Adverse selection Consumer can’t decide between good/bad offers due to information asymmetry >>

(pre contractual) always take average price; “good” sellers can’t sell with fair premium >> suppliers
with good offers can remover offers. Possible fixes:
• Add. contractual components (buy-back option, guarantee, performance pay, pawn)
• Trust reduces opportunism (e.g. through family ties, reputation)
• Involvement of third parties (e.g. licenses, quality labels, diplomas/certificates)
Arrow Paradox • Set of actors and set of public choices, actors differ in preferences
• Design a mechanism that aggregates indiv. Preferences to a social pref. order?
• Yes with dictator. No without >> always conflict in collective decision making
• Completeness: any pair of alternatives can be socially compared in a
transitive way (if A>B and B>C then A>C).
• Pareto-condition: If every actor prefers A over B, then A shall be
preferred over B in the social preference order
• Independence: The social preference order between two alternatives
does not depend on the actor’s order in relation to further
alternatives

is logically impossible
Asset specificity is the degree to which an asset can have use across multiple situations and purposes.
Site specificity (e.g. lignite mining and power plant)
Physical asset specificity (e.g. specialized computer components)
Human capital specificity (e.g. social relations to trade partner)
Dedicated assets (production capacity that would be in excess without contract)
Bounded Rationality Actors assumed to be intendedly rational, but only limited so
• Justification: limited capacity to make perfect decisions (uncertainty; limited memory,
time and resources for perfect decision making)
• Consequences: decision heuristics, imitation, satisfying instead of maximizing
behavior
Collective action occur when interdependence shapes payoff functions so that game equilibria are not
dilemmas Pareto-efficient / socially optimal / violate some other normative criteria (e.g.
sustainable resource use).
• These are “rationality traps” (“Understanding problems caused by non-malevolent,
intelligent and well-informed people.”
Constitutional Choice =selection of voting rules before actual decisions; purly individualistic decision making
Also about: which activities shall be organized by collective action/voluntary contract?
Consumer/Producer CS is sum of all savings for a given market price p*compared to the willingness to pay
Surplus (up to the quantity that is bought)
PS are the revenues minus costs >> W=PS+CS
Contracts • Component 1: types/bundles of property rights involved e.g. right to use
(voluntary or not), • Component 2: incentives for involved parties and opportunism (problems) ec of scale
analysing • Component 3: time structure: pre- and post-contractual opportunism e.g. precontrac.
Asymmetric information > opportunism for x
Cost minimization Min C1(x) + C2(y) s.t. x+y = t
Costs marginal cost is the change in the total cost that arises when the quantity produced is
incremented by one unit
(can be social=price too marginal costs function is the (inverse) supply function (in partial equilibrium)
low/private: producing, Calculus: derivative Y´(x) of Y(x)
polluting, enforcing
AND benefit for other), Equalizing marginal costs and demand D(q*) = p* = C‘(q*) leads to the price p*
marginal where producers and consumers agree
Discriminating = competition leads to the institutions that fit best to the transactions:
alignment Resons: Technology, value change, demography, disasters,…
“Discriminating alignment hypothesis” as argumentative heuristic: In the long run, institutions
emerge so that the sum of production and transaction costs is minimized

Title of graph: explaining contract design by… s.o.
The central hypothesis underlying TCE is that
contracting partners choose
organizational arrangements to minimize
transaction costs. This hypothesis is termed
discriminating alignment hypothesis and
expresses a matching principle Williamson
himself formulates as follows:
transactions, which differ in their
attributes, are aligned with governance
structures, which differ in their cost and
competence, so as to effect a (mainly)
transaction cost economizing result.

Simpler contract, more inf. asymmetry

Optimal contract design (not pareto eff.)
More sophisticated contract, less asymmetric inf.
Dominant strategy • A strategy of one player is called dominant, if it is not worse than the
other strategies, whatever strategy the other player(s) chose
Elasticity e.g. of supply: if the price is rising by 1%, by how much % does supply rise? (dq / dp)
* (p/q)
externality is the cost or
Externalities, dealing axes / charges / subsidies Quota / tradable quota Liability rules (e.g. strict liability / benefit that affects a third
party who did not choose to
with negligence) incur that cost or benefit.
Externalities often occur
Input / output control Collusion / vertical integration Rules for moratoria / rotation /when the production or
caused by poorly defined
zoning /taboos consumption of a product or
service's private price

property rights and high Coasian bargaining / contracts Bonds / public or private funds Building trust / equilibrium cannot reflect the
true costs or benefits of that
transaction costs (Coase) reciprocity product or service for society
as a whole

