goods or information and are capable of
problem. services. calculations and complex
choices to be done.
Involvement and Effectiveness: BE considers that As ME expects people to act
With too much information more information can rationally, more information
people get the impression of be overwhelming and will be considered as optimal in
helplessness and inaction. With reduce self- order to make the best choice
too many choices, an effectiveness. possible.
overwhelming feeling will arise
and people do not know what to
choose.

7 biases that lead to computation problems:

 Salience: overestimation of likelihood of events. Things that happen often are also
underestimated.
 Discounting: underestimation of relevance of distant future events. Choosing short-
term rewards over long-term rewards.
 Framing: influence of presentation of outcomes when deciding between two actions.
Often combined with loss aversion.
 Defaults: Influence of defaults set by authorities
 Intuition: Intuitive answers, which are more likely to be wrong, will be used instead of
thinking about it with a simple mathematical question.
 Fundamental attribution error: The feeling of having control over a situation is very
important for humans.
 Price can signal value: if something is offered for free, people will not value it the
same as the same product or service which has a monetary price.
The BE modifies three traits of the standard economic model:
 unbounded rationality,
 unbounded willpower.
 unbounded selfishness.

Prospect/Loss-Aversion Theory
Prospect theory was first introduced in 1979 by Amos Tversky and Daniel Kahneman.
If two choices are put before an individual, both equal, with one presented in terms of
potential gains and the other in terms of possible losses, the former option will be chosen.
The underlying explanation for an individual’s behavior is that because the choices are
independent and singular, the probability of a gain or a loss is reasonably assumed as being
50/50 instead of the probability that is actually presented. Essentially, the probability of a
gain is generally perceived as greater.
The certainty effect leads to individuals avoiding risk when there is a prospect of a sure gain.
It also contributes to individuals seeking risk when one of their options is a sure loss.
The isolation effect occurs when people have presented two options with the same outcome,
but different routes to the outcome. In this case, people are likely to cancel out similar
information to lighten the cognitive load, and their conclusions will vary depending on how
the options are framed.
The prospect theory is part of behavioral economics, suggesting investors chose perceived
gains because losses cause a greater emotional impact.
Example -> A = Rs. 50; B = Rs. 100 – Rs. 50 = Rs. 50 => People would choose option A.
The pain of loss > The happiness of gain.
Prospect Theory: An Overview

