Roger B. Myerson Prize Lecture
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337 problems of adverse selection. Conversely, collectivism can often ameliorate adverse-selection problems while exacerbating moral-hazard problems. 5. A SIMPLE ECONOMY WITH MORAL HAZARD IN THE CENTRAL GOVERNMENT Proponents of the free-market system do not advocate it merely as an excuse for abandoning egalitarianism. The free market distributes economic power and rights to people throughout the population, and so the free market may be seen as the antithesis of centralized political control of the economy. From this perspective, we may try to derive the rationale for the free market from a model where centralized political control causes economic inefficien- cy. The costs of unrestrained central power can be understood as problems of moral hazard at the center of government. So our third example involves moral hazard in the government and shows how even an autocratic ruler may prefer to create political guarantees of private property rights, even when such liberalization entails a risk of his losing power. The key is that political liberalization can encourage investments that increase the ruler’s tax base. 7 Let Y(K) denote the net flow of output (per unit time) that can be pro- duced in a nation when any K > 0 is the capital invested in the nation. To produce this output Y(K), the capital K must be used and controlled by many individuals in the general population, whom we may call capitalists, and their control over the capital would enable them to take it abroad at any time. The capitalists’ rate of time discounting is r. So to deter capital flight, the capitalists must enjoy an income flow worth rK from their capital holdings. We may assume that Y(K) is net output after input costs and labor, and so the authoritarian rulers of the government can take (in taxes) the remaining flow Y(K)–rK. Let r+b denote the rate of time discounting for an authoritarian ruler, which may be different from r because the authoritarian ruler might face some exogenous risk of losing power, say at a probabilistic rate b per unit time. The moral-hazard problem here is that the ruler could, at any time, ex- propriate the capital and sell it abroad. Of course the capitalists would not invest in this nation if they expected to be expropriated, and so the ruler needs to promise that their capital will not be expropriated. Making this promise credible is the central moral-hazard problem here. If the authoritar- ian ruler never expropriates, then the expected present-discounted value of his income stream is (Y(K)–rK)/(r+b). But without political liberalization, nobody can prevent the absolute authoritarian ruler from breaking his word. If he expropriated the invested capital, the worst that could happen is that nobody would ever invest in his nation again, and so he would get national income Y(0) thereafter, but he could still benefit from selling the expropri- ated capital K abroad (for use in some other nation where capitalists can still 7 For a broader introduction to such problems of time-inconsistency or political credibility of government policies to protect investors, see also chapter 16 of Tirole (2006). 338 trust the ruler). Thus, it can be credible that the authoritarian ruler will not expropriate the invested capital K only if (Y(K)–rK)/(r+b) > K + Y(0)/(r+b). But now let us allow that the ruler may liberalize his regime to various de- grees λ, where a greater liberalization λ means that it is easier for people to organize and overthrow him. To be specific, let us say that a regime has liberalization λ when the probability of the ruler losing power if he tried to expropriate capital (or if he tried to reduce liberalization) would be this number λ, which as a probability must satisfy 0 < λ < 1. Such liberalization λ can help to satisfy the ruler’s moral-hazard constraint, because his ex- pected return from trying to expropriate the capitalists would now become (1–λ)[K + Y(0)/(r+b)]. But liberalization also increases the ruler’s political risks. Suppose that there are also false-alarm scandals that occur at some expected probabilistic rate a per unit time, and people react to such scandals exactly as they would to a genuine attempt to expropriate capital. So for a regime with liberaliza- tion λ, when the government is not willfully expropriating anything, still scandals can randomly occur at an expected rate a per unit time, and so scan- dals that cause the ruler to lose power will randomly occur at an expected rate of aλ per unit time. So in a regime with liberalization λ, the current ruler should discount future revenue at rate r+b+aλ. Thus, with invested capital K, the ruler’s present discounted value is V(K,λ) = (Y(K)–rK)/(r+b+aλ). Then the ruler’s moral-hazard constraint with liberalization λ is V(K,λ) > (1–λ)[K + Y(0)/(r+b)]. In an optimal political regime, the ruler wants to invite investment K and offer liberalization λ to maximize V(K,λ) subject to this moral hazard con- straint, as well as K > 0 and 0 < λ < 1. To be specific in our example, suppose that Y(K) = (K+n) 0.5 where the pa- rameter n denotes the nation’s endowment of natural resources, say n = 12. Suppose that the capitalists’ discount rate is r = 0.05, the basic political-risk rate for authoritarian rulers is also b = 0.05, and the additional political-risk rate per unit of liberalization is also a = 0.05. With this Y and r, if there were no moral-hazard constraint, the ideal capital stock that maximizes the net revenue Y(K)–rK would have K+n equal to 100. But with the moral-hazard constraint, this numerical example allows no positive investment if the ruler does not liberalize; that is, if λ=0 then only K=0 would be feasible here with n=12. The ruler’s optimal regime for this example has liberalization λ=0.504, so that the ruler can credibly invite capital investment K = 52.4. 339 On the other hand, if natural resources were decreased to n = 0, keeping all other parameters the same, then the ruler’s optimal regime would have λ = 0 and K = 44.4. Intuitively, a lack of natural resources makes it more costly for the ruler to lose his reputation for protecting capital, and so he can cred- ibly encourage substantial investments even without liberalizing. If the endowment of natural resources were increased to n = 25, however, still keeping all else the same, then the ruler’s optimal regime would have λ = 0 and K = 0. Intuitively, a great wealth of natural resources makes the ruler unwilling to accept the additional political risk from liberalization, even though it means that nobody will invest in his nation without liberalization. Thus, an increase in natural resources can reduce the ruling government’s incentive to liberalize, and indeed investment may decrease by more than the value of the natural resources themselves. In this sense, a nation may be cursed by too many natural resources. 6. CONCLUSIONS Mechanism design has extended the scope of economic analysis by adding incentive constraints to resource constraints in our definition of the eco- nomic problem. Incentive constraints provide an analytical framework for understanding failures of allocative efficiency, showing how such failures may depend on the initial allocation of property rights in a society. But mechanism-design theory changes the basic object of analysis from the re- source allocation to the social plan or allocation mechanism that specifies how resource allocations should depend on people’s information. Concepts of incentive efficiency can be applied to identify good institutional rules or mechanisms, taking incentive constraints into account. The cases for collectivism or private ownership may depend on trade-offs between different kinds of incentive problems: moral hazard and adverse se- lection. Moral-hazard incentive problems particularly are fundamental in any institution, because institutional rules are enforced by actions of leaders and officials, who must be motivated by an expectation of rewards and privileges as long as they fulfill their institutional responsibilities (see Hurwicz 2007; Myerson 2007, 2008). Mechanism design and other areas of game theory have contributed to a fundamental change in the scope of economics. Once the scope of econom- ics was defined by the allocation of material goods, but now economists study all kinds of questions about incentives in social institutions. Our theoretical framework now is broad enough to analyze competitive incentive problems in both markets and politics. In the quest for a better analytical understand- ing of how the wealth of nations may depend on their institutions, economic analysis has returned to the breadth of vision that characterized the ancient Greek social philosophers who first gave economics its name. 340 REFERENCES Robert J. Aumann, “Subjectivity and correlation in randomized strategies.” Journal of
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