Econmfyg Essay Research Paper MARKET FAILURE AND

Econmfyg Essay, Research Paper

MARKET FAILURE AND UNCERTAINTYIn this essay I would like to argue that market failure is the reason for hierarchy. I willargue that market failure leads to uncertainty and that uncertainty leads to incompletecontracts. To explore the notion of incomplete contracts I have used the ideas of Milgromand Roberts. They describe how incomplete contracts can lead to a “relational contract” oran “implicit contract. I will argue that relational contracts can lead to the formation ofan organisation. Once an organisation is established it differs from other equallyorganisations by its social capital. This social capital, I will argue, leads again touncertainty and again to incomplete contracts. To prove this I will use repeated game theoryand the folk theorem. I believe that the uncertainty within an organisation leads toimplicit contracts that capture the reputation of cooperation of the members of theorganisation. In conclusion I will argue that this reputation of cooperation is corporateculture. In the first part of ‘Managerial Dilemma’ Miller argues that hierarchy, at least in theory,exists by the grace of market failure. Market failure is described by Miller (1992) as:”(…) market equilibria that fail to allocate resources efficiently” (p.17). Miller statesthat market failure is caused by market power, information asymmetries and (team)externalities. However if I take a closer look at these reasons for market failure I willargue that they can be the reason to form an organisation, but not nesecarily have to be. Market power by a small number of parties increases the amount of uncertainty about howthese parties are planning to use this power in ongoing or future transactions when faced byunforeseen contingencies. Information asymmetry -when one party is deprived of vitalinformation available to the other side- also raises the amount of uncertainty about how theother party is likely to react to unforeseen contingencies. The third reason for marketfailure (externalities) can also be seen as driver for uncertainty since transactions in themarketplace can have an impact on third parties. So far, I have argued that market failure leads to uncertainty. The general assumptionpresented in the lectures is that uncertainty leads to incomplete contracts andinterdependency between the parties involved in a transaction. This takes me to the nextstep of my argument. This general assumption makes parties to design their contractsrecognising that they cannot possibly be perfectly adapted to all possible futurecircumstances. Milgrom and Roberts (1992) describe how this can lead to a “relationalcontract” or an “implicit contract”.A relational contract is defined as: “A contract that specifies only the general terms of arelationship and specifies mechanisms for decision making and dispute resolution”(p.602). Animplicit contract is defined as : “Shared understandings that are not legally enforceablebut that the parties consider to be binding on one another’s conduct” (p.599). An employment contract is a good example of a relational contract, because it delegatesauthority to the employer to direct the employees actions rather than describing preciselythe work that has to be done in every contingency. In this stage of my argument I would liketo take the notion of relational contracts further.If an exchange in the market is more costly than the same exchange in an organisationalstructure, due to the degree of uncertainty caused by market failure, one of the parties candecide to add the relation to its organisation structure. Especially if we assume that basedon rationality a contract will occur within whatever infrastructure minimises its costs. This notion combined with the fact that most people dislike having their incomes dependenton random factors and are therefore “risk averse”. I argue that uncertainty caused bymarket failure can lead to relational contracts such as an employment contract and thereforecan lead to the formation of an organisation. I put emphasis on the word can because if theparties concerned in the transaction are all “risk neutral” and there are no wealth effectsit is more likely that the same uncertainty will lead to the building of trust between theparties by means of implicit contracts in order to prevent that one of the parties behaves”opportunistic” (e.g. monopolises the contracts residual). Later on I will return to thenotion of implicit contracts when I discuss the role they play in social capital. Until this point I have argued that market failure leads to uncertainty and that thatuncertainty can lead to relational contracts and therefore can lead to the formationof an organisation. Now I would like to argue that once an organisation is formeduncertainty within the organisation can lead to implicit contracts. Furthermore I would liketo argue that these implicit contracts can lead to social capital and therefore can lead toa cooperative corporate culture. How can two organisation that have the same capital, human capital, technology, operatingenvironment and the same incentive system differ in performance? In the lectures we arguedthat in the absence of non-standard utilities, one answer can be that they differ in “social