Mental Accounting
 The concept was first named by Richard Thaler.
 Mental accounting refers to the different values a person places on the same amount
of money, based on subjective criteria, often with detrimental results.
 Individuals should treat money as perfectly fungible when they allocate among
different accounts. (Money is fungible).
 Thaler observed that people frequently violate the fungibility principle.
Ex. Tax Refund is mostly treated as a gift rather than something that they already owed, and
therefore people choose to spend it in a careless way.
Dual-system Theory
This is a concept that individuals have two different sets of decision-making processes.
 Firstly, impulsive, fast, emotional and acts without thinking – but relies on heuristics
and past knowledge/experience.
  Secondly, a more cognitive, deliberate, thinking process which can take in a greater
range of data than just our own experience.
Daniel Kahneman - “Jumping to conclusions is efficient if the conclusions are likely to be
correct and the costs of an occasional mistake acceptable. Jumping to conclusions is risky
when the situation is unfamiliar, the stakes are high and there is no time to collect more
information”
 Thinking fast and slow: For important purchases and decisions, it may be important to
make sure we engage both aspects of our decision-making process.
 Inherent optimism bias: Kahneman notes that our quick decision-making mind often
bases its decisions on past experiences. Weighing up the costs and benefits will lead
to different decision making than relying on the non-thinking aspect. Ex. The
optimistic mind thinks accidents can’t happen to us as it didn’t happen earlier.
 Government nudges: Given that consumers may purchase expensive products under
impulse purchase, many have a mandatory cooling off period where a consumer can
change his/her mind.
Nudge Theory
Any aspect of the choice architecture that alters people’s behavior in a predictable way
without forbidding any options or significantly changing their economic incentives. - Thaler
and Sunstein
Proponents of nudge theory suggest that well-placed ‘nudges’ can
 reduce market failure,
 save the government money,
 encourage desirable actions,
 help increase the efficiency of resource use.
There is a difference between nudging a certain behavior and compelling a certain choice. A
good nudge is:
 Transparent, not hiding costs / other options.
 Choice is retained.
 Good reason to believe that the nudge is warranted.
Example - Putting the fruit at eye level counts as a nudge. Banning junk food does not.
A few practical ways of implementing nudge theory is given below: -
 Up-sell: Offering extra options. Example - ‘drinks, extras and deserts’ with meal.
 Product placement: Related to ‘choice architecture’ – the idea that if goods are
presented in a different way, it can help ‘nudge’ people’s consumption to the desired
option. Example -school lunches could be carefully monitored to reduce unhealthy
options.
 Default options: Setting the desired outcome as the default option.
 Save more tomorrow: Economists Richard Thaler and Shlomo Benartzi developed this
program to nudge people into taking private pension plans. It uses the default choice
of enrolling people in a pension scheme, with the added proviso they only start off
making small contributions which will rise with their wages.
 Calorie/sugar counts: To discourage unhealthy eating, the amount of sugar can be
included prominently on the packaging. Example - By labelling a muffin as 450
calories.
  Use of technology: Technology can be left to make better decisions for people.
Example - the UK behavioral team trialed the use of automated technology, which
was much more successful than educating people about it.
Irrational Decision Making
Irrational means poorly adapted to goals. Rational and nonrational decisions are thought out
with common sense, irrational is not. An irrational decision is a decision that goes against or
counter to logic.
Rationality: Pursuing enlightened self-interest.
When any of these three things are violated, it is an irrational decision.
“… we are not only irrational, but predictably irrational … our irrationality happens the
same way again and again.” — Dan Ariely
Herbert Simon recognized that the individuals mostly do not have complete information and
the mental capacity to process all of the available data.
"Bounded rationality” - Herbert Simon introduced it. The limitation on the ability of
individuals to make entirely rational decisions.
 Individuals can make decisions based on heuristics – these are simple efficient rules
of thumb.
 It places a check on economic theory which assumes firms and consumers are
perfectly rational.
 However, supporters of rational choice theory, assume that if many thousands of
people are making decisions from bounded rationality, then the economic average will
lead to rational behavior, even if not everyone makes ‘perfect decisions.’
 Also, supporters of the rational choice theory argue that in many cases, it is rational to
use rules of thumb. Because the rational choice can often be not to worry about
making ‘optimal choice’ but make life easy.

“Satisficing”- According to Simon, individuals don’t make decisions that maximize utility,
but those that best satisfy their decision criteria in the given situation. Simon called this
behavior
 Satisficing is a decision-making process that strives for adequate rather than perfect
results.
 Satisficing aims to be pragmatic and saves on costs or expenditures.
 Customers often select a product that is good enough, rather than perfect, and that's an
example of satisficing.
 A limitation of satisficing is that there is no strict definition of an adequate or
acceptable outcome.
Demerit goods: Demerit goods are damaging to individuals, but people continue to consume
– either unaware or ignoring their harmful effects. Example - Heavy drinking.

Implications of Irrational Behavior

 Market failure – An inefficient allocation of resources in society. Ex. - If people get
addicted to drugs, the social cost is much higher than the social benefit.
 Nudges – If individuals are prone to emotional/impulsive decisions, both firms and
governments can make use of this in both negative and positive ways.

