Risk Sharing, Risk Spreading and Efficient Regulation PDF
Preview Risk Sharing, Risk Spreading and Efficient Regulation
T.V.S. Ramamohan Rao Risk Sharing, Risk Spreading and Effi cient Regulation Risk Sharing, Risk Spreading and Effi cient Regulation T.V.S. Ramamohan Rao Risk Sharing, Risk Spreading and Effi cient Regulation T.V.S. Ramamohan Rao Indian Institute of Technology Kanpur Kanpur , Uttar Pradesh , India ISBN 978-81-322-2561-4 ISBN 978-81-322-2562-1 (eBook) DOI 10.1007/978-81-322-2562-1 Library of Congress Control Number: 2015944074 Springer New Delhi Heidelberg New York Dordrecht London © Springer India 2016 T his work is subject to copyright. All rights are reserved by the Publisher, whether the whole or part of the material is concerned, specifi cally the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfi lms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. T he use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specifi c statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. T he publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made. Printed on acid-free paper Springer (India) Pvt. Ltd. is part of Springer Science+Business Media (www.springer.com) Dedicated to the generous presence of the Goddess Saraswati Pref ace A large proportion of economic exchange, even in predominantly market-oriented economies, utilizes contracts as the major institutional mechanism. Contracts are, in most cases, with independent agents outside the fi rm. There will be information issues, transaction cost considerations, risk sharing in several directions, issues related to control, and fi xed cost considerations that defi ne the nature of contracts. Almost invariably some fi xed assets, such as technology and know-how, physical or fi nancial capital, brand name and reputation, and/or the characteristics of informa- tion, underlie the specifi c contract under consideration. Coase initially identifi ed transaction cost advantages. Spot contracts, or onetime exchanges, probably corre- spond to this closely. G iven the cost advantage of contracts over the market mode, there is always a possibility that contract execution will increase costs so long as the market does not supplant such contracts. Different agents may have different propensities to create ineffi ciency. But, given the market for the product of the contract, they tend to create signifi cant variations in profi ts of the principal. Hence, diversifi cation of production through contracts increases the variability of profi ts for the principal. Some effi cient regulation by the principal may be conceptualized, but the variability will persist. O ver time, risk sharing emerged as an altogether different reason for any form of contracts. In essence there is an acknowledgment that some randomness is endog- enous to all imperfect product markets. For instance, an automobile assembler may fi nd the recovery, of fi xed costs of full vertical integration, to be too risky once the assets are sunk. He may prefer subcontracts with outside agents who willingly make investments in such idiosyncratic assets. The agents, in their turn, may feel that the contracts reward their risk taking adequately. This is the essential precondition for contracts to materialize. Variability of demand may add to randomness in costs as a factor that prompts fi rms to enter into contracts with outside agents. Hence, two issues need careful analysis: Can the risk-sharing phenomenon preserve the transac- tion cost reduction that Coase emphasized? How can risk spreading be regulated? Note that in case the transactions are conducted on the market, the necessity for information is low (because the price signal contains all the requisite information), vii viii Preface and the participants provide all the requisite information completely and truthfully. For, competitors will prevail if they fail to do so. By way of contrast, self-interest- seeking outside agents may benefi t from hiding information and/or not fulfi lling the promises they make. This is more generally the case in spot contracts. However, it may persist even in long-term contracts. This suggests the possibility of adverse selection (choosing an agent who may not be the best choice) and/or moral hazard (the agent not delivering promises). For all practical purposes it may be claimed that depending on an agent results in agency costs, which are now internal to the con- tracting parties, in contrast to transaction costs as construed by Coase and Williamson. Many studies on contracts consider these as the major risks. Once it is acknowledged that risks can be shared by contractual arrangements, it is axiomatic that both the principal and the agents will have the propensity to aug- ment risks and engage in a larger volume of transactions not necessarily commen- surate with the overall profi tability of the enterprise. For all practical purposes their own self-interest-seeking behavior may overshadow the need for stability of the entire enterprise. Such shortsighted behavior and its long-term consequences may get to be acknowledged only when they reach catastrophic proportions. Anticipating such negative effects the agents may signal their suitability, their willingness and ability to comply with contract terms, and/or their understanding about sharing risks. Similarly, the fi rms (or principals) may devise mechanisms of monitoring, control, and incentives to ensure compliance. Both sides tend to make sure that risk sharing is along the lines stipulated in the contract. Residual risk persists despite the best possible precaution on both sides. One of the sources may be the market (or any other) dimensions not under the control of the contracting parties. The most important example is that of agriculture tenancy where the output delivered by the tenant may be predominantly determined by weather conditions not under his control. Another context of this nature is related to health insurance. For, neither the insurance company nor the insured (the potential patient) has any control on the likely prescription of the physician when the insurer needs treatment. Similarly