MARKET AND

GOVERNMENT
FAILURES
Public Goods, Externalities, Information Asymmetries
INTRODUCTION
 If all markets were perfect, we would only have to
study supply and demand carefully, and be done
with it.
An essential property of imperfect markets is that
they are contagious: a market failure in some sector
can lead to problems in other markets.
INFORMATION: UNOBSERVED
ACTIONS
 Suppose that you are leasing out land to a tenant. Ideally, you write
this into a contract: “our agreement requires that you work ten
hours a day, with a break for meals.”
 Such clauses are useless if you are an absentee landlord.
 You could respond, “I can tell just by looking at what he produces.”
Can you? Many factors determine output: the hardworking or lazy
tenant, the rains, crop damage caused by pests, and so on.
INFORMATION: UNOBSERVED
TYPES
A nongovernment organization (NGO) is lending to
poor farmers. Although not necessarily driven by
profits, it would like to cover its costs of lending.
The problem is that some borrowers are intrinsically
bad risks, but the NGO cannot spot this by looking
at a borrower’s face and, moreover, past records are
misleading or nonexistent. What can do?
ENFORCEMENT: LIMITED
LIABILITY
 Suppose that you are a moneylender advancing a loan. You know
that the loan will be used in an investment project that is risky. If it
pays off, you will get your money back with interest, but if it does
not, you will get nothing.
 This very natural limited liability constraint can have sharp
implications: borrowers who are thus insulated may want to
overinvest in risky projects. You do not raise loan levels afraid of
losing more if the project collapses, yet you are afraid to raise
interest rates, because in this way you attract the more risky
borrowers.
AGRICULTURE LAND AND
LABOR MARKETS
 Land and labor are important assets in the economy, and
distribution of land holdings is likely to be far more unequal than
the distribution of labor endowments.
 Labor market: Under this scenario, the agricultural labor market
clears by allocating labor from those who have little land to those
who have a lot. (Hire labor!)
 Land rental market: tracts of land leased from landlords to tenants
in exchange for rent or perhaps a share of the crop.
 Which market will dominate?
AGRICULTURE LAND AND
LABOR MARKETS
 Assume that the efficient production ratio is one Farmer to work in
one Hectare. A different ratio is inefficient.
 Labor market: the agricultural labor market clears by allocating
labor from those who have little land to those who have a lot. (Hire
labor  Plantations dominate!)
 Land rental market: tracts of land leased from landlords to tenants
in exchange for rent or perhaps a share of the crop.
Tenanted lands dominate!
 Depending on which market will dominate?
AGRICULTURE LAND AND
LABOR MARKETS
 Assume that the efficient production ratio is one Farmer to work in
one Hectare. A different ratio is inefficient.
 Labor market: the agricultural labor market clears by allocating
labor from those who have little land to those who have a lot. (Hire
labor  Plantations dominate!)
 Land rental market: tracts of land leased from landlords to tenants
in exchange for rent or perhaps a share of the crop.
Tenanted lands dominate! The social-economic outcome
depends on which market will dominate?
AGRICULTURE LAND AND
LABOR MARKETS
 In the “Inputs of Production” markets: If one input market
fails, the other input market must compensate to achieve
efficient ratio of inputs, such as one Farmer to work in One
hectare.
 Why do we need both markets to function when it seems that
one is a perfect substitute for the other? Is it not the case that
labor “moving” to join land for a wage is the same as land
“moving” to join labor for a rent?
AGRICULTURE LAND AND
LABOR MARKETS
 If markets were perfectly competitive, if production
exhibited constant returns to scale, and there were no
uncertainty, a labor market would generate equilibrium
wages to labor. What’s left is rent to the landlord.
 By constant returns to scale, all rents per acre must be
identical across landlords. Now a tenancy contract for the
same level of rent must yield, as a residual, the same
income as the equilibrium wage to a laborer.
AGRICULTURE LAND AND
LABOR MARKETS
 Matters are different if the foregoing conditions do not
hold. For instance, if there is some increasing returns to
scale (over a range at least), land will be rented in large
chunks and the labor market will also be needed to allocate
labor to the farmers of these large tracts of land.
AGRICULTURE INPUT
MARKETS
 For instance, a critical input is animal power. Then the ownership
of bullocks becomes relevant. With this mental extension, we now
have three sets of inputs: land, labor, and bullock power. Typically,
the ownership of these three inputs will be distributed differently
among the population. The use of input markets brings the ratios of
these inputs into balance with one another, so that they can be used
in an efficient way for cultivation. If one of these markets fails
quite dramatically, the other two will have to compensate somehow.
AGRICULTURE INPUT
MARKETS