UNIT 3
Asymmetric Information/Information Failure
Def: When one party in a transaction is in possession of more information than the other.
Often, sellers can take advantage of buyers because asymmetric information as the seller has
more knowledge of the good being sold. The reverse can also be true.
Advantage of AI -
  A more desirable healthy market economy: As workers strive to become increasingly
specialized in their chosen fields, they become more productive, and can consequently
provide greater value to workers in other fields.
Disadvantage of AI -
 Adverse selection: A phenomenon where an insurance company encounters the
probability of extreme loss due to a risk that was not divulged at the time of a policy's
sale.
Prevention of Frauds: Financial markets often rely on reputation mechanisms. Financial
advisors and fund companies that prove to be the most honest and effective stewards of their
clients' assets tend to gain clients, while dishonest or ineffective agents tend to lose clients,
face legal damages, or both.
Adverse Selection
It is a case where asymmetric information is exploited.
Seller as the more knowledgeable party: A seller may have better information than a buyer
about products and services being offered, putting the buyer at a disadvantage in the
transaction.
Buyer as the more knowledgeable party: In the case of insurance, adverse selection is the
tendency of those in dangerous jobs or high-risk lifestyles to purchase products like life,
health or disability insurance. If the company charges an average price but only high-risk
consumers buy, the company takes a financial loss by paying out more benefits or claims.
In the case of insurance, avoiding adverse selection requires identifying groups of people
more at risk than the general population and charging them more money by raising their
premium.
 The lemon Problem: Refers to issues that arise regarding the value of an investment
or product due to asymmetric information possessed by the buyer and the seller.
 This theory was put forward in a 1970 research paper titled, “The Market for
'Lemons': Quality Uncertainty and the Market Mechanism”, written by George A.
Akerlof.
 Akerlof examined the used car market and illustrated how the asymmetry of
information could cause the market to collapse, getting rid of any opportunity for
profitable exchange and leaving behind only "lemons"(poor products with low
durability).
 Akerlof's original example noted that the buyer may be willing to pay no more
than an average price, which they perceive as somewhere between a bargain price
and a premium price. This may appear to offer the buyer some degree of financial
protection, it actually favors the seller, as an average price would still be more if
the buyer knew the car was a lemon.
 Ironically, it creates a disadvantage for a premium vehicle seller, since the
potential buyer's resulting fear of getting stuck with a lemon means they will
avoid a premium price for a superior vehicle.
Solutions to lemon problem:
 Strong warranties: Akerlof proposed strong warranties as one means of overcoming
any negative consequences of buying a lemon.
  Internet: Another solution that Akerlof knew nothing about in 1970 is the explosion
of readily available, widespread information through the Internet.

 Lemon Laws: Lemon laws are regulations that attempt to protect consumers in the
event that they purchase a defective vehicle or other consumer products or services
that do not meet their purported quality or usefulness.
 Lemon laws have been enacted in every U.S. state and the District of Columbia as
well as at the federal level.
 The kinds of goods lemon laws cover and how far consumers are protected
depends on the jurisdiction of the law, but the term "lemon law" originally
referred to defective automobiles that were called lemons.
 Lemon laws are generally used to legally hold manufacturers to reasonable
implementation of their warranties.
 No lemon law for India. No law compels a vehicle seller to offer warranty to the
buyers.
Moral Hazard
Moral hazard is the risk that a party
 has not entered into a contract in good faith, or
 has provided misleading information about its assets, liabilities, or credit capacity, or
 can take risks without having to suffer consequences.
A moral hazard occurs when one party in a transaction has the opportunity to assume
additional risks that negatively affect the other party. The decision is based not on what is
considered right, but what provides the highest level of benefit, hence the reference to
morality.
Moral hazard is common in
 lending industries
 insurance industries
 employee-employer relationships.
Leading up to the 2008 financial crisis, the willingness of some homeowners to walk away
from a mortgage was a previously unforeseen moral hazard.
When moral hazards in investing lead to financial crises, the demand for stricter government
regulations often increases.
 Principal-Agent Problem
The principal-agent problem occurs when a principal delegates an action to another
individual (agent), but
 Firstly, the principal does not have full information about how the agent will behave.
 Secondly, the interests of the principal diverge from that of the agent, I.e., the agent
does not share the same interest in maximizing profits as the principal.
Requirements of principal-agent problem: -
 Multiple actors who have a different set of objectives.
 Asymmetric information (the agent having more information than principle).
Examples of principal-agent problem: -
 Shareholders and managers of a company.
 Landlord and tenant.
 Sub-contracting essay. (A lazy student paid a random stranger to write a dissertation.
Apart from being cheating, the person writing the essay in anonymity has not the
same motivation and may not care about the quality.)
Costs of Principal-Agent Problem: -
 Agency costs: Due to information asymmetries, principals may be unaware of how
much a contract has been fulfilled or to enter into a contract at all for the fear that they
will not know what is going on.
 Inefficiency: It enables agents to produce sub-optimal work.
 Cost of monitoring/incentives: The principal will have to spend money on monitoring
and providing incentives for workers to avoid this.
“However, it is generally impossible for the principal or the agent at zero cost to ensure that
the agent will make optimal decisions from the principal’s viewpoint.” - Jensen and Meckling
(1976)
Overcoming this problem: -
 Tipping: Waiters who rely on tips for pay will have their interests more aligned with
owners (principals).
 Performance Related Pay: Giving agents an incentive to work hard by proper
implementation.
 Different workplace environment: A management structure which encourages
independence and workers taking responsibility for work can be more effective than
crude pay bonuses.