Framework “identifies, categorizes and organizes those factors

deemed most relevant to understanding some phenomenon”
General Equilibrium • Holds for many goods, many non-representative consumers, different initial
Features endowments with property rights, and perfect markets
• Factor income = budget = consumption expenditures
• All relative prices are equal to the (inverse) ratio marginal costs
• All relative prices are equal to the ratio of the respective marginal utility
• Consumption goods: Price ratios equal RTS equal MRS
• MRS for any pair of goods equal for all consumers
• If one would obtain less marginal utility from one good, and someone else less
marginal utility
from another good, they could trade for mutual benefit
• Factor markets: RTS equals ratio of factor prices
• RTS for any pair of goods equal for all producers
• Zero-profit condition: all producers’ revenues exactly cover costs
Goods material or immaterial means that satisfy needs or provide utility
through u se or consumption. Also “Bads”=provide neg. utility
Governance Modes

IAD Framework

Structure of an Action 1. Participants: Actors that are capable of making a choice (and assigned to a position)
Situation (AS) • Important attributes: number of participants; status as individual or collective actor;
attributes like demographic data, experience, size. >> boundary rules
=institutions of IAD 2. Positions: Roles that participants can play in an AS (“hat they can wear”) and that
=working parts are linked to the potential actions that participants can make >> position rules
3. Actions: Participants assigned to position choose actions from choice set>choice rule
4. Control: Extent to which participants have control over the action situation, e.g. to
affect decisions of others >> Aggregation rules
5. Information: The information that (different) participants have of specific attributes
of the action situation >> Information rules
6. Potential outcomes: Possible consequences depending on actions (and other factors)
• Can be the consequence of self-conscious decisions or unintended. >> Scope rules
7. Costs and benefits: How participants value potential outcomes (possibly in different
ways)
• Can be expressed in monetary term, but also in other metrics. >> Payoff rules
Interdependence: • Separation of societal functions (e.g. specialization, producers and consumers)
(can be capped by rule) • Complementary goods, factor inputs or skills (e.g. gains from cooperation/ trade)
• External effects (e.g. presents & theft, pollution, harvest from a common pool)
• Public goods (e.g. knowledge, electricity grid stability, stable climate)
Institutional change Reasons: change.: technology, value change, demography, disasters,…
Determinants of bargaining power: Asymmetric inf./TAC/exit costs/time
preference/positional power/sanctioning power
Evolution: shared strategies -> norms -> rules-in-use -> rules-in-form
Path dependence: locked state that can’t be easily changed – QWERTY >> high TAC
Institutions are the humanly devised constraints that shape human interactions
• Note 1: Institutions are the “rules of the game”, and not the same as organizations
• Note 2: There are formal and informal institutions
• Note 3: Institutions can be regarded as contracts
Institutions matter • Society has to deal with interdependency and coordination problems
• Transaction costs (TAC) introduce friction
(e.g. bc of opportunism • Actors have to deal with uncertainty & asymmetric information
= theft, betrayal) • Bounded rationality and opportunism of actors
Institutions, grammar of Attributes: characterizes to whom the institutional statement applies
Deontic: the mode characterizing the statement: permitted, obliged, forbidden
=instit. statements AIm: the actions or outcomes to which the deontic is assigned
Condition: when and where the action or outcome applies
Or Else: institutionally assigned consequence for not following the aim
(E. Ostrom, 1933-2012)
• Rules: ADICO
• E.g. “All male citizens / must / go to the selective military service / when they are
eighteen years
old / or will face a punishment”
• Norms: ADIC
• E.g. “Anyone / must / clean the kitchen / after (s)he has used the kitchen”
• Shared strategies: AIC
• E.g. “A person who places a phone call / calls back / when the call gets disconnected”
Institutions, types of • Markets (Allocation of goods by voluntary contracts) = stock market
• Hierarchy (Allocation of goods not completely determined by voluntary contracts, An
(=coordination) authorized actor (principal) sets the condition for other actors (agent)) = military
• Collective action (Allocation of goods not completely determined by voluntary
contracts. An authorized group of actors (possibly all affected actors) jointly decide =
trade union, flatshare
Isoquant curve of all possible factor
input combinations that produce
output objective q
Marginal Rate of is the rate at which a consumer can give up some amount of one good in exchange for
Substitution another good while maintaining the same level of utility.