capital”. In class we defined social capital as follows: “B has access to a stack of social capital tothe extent that she has either pre-existing or can generate at ‘low costs’ relationshipsfrom ‘others’ whereby B can draw (with high probability) upon an insecure commitment ofresources from others (i.e. in the absence of collateral at zero interest rate).”A will invest in the social capital of B only if she believes there exists high probabilitythat B will discharge the debt at an appropriate time and in a self-enforcing manner. Inother words A must not feel uncertain about B returning her ‘help’. This brings me back tothe first notion that unforeseen contingencies can influence transactions. Earlier I haveshowed that uncertainty can lead to incomplete contracts and that these incomplete contractscan lead to hierarchical transactions. However, I will argue here that it will lead toimplicit contracts because I believe that the existence and the level of social capitalwithin the firm depends on the reputation of cooperation of the individuals within anorganisation. Cooperation will be defined as occurring when individuals in a social dilemmaselect alternatives that are not rewarded by the formal incentive system but that result inPareto efficient outcomes (Miller 1992). The other party will only select these alternativesif it believes that it will be reciprocated. Kreps (1984) argues that the source of thisfaith is the “reputation” of the other party. In order to get a clear picture about reputation, Kreps uses repeated game theory and thefolk theorem. Repeated game theory can best be approached from a one-sided version of thePrisoners’ dilemma game; the trust game (see figure 1). If this game is played only once andnoncooperative both of the parties have a dominant strategy to not trust. The Nashequilibrium will therefore be a $0 pay-out to both A and B. From an economical point of viewthis is a Pareto inefficient outcome. A Pareto efficient outcome can be achieved by a “tit-for-tat” strategy in repeatedprisoner’s dilemma games. A tit-for-tat multiperiod strategy is defined as playing thecooperative (dominated) alternative in the first play of the game and thereafter mimickingthe other player’s previous choice. In other words the trust-honour arrangement allows forthe possibility of self-enforcing if the game is repeated with sufficiently highprobability. Unfortunately, even when the game is repeated with sufficiently high probability a Paretoefficient outcome is not inevitable. The folk theorem states that in any repeated Prisoners’dilemma game, there are an infinite number of outcomes that are sustainable as long-runequilibria by rational, self-interested actors. Imagine for instance what will happen if Bstates that he will violate A’s trust once every three times the game is played. Andfurthermore, if A ever retaliates by not trusting B, player B will be less likely to trust Aagain. A’s dominant strategy will still be trusting B all of the times, as long as B doesnot violate A’s trust more than once every three times. This is just one example of the widerange of equilibria of a repeated Prisoner’s dilemma.Even in a repeated game the player’s have an incentive to specify and enforce the terms ofthe transaction and therefore allow the transaction cost to “eat” some of the residualgained by the transaction. This is where reputation comes in. Reputation means that thetrusted party will honour that trust because not honouring it would preclude orsubstantially limit opportunities to engage in future valuable transactions. To make thispoint clear I will use the social capital example that I used earlier. Say that A invests inthe social capital of B and B does not reciprocate. If this noncooperation of B isobservable A will never invest in the social capital of B anymore, and furthermore she willrefuse to reciprocate B’s future investments in her social capital. This observable failureto reciprocate reduces B’s social capital to zero. If we take this “bilateral reciprocity”up to a corporate level we can speak of “generalised reciprocity”. This means that B dependson several A’s to build up his social capital. This generalised reciprocity is much moreefficient because it reduces the chance that any A is not available at the moment that Bneeds her help. On the other hand, the shift towards generalised reciprocity exacerbates”free-riding” problems as B will attempt not to reciprocate all A’s and as A’s will attemptnot to reciprocate B. I have argued that the existence and the level of social capital within the firm depends onthe reputations of cooperation of the individuals within the organisation or, in otherwords, the implicit contracts. And I have argued that the social capital is more efficientwhen it exists out of generalised reciprocity. Furthermore I have showed with the use ofrepeated game theory that there is a possibility that individual behaviour in a coordinationgame is rationally constrained by social conventions and norms. The viability of thisconvention depends on the level of generalised reciprocity (Miller 1992).I believe, to conclude my argument, that corporate culture is a mechanism of generalisedreciprocity. This takes me back to Miller when he states: “The term ‘corporate culture’denotes these mutually reinforcing expectations in a firm. A ‘cooperative’ corporate cultureis one in which each player expects all others to cooperate and to enforce the norm ofcooperation.”(p.207)