 Efficiency Wage Theory

The idea is that increasing wages can lead to increased labor productivity because workers
feel more motivated to work with higher pay.
Reasons for efficiency wage theory: -
 Fear of losing jobs – “Shirking model”: Shapiro and Stiglitz posited that a worker
with a higher wage will work at an effort level which involves no shirking. This wage
is above market-clearing levels.
 Loyalty: Workers may just feel more loyalty towards the company and be willing to
work harder and with more determination.
 Labour market “Gift Exchange”: Firms could pay wages above market-clearing
levels, and in return, workers would take on more responsibility and initiative.
 Lower costs of supervision: Workers receiving higher wages were more motivated
and therefore needed less managerial supervision.
 Attract higher quality labor: It will attract a better-quality worker who will feel they
can get a relatively better-paid job.
 Nutritional theories: Better health, and nutrition lead to better quality labor.
Limitations of efficiency wage theory
 In practice, many factors like work conditions, management, etc. determine worker
morale and productivity other than wages. If these are negative, then higher wages
may be insufficient to boost productivity.
 Depends on the reaction of other firms and if they also start paying above market
clearing levels.
 Firms with monopsony power may not need to pay higher wages to create the threat
of workers losing their jobs.
Involuntary Unemployment and Efficient Wage Theory – DID NOT UNDERSTAND
Adverse Selection Vs. Moral Hazard
Adverse selection Moral Hazard
Adverse selection is the phenomenon Moral hazard is the phenomenon that having
that bad risks are more likely than insurance may change one’s behavior. If one is
good risks to buy insurance. insured, then one might become reckless.
It is a before contract thing. It is an after contract thing.
It is about the type of people that are It is how the behavior of the people change after
attracted to such incentives. the contract following the incentive.

Game Theory
Game study is the study of strategic interaction where one player’s decision depends on what
the other player does. What the opponent does also depends upon what he thinks the first
player will do.
All models of game theory only work if the players involved are "rational agents".
Prisoner’s Dilemma
Here, both parties choose to protect themselves at the expense of the other. As a result, both
participants find themselves in a worse state than if they had cooperated with each other in
the decision-making process. This is a situation where individual decision makers always
have an incentive to choose in a way that creates a less than optimal outcome for the
individuals as a group.