(dU / dx ) / (dU / dy)

Marginal Rate of Along an Isoquant, the MRTS shows the rate at which one input (e.g. capital or labor)
technical substitution may be substituted for another, while maintaining the same level of output. Thus the
MRTS is the absolute value of the slope of an Isoquant at the point in question.
- (df / dL) / (df / dK) = RTS
(always negative)
Median Voter Theorem How can we explain the outcome of majority voting? (and: party strategies in elections)
Assumptions
Extension: Electoral • Political options can be arranged on a spatial continuum
competition (Anthony • Individual voters always prefer the point on this continuum that is closer to where
Downs) individual utility is optimized
Alternatives: • Political decision on only one issue is taken into account
dictatorship/unanimity Theorem
vote>guarantees pareto- • Under majority rule, the voting system selects the outcome most preferred by the
improvement & no median voter
opportunity costs but Definition: The median voter is the actor whose optimal outcome lies closest the
high cost of agreement optimal outcome of just half the voters
Models specifies the specific functional relationships among
particular variables or indicators that are hypothesized to operate in
some well-defined set of conditions”
Monopoly: Reasons:
• Natural monopoly: If quantity can be supplied at lower costs by a single
= market failure, supplier than by more than one supply (typically due to high fix costs, e.g. rail
justification for policy track, electricity grid)
instruments • Legal barriers (e.g. granted monopoly, intellectual property rights,
trademarks)
• Deliberate barriers (e.g. through physical investments, illegal practices
Nash-equilibrium, A combination of strategies is called non-cooperative Nash-equilibrium, if
non-cooperative no player can improve its payoff by unilaterally changing its strategy.
… may not exists, may not be unique, may not be Pareto-efficient
Neoclassical Exclusive Non-exclusive
economics,
basic assumptions Rivalry Private good Open access good
(commons)
;restrict through state who
grants access rights
Non-rivalry Club good Public good
;provide through state that
collects contributions

Methodological individualism
Exogenous preferences
Economy is in equilibrium
Markets without transaction costs
Perfect information, but possibly uncertainty
Rational / maximizing actors
Institutional basics (e.g. markets, property rights) taken as given and neutral
New and classical New IE Classical / old IE
institutional economics 1. Methodological individualism 1. Stresses the role of the collective
2. Exogenous preferences 2. Endogenous preferences
(why do institutions 3. Homo oeconomicus strives for achieving given
matter?) preferences 3. Homo sociologicus
4. “Institutions as norms”: preferences and beliefs
are not exogenous to the analysis
4.“Institutions as rules”: constraints
New Institutional Neoclassical theory New institutional economics
Economics (applying 1. Methodological individualism 1. Methodological individualism
neoclassical ideas to 2. Exogenous preferences 2. Exogenous preferences
analyze public decision 3. Economy is in equilibrium 3. Economy (not) in equilibrium
making -> realisitc) 4. Markets without frictions 4. Markets with transaction costs
vs. 5. Perfect information /
Neoclassical Theory probabilistic uncertainty 5. Uncertainty & asymmetric information
(welfare-theoretic 6. Rational / maximizing actors 6. (Bounded) rational actors
“nirvana economics”) 7. Institutional basics (e.g. markets, property rights)
taken as given and neutral 7. Consider different / dynamic institutions
Opportunity Costs: Lost benefits in comparison to the best alternative decision
Pareto efficiency: An allocation where no one can be made better off without making at least
someone else worse off

Welfare economics: a perfect market e.g. private property leads to a socially optimal
allocation e.g. partial equilibrium >> ”benevolent dictator”/”social planner” would
optimize maxW

Pareto improvement: a re-allocation of goods that makes at least one actor better off, but no
one worse off
Perfect Markets: Private property rights in consumed and produced goods
Perfect competition: no party can exploit market power
No further interdependence between producers and consumers
Full information: utility and costs of goods known to all parties
Transactions without costs

Justification of neoliberal ideology:

If taxes/subsidies are introduced, general equilibrium would be changed
Sing original general equilibrium is efficient, intervention would lead to losses
If markets not perfect, interventions are not as good as improve. market (priv. property)

Polity, Politics, Policy Polity (form): Group of people who are collectively members of an entity like a state;
Politics (process): Group interactions to make decisions for the group, in particular in a
state;
Policy (content): Statement of intend, procedures or measures to be
implemented (e.g. regulatory, distributive, constituent)
Principal Agent occurs when one person or entity (the "agent") is able to make decisions and/or take
actions on behalf of, or that impact, another person or entity: the "principal". This
dilemma exists in circumstances where agents are motivated to act in their own best
interests, which are contrary to those of their principals, and is an example of moral
hazard.

Ingredients: Information asymmetry; Principal and agent enter into an incomplete

contract; Opportunistic behavior

Reducing information asymmetry requires transaction costs, so that

P-A problems might be accepted to some degree

Principal Agent
Buyer - Voter - Regulator Seller - Politician - Polluter

Due to asymmetric information, more sophisticated contracts or

institutional arrangements have to be chosen, e.g.
• Principal offers a menu of contracts (e.g. different wage-effort combinations), ideally
truth-revealing
• Additional contractual components (e.g. buy-back option, guarantee, performance
pay, pawn)
• Trust reduces opportunism (e.g. through family ties, reputation)
• Involvement of third parties (e.g. licenses, quality labels, diploma
Priviledged groups = One provides (nearly) everything, smaller are privileged
(Olsonian) Good not provided by any individually rational actor
 Privileged groups more likely if group size is small, or if there are very large members
Profit maximization π= max pq - C(q)
Property Rights … use the good (usus), and to exclude others from using it
... use to modify or destroy the good (abusus)
... obtain rights to benefits or revenues provided from the good (usus fructus)
... transfer property rights to other actors (ius abutendi)
Quasi Rent asset value at first-best use – asset value at second-best use
• High for specific assets (high gains from specific use). The more
specific the asset, the more irreversible are investment costs
• Is almost zero for generic assets since they can be used at almost no
loss in alternative uses

Asset Type
Frequency Generic Mixed Specific
Low Market Trilateral -
Governance
High Market Bilateral Hierarchy /
Governance Integration
Rent-seeking behavior attempts of interest groups, firms and other actors to obtain, improve or defend rents
Rents Payments or benefits to a producer actors above its opportunity costs;
not possible under perfect competition >> indicated market imperfections e.g.
monopoly rents
Theory “posits general causal relationships among some subsets of
these variables and categories of factors, designating some types of
factors as especially important and others as less critical for
explanatory purposes
Tragedy of the 1. Private property of cattle: can be individually used, sold or eaten
commons 2. No private property of pasture: everyone can let cattle graze, benefits from fed cattle
accrue for private owners, costs in terms of pasture use are socialized
3. As long as pasture regenerates faster than cattle grazes, there are (individual) gains
from letting more cattle graze
4. If grazing is faster than regeneration, it is not individually rational to withdraw own
cattle: losses to the individual, gains for everyone else
>>Overgrazing goes on until the pasture is destroyed >> Command&Control?!
Transaction cost theory
Transaction Costs • Actors have the capacity to anticipate possible contractual hazards, posits that the optimum
Economics – TCE and work out contractual ramifications organizational structure is
(Williamson) • Actors make strategic and opportunistic considerations one that achieves economic
efficiency by minimizing the
• Contracts are made in the presence of transactions with more or less costs of exchange. The
• Asset specificity: investments might loose value if contract canceled theory suggests that each
type of transaction produces
• Uncertainty: unexpected disturbances might lead to maladapted contract coordination costs of
• Frequency: frequently repeated transaction can discipline opportunism and monitoring, controlling, and
can reduce the average internal transaction costs managing transactions.
Williamson has defined
• Complex contracts are unavoidably incomplete transaction costs broadly as
the costs of running the
Transaction costs • “the costs of running an economic system” (Arrow 1969) economic system of firms.
(TAC) • TAC stem from (i) transferring property rights within an institutional setting,
and (ii) from establishing, sustaining and changing contracts or institutions.
Transactions • “occurs when a good or service is transferred across a technologically
separable interface.” (Williamson 1985)
• More general understanding: transfer of property rights