 At this point yet another market must make an appearance.
This is the market for credit or capital. Bullocks, other
inputs, and indeed land should all be possible to acquire,
provided that their acquisition is profitable. A perfect credit
market will make the necessary funds available, and our
story of markets working to bring endowments into
operational line can be largely dispensed with.
AGRICULTURE INPUT
MARKETS
 However, if the credit market fails, the other markets will have
to adjust accordingly. For instance, without access to working
capital (which entails the purchase of other inputs such as
fertilizer or pesticides), a farmer may be constrained to lease
out part or even all of his land and his labor as well. In other
words, the lack of a capital market might create a situation in
which land and labor flow from those who have no access to
capital to those who do.
AGRICULTURE INPUT
MARKETS
 In this increasing complexity it is best to keep a single rule
of thumb in mind: the more flexible markets will attempt
to adjust for the failings of the less flexible markets,
bringing the “flexible” inputs into line with the
“inflexible” ones. So, for instance, in a situation of
restricted credit, land and labor markets are both likely to
funnel inputs in the direction of those who have access to
capital equipment or bullocks.
TECHNOLOGY AND MARKET
DISRUPTIONS
TECHNOLOGY AND MARKET
DISRUPTIONS
New technology disrupts current value of physical
and human capitals. Ex., new sources of energy that
decrease the value of “Fossil oil’s physical and
human capitals”
Artificial intelligence (robotics) that will replace
human labor. How to put economic sense into these
issues?
TECHNOLOGY AND MARKET
DISRUPTIONS
 1900 – 41 percent of US workforce were in agriculture
 2000 and currently – only 2 percent are in agriculture
ATM Machines in US: 1995: 200,000 and by 2010: 400,000
Bank Tellers: 1980: 50,000 and by 2010: 550,000
 #tellers/bank reduced by 30%
 But bank branches went up by 40% out of lower cost
 Higher demand of complementary banking services
AUTOMATION AND MARKET
DISRUPTIONS
 Automation does indeed substitute for labor
 However, automation also complements labor
 Raises outputs in ways that lead to higher labor demand
 Interacts with adjustments in labor supply
 Does not necessarily reduce aggregate employment even
as it demonstrably reduced labor requirement per unit of
output reduced.
TECHNOLOGY AND MARKET
DISRUPTIONS
 Changes in technology do alter the types of jobs available
 Interplay between machine and human comparative advantage
allows AI to substitute for worker in routine tasks amplifying the
comparative advantage of workers in supplying problem solving
skills, adaptability, and creativity.
 Machines and AI both substitute and complement labor
 Automation raises the value of the tasks that workers uniquely
supply.
TECHNOLOGY AND MARKET
DISRUPTIONS
 Tasks that cannot be substituted by automation are
generally complemented by it, because most work
processes draw upon a multifaceted set of inputs: Physical
and human; brains and brawns; creativity and rote
repetition; technical mastery and intuitive judgement;
perspiration and inspiration; improvement in one do not
obviate the need for the other. Productivity in one task,
increases the value of the remaining tasks.
TECHNOLOGY AND MARKET
DISRUPTIONS
 1st, workers will benefit if they supply the complementary tasks to
the tasks that were automated.
 2nd, the elasticity of labor supply can mitigate wage gains.
 3rd, output elasticity of demand combined with income elasticity of
demand can either dampen or amplify the productivity gains of
automation.
 Over the long run, gains in productivity have not lead to shortfall in
demand for g and s as HH consumption increase
TECHNOLOGY AND MARKET
DISRUPTIONS
 Difficult to automate: problem solving, intuition, creativity,
and persuasion – professional, managerial, technical
 Difficult to automate: situational adaptability, visual and
language recognition in-person interaction such as service
works: security and protection, food preparation and
services, health care…
TECHNOLOGY AND MARKET
DISRUPTIONS
 Wages increased – technology has boosted the output of
professionals while demand for their services has kept
pace: strong complement with routine tasks, elastic
demand for professional services, and inelastic
professional labor supply.
 While wages did not increase in manual tasks-intensive
work in services because it is relatively price inelastic
while labor supply is elastic.
TECHNOLOGY AND MARKET
DISRUPTIONS
 Let us assume that a new Kubota is invented with lesser cost and
combines 1. rice transplanter, 2. thresher, 3. harvester. Assume also
that seasonal labor is no more…
 If the output of Rice industry were to remain unchanged, it would
released large K (old obsolete Kubota machines) and small amount
of owner-farmers.
 Since the demand for Rice is relatively inelastic, then small amount
of labor released will not be reabsorbed.
MONEY, BANK RUNS, THE
MACROECONOMY
ASSETS LIABILITIES
Reserves - 200 Deposits - 750
Loans - 500 Debt - 200
Securities - 300 Capital – 50 (owners’ equity)

Assume the value of total assets decreased by 5%.