Examples of Prisoner's Dilemma: -

 Tragedy of the commons: It may be in collective advantage to conserve a common
pool natural resource, but each individual always has an incentive to instead consume
as much as quickly as possible, which then depletes the resource.
 Behavior of cartels: All members of a cartel can collectively enrich themselves by
restricting output to keep the price that each receives high enough to capture
economic rents from consumers, but each cartel member individually has an incentive
 to cheat on the cartel and increase output to also capture rents away from the other
cartel members.
3 ways to combat prisoner’s dilemma: -
 Rewarding and Punishing: Most interactions are repeated more than once (called
iterated prisoner’s dilemma). In such case, the players can choose strategies that
reward co-operation or punish defection over time.
 Developing formal institutional strategies: To alter the incentives that individual
decision makers face.
 Behavioral biases: These will likely develop over time that undermine “rational”
individual choice in prisoner’s dilemmas and lead groups of individuals to
“irrationally” choose outcomes that are most beneficial to all together.

Nash Equilibrium
 Nash Equilibrium is:
1. a stable state of a system
2. that involves several interacting participants
3. in which no participant can gain by a change of strategy
4. as long as all the other participants remain unchanged.
 It was introduced by John Forbes Nash, Jr. in 1950 and was republished in 1952.
 No actor has an incentive to change from their chosen strategy, taking all factors
constant.
 Players in this outcome must consider the affairs of the other. The alternative leaves
either of the players in a lesser preferred state.
 The primary limitation of the Nash equilibrium is that it requires an individual to
know their opponent's strategy.

Dominant Strategy
The dominant strategy in game theory refers to a situation where one player has a superior
tactic regardless of how the other players act.
The Nash Equilibrium is an optimal state of the game, where each opponent makes optimal
moves while considering the other player’s optimal strategies.
There are four probable outcomes in game theory – the strict dominant, the weak dominant,
the equivalent, and the intrusive.
A Nash equilibrium describes the optimal state of the game where both players make optimal
moves but now consider the moves of their opponent.

Dominant Strategy Nash Equilibrium

It is the optimal move for an It is the optimal state of the game where both players
individual regardless of how other make optimal moves but now consider the moves of
players act. their opponent.

Overcoming Asymmetric information

 Giving signals - Invest in the business: If a car dealer invests in a large property and
advertising, it is a signal that the firm intends to stay in the long-term. In this case, the
firm has a greater incentive to sell reliable cars and avoid costs to its reputation.
 Warranties, Guarantees, and Refunds: In car markets and for their reliability.
 Employing an expert to test before buying: It would be worth paying to a qualified
mechanic to run the car through independent tests. Also, the car dealer would be wary
of trying to sell ‘duds’ if you were bringing a qualified mechanic to test.
 No claims bonuses: By giving big discounts for ‘no claims bonuses’, insurers can gain
better information about ‘careful’ and ‘unlucky’ consumers.
 Lemon laws: The government can step in to regulate the quality of good sold.
 Monitoring: Another intuitive and natural response is for consumers and competitors
to act as monitors for each other.
UNIT 4
Market Failure
A market failure is when there is
 an inefficient distribution of goods and services
 that leads to a lack of equilibrium in a free market
 due to some outside force.
The law of supply and demand is meant to lead to an equilibrium in prices, and when it does
not, it indicates a factor in the market has failed.
Market failure can be caused by
 monopolies
 a lack of perfect information
 public goods
 Externalities.
Externality
An externality is a
 cost or benefit (positive or negative)
 caused by a producer
 which impacts a third party
 is not financially incurred or received by that producer
 can stem from either the production or consumption of a good or service
 can be both private (to an individual or an organization) or social (affect society as a
whole)
 may be intentional or unintentional.
People advocate for government intervention to curb negative externalities through taxation
and regulation.
Positive Externalities Negative Externalities
Positive externalities occur Externalities are negative when the social costs outweigh
when there is a positive gain the private costs. Most externalities are negative. (Social
on both the private level and Marginal Cost > Private Marginal Cost)
social level.
Ex - Research and Ex - Pollution - A corporation may decide to cut costs by
development (R&D) implementing new operations that are more harmful to the
conducted by a company environment. Traffic Congestion – Can be tricky to handle
since no business owns the roads and the individual drivers
have no distinct property rights.

Overcoming Negative Externalities

Through government intervention such as new laws or taxes, tariffs, subsidies, and trade
restrictions. The solution is to convince the recipient of external benefits or the producer of
external costs to pay fairly for them.
1. Taxes: Governments can impose a tax on the goods causing the externalities. Ex -
Pigovian tax/Pigouvian tax—considered to be equal to the value of the negative
externality and is meant to discourage activities that impose a net cost to an unrelated
third party.
2. Subsidies: Encouraging the consumption of a positive externality. Ex - subsidizing
orchards that plant fruit trees to provide positive externalities to beekeepers.
3. Legislation and Regulation: The most common solution to offset the effects of
externalities as the public often turns to governments. Ex - environmental regulations
or health-related legislation.
4. Protection private property rights: If those rights are not clear, market failure can
occur. A legal system that protects private property rights is often the most efficient at
correctly distributing costs and benefits to all parties, as long as there is a measurable
economic impact to each of them.
Pareto Optimal Solution/Pareto Efficiency: This theory states that it is sometimes impossible
to arrive at a resolution that makes someone better off without also making someone else
worse off.
Pareto optimality represents an ideal that is probably impossible. That is, that an exchange of
goods or services could occur in which every single person who is directly or indirectly
affected by it is perfectly satisfied.

Pollution Permits
 Pollution permits involve giving firms a legal right to pollute a certain amount. Ex -
100 units of Carbon Dioxide per year.
 If the firm produces less pollution, it can sell its pollution permits to other firms.
 However, if it produces more pollution it has to buy permits from other firms or the
government.
 This creates a market for pollution permits with the price set by demand and supply.
The aim:
 to provide market incentives for firms to reduce pollution and reduce the external
costs associated with it.
 to make the price of pollution permits as close as possible to the social marginal cost.
 a way for the government to raise revenue by selling firms these permits.
HAS A BUNCH OF GRAPHS LIKE I’M DEAD💩
Pollution permits and social efficiency
If firms produce carbon as a side-effect of production - negative externality. (the social
marginal cost of the polluting industry > private marginal cost).
In a free market, we get over-production of pollution and social inefficiency.

Property Rights
Property rights define the theoretical and legal ownership (by individuals, businesses, and
governments) of resources (tangible or intangible) and how they can be used.
They are:
 secured by laws that are clearly defined and enforced by the state.
 define ownership and any associated benefits that come with holding the property.
 generally owned by individuals or a small group of people.
 can be extended by using patents and copyrights to protect:
 Scarce physical resources such as houses, cars, etc.
 Non-human creatures like dogs, cats, etc.
 Intellectual property such as inventions, ideas, etc.
 give the owner or right holder the ability to do with the property including
 holding on to it,
 selling or renting it out for profit,
 transferring it to another party.

communal or government property

 are legally owned by well-defined groups in positions of political or cultural power.
 typically deemed public property.
Private property
Individuals in a private property rights regime acquire and transfer in
 mutually agreed-upon transfers (include)
 rents,
 sales,
 voluntary sharing,
 inheritances,
 gambling,
 charity.
 through homesteading - acquiring a previously unowned resource by mixing his labor
with the resource over a period of time (include)
 plowing a field,
 carving stone,
  domesticating a wild animal.
Open-Access Property
 no one owns or manages it
 Ex. -waterways.
In areas where property rights don't exist, the ownership and use of resources are allocated by
force, normally by the government by political ends rather than economic ones. Here
governments determine who may interact with, can be excluded from, or may benefit from
the use of the property.