MONEY, BANK RUNS, THE
MACROECONOMY
1st Bank: ASSETS LIABILITIES
Reserves - 200 Deposits – 1,000
Loans - 800

2nd Bank: Assets Liabilities

Reserves - 160 Deposits - 800
Loans - 640

Assume the reserve requirement is 20 percent.

MONEY, BANK RUNS, THE
MACROECONOMY
 Concept of Velocity: the rate at which money circulates
 definition: the number of times the average dollar bill changes
hands in a given time period
 example: In 2003,
$500 billion in transactions
money supply = $100 billion
The average dollar is used in five transactions in 2003
So, velocity = 5
MONEY, BANK RUNS, THE
MACROECONOMY
 This suggests the following definition of Velocity of
Money:
T
V 
M
where
V = velocity
T = total value of all transactions
M = money supply
MONEY, BANK RUNS, THE
MACROECONOMY
 Use nominal GDP as a proxy for total transactions.
Then,
P Y
V 
M

where
P = price of outputs (Price Level)
Y = quantity of output (real GDP)
P Y = value of output (nominal GDP)
MONEY, BANK RUNS, THE
MACROECONOMY
M V  P Y M V P Y
  
M V P Y

How the price level (inflation) is determined:

With V constant, the money supply determines nominal
GDP (P Y )
Real GDP is determined by the economy’s supplies of K and
L and the production technology
Thus Money Supply determines Inflation!
 MONEY, BANK RUNS, THE
MACROECONOMY
 
𝒓= 𝒊 − 𝝅 i M2 M1
 
r = real interest rate L = money demand
i = nominal interest rate Y = income
= inflation rate M = money supply
i2

M V P Y i1
  
M V P Y L (i, Y )

M
GOVERNMENT FAILURES:
DISCUSSION
Problems inherent in representative government made up of
legislators, executives, and judges:
 Dilemma of choosing between what is good for society
that is not necessarily a preference and priority of their
constituencies.
Three factors of representative behavior: 1) Self-interest, 2)
individual constituents will incur costs to monitor
representatives, 3) party discipline or somewhat like…
GOVERNMENT FAILURES:
DISCUSSION
Preference of School Budget
Allococation
Voters group First Second Third Percent of
choice choice choice voters
Moderates Medium High Low 45%
Conservatives Low Medium High 35%
Schoolers High Low Medium 20%
GOVERNMENT FAILURES:
DISCUSSION
Agenda A (Result: Medium)
 Round 1: High vs. Low High wins 65% to 35%
 Round 2: Medium vs. High Medium wins 80% to 20%
Agenda B (Result: High)
 Round 1: Medium vs. Low Low wins 55% to 45%
 Round 2: Low vs. High High wins 65% to 35%
Agenda C: (Result Low)
 Round 1: High vs. Medium Medium wins 80% to 20%
 Round 2: Medium vs. Low Low wins 55% to 45%
GOVERNMENT FAILURES:
DISCUSSION
Arrow General Impossibility Theorem
1. Given freedom of each person to choose, let us say from three
alternatives A, B, and C.
2. Given the requirement of transitivity: A to B, B to C, therefore B
to C.
3. Given independence of ranking alternatives: B to C, even without
A, and with A, it will still be B to C.
4. Given NO Dictatorship allowed.
 Arrow concludes: There is no fair transitive social ordering if
required to follow all four (4) requirements above. CYCLE
GOVERNMENT FAILURES:
DISCUSSION
 Tyranny of majority
 Minorities with intense preferences
 Paradox of voting
 Democratic processes do not always give us a true
statement of the social values and benefits.
 Hence, government following “the will of the people” will
not be always doing good.
THANK YOU AND
RANDY TUANO AND
EDWIN YAPTANGCO
WILL TAKE OVER
FOR THE NEXT 4
SESSIONS!