Private Property Rights

Private property rights are one:
 Where individuals need the ability to exclude others from the uses and benefits of
their property and have exclusive right to use and benefit off of that property.
 Is of the pillars of capitalist economies, many legal systems, and moral philosophies.
 only a single user may possess the title and legal claim to the property.
 whose owners may exchange the resource on a voluntary basis.
 where each transaction takes place between one property owner and someone
interested in acquiring the property.
 the value at which the property exchanges depend on how valuable it is to each party.
Public Goods and Common Resources
Excludable Non-excludable

Rival Private Goods Common Resources

(Food) (Fish in the ocean)
Non- Club Goods Public Goods
rival (Cable TV) (National Defense)

Excludability
 Property of a good whereby a person can be prevented from using it
 Excludable: MOS rice burgers, Wi-Fi access
 Not excludable: radio signals, national defense
Rivalry in consumption
 Property of a good whereby one person’s use diminishes other people’s use
 Rival: MOS rice burgers
 Not rival: An MP3 file of David Tao’s latest single
Public Goods
 Def: A commodity or service that is made available to all members of a society.
 Must be non-rivalrous and non-excludable.
 Typically, these services are administered by governments.
 Are paid for collectively through taxation.
 Free rider: -
  Person who receives the benefit of a good but avoids paying for it.
 The free-rider problem: - Prevents the private market from supplying the
goods (leading to Market failure).
 Ex - People who do not pay taxes, for example, are essentially taking a "free
ride" on revenues provided by those who do pay them.
 The opposite of a public good is a private good.
 “Quasi-public” goods: -
 Not fully non-rivalrous and non-excludable.
 Although they are made available to all, their value can diminish as more people use
them.
 Ex - the post office (using it does require some nominal costs, such as paying for
postage.)
 Ex - a country’s road system (their value decline when they become congested during
rush hour.)
Common Resource/ Open-Access Resource
 Def: A common resource (or the "commons") is any scarce resource that provides
users with tangible benefits but which nobody in particular owns or has exclusive
claim to.
 A major concern is overconsumption, under-investment, and ultimately depletion in
long-term. (Tragedy of commons)
 Generally, the resource of interest is easily available to all individuals.
Tragedy of Commons
 Although technically created by Garrett Hardin, 'the tragedy of the commons,'
originated with Adam Smith.
 Due to interplay of individuals and private economic agents exploiting scarce and
rival common resources (environmental) for their own rational, self-interested
purposes
 leading to over-production and, ultimately, the possibility of an irreversible depletion
of them.
 As consumers do not own common goods, they have little incentive to preserve or
multiply them, but rather to extract maximum personal utility or benefit while you
still can.
 Happens especially when there are poor social-management systems in place to
protect the core resources.
 Proves that 'invisible hand' doesn't always reach for self-interested, rational actions to
socially optimal outcomes.

Overcoming Tragedy of Commons

1. Regulatory Solutions
 Direct Control: Top-down government regulation or direct control of a common-pool
resource by regulating consumption and use, or legally excluding some individuals.
 Ex - setting limits on how many cattle may be grazed or issuing fish catch
quotas.
 Tend to suffer from the well-known rent-seeking, principal-agent, and
knowledge problems that are inherent in economic central planning and
politically driven processes.
  Assigning Private Property Rights: Assigning such over resources to individuals and
effectively converting a common-pool resource into a private good.
 Institutionally this depends on developing some mechanism to define and
enforce private property rights.
 Technologically it means developing some way to identify, measure, and mark
units or parcels of the common pool resource off into private holdings.
 Problem: government forcibly assuming control over a common-pool resource
and then assigning private property rights over the resource to its subjects
based on a sale price or simple political favor.
2. Collective Solutions
 It is about co-operative collective action (as described by economists led by Nobelist
Elinor Ostrom.)
 By limiting use to local farmers and herders, managing use through practices such as
crop rotation and seasonal grazing, and providing enforceable sanctions against
overuse and abuse of the resource.
 Can be useful in situations where technical or natural physical challenges prevent
convenient division of a common-pool resource in to small private parcels.
 Often this also involves limiting access to the resource to only those who are parties
to the collective action arrangement, effectively converting a common pool resource
in to a kind of club good.

UNIT 5

Transition Cost
A transaction cost is any cost involved in making an economic transaction other than the
money price that are incurred in trading goods or services.

High transaction costs are very often at the root of externalities, especially in those situations
where the external costs or benefits accrue to very large numbers of third parties.

It is in the interests of management to internalize transactions as much as possible, to remove

these costs and the resulting risks and uncertainties about prices and quality.

 Search and Information costs: (to find the supplier or customer)

  In reality, information is substantially incomplete and there exists market
uncertainty. No decision maker knows immediately and automatically who
will buy or sell each commodity.
 An individual contemplating a particular market transaction must search for a
suitable party with whom to deal, and the search process inevitably results in
costs.
 Bargaining costs: (to purchase or sell the component)
 No decision maker knows immediately and automatically under what
conditions to buy or sell each commodity.
 Policing and enforcement: (to monitor quality)

 Bounded rationality: our limited capacity to understand business situations, which

limits the factors we consider in the decision.
 Opportunism: actions taken in an individual's best interests, which can create
uncertainty in dealings and mistrust between parties.
 Frequency: how often such a transaction is made.
 Uncertainty: close and long-term relationships are more uncertain, lack of trust leads
to uncertainty.
 Asset specificity: how unique the component is for your needs.

Internal transactions
Transaction costs still occur within a company, transacting between departments or business
units.
The degree of impact of the three variables that leads to a precise determination of the degree
of monitoring and control needed by senior management: -
1. Asset specificity: amount the manager will personally gain.
2. Certainty: or otherwise of being caught.
3. Frequency: endemic nature of such action within corporate culture

Agency Theory Vs Transaction Theory

Both deal with the same issues and problems.
Agency Theory
focuses on the individual agent.
looks at the tendency of directors to act in
their own best interests, pursuing salary and
status.
Transaction Theory
focuses on the individual transaction.
considers that managers (or directors) may
arrange transactions in an opportunistic
way.

 Opportunistic behavior could have dire consequences discouraging potential

investors.
 Businesses therefore try to minimize the impact of bounded rationality and
opportunism.
 Governance costs build up including internal controls to monitor management.
Managers become more risk averse seeking the safe ground of easily governed
markets.

Coarse Theorem
 Developed by economist Ronald Coase regarding property rights.
 The Coase Theorem is applied when there are conflicting property rights.
 Def: The Coase Theorem states that under ideal economic conditions, where there is a
conflict of property rights, the involved parties can bargain or negotiate terms that will
accurately reflect the full costs and underlying values of the property rights at issue,
resulting in the most efficient outcome.
 Conditions for it to apply:
 competitive markets must be in place
 zero transaction(bargaining) costs (information must be free, perfect, and
symmetrical.)
 Perfect information.
 No market power difference.
 Efficient markets for all related goods and production factors.
 involved parties do not consider issues such as personal sentiment, social
equity, or other non-economic factors.
 Applied to situations where the economic activities of one party impose a cost on or
damage to the property of another party.
 Based on the bargaining during process, funds may either be offered to compensate
the damage bearing party or to pay the party inflicting damages to stop that activity.
 Real World Application
  Because the conditions necessary for the Theorem to apply in real-world
disputes over the distribution of property rights virtually never occur outside
of idealized economic models, its relevance is questionable.
 Can be viewed as a prescription and not an explanation to these real-world
shortfalls.

Bounded Rationality
 Def: The idea that the cognitive, decision-making capacity of humans cannot be fully
rational because of a number of limits.

These limits include:

1. Information failure – there may be not enough information, or it may be unreliable, or
maybe not all possibilities or consequences have been considered.
2. Frequency of decision-making.
3. The limits of the human brain to process every piece of information and consider ever
possibility.

 To make decision, we end up using “rules of thumb”, heuristics, or rely on

automatized routine.
 This suggests that markets rarely work perfectly.
 Behavioral economists point out that bounded rationality and irrationality are different
because decision-makers are still attempting to make as rational a decision as
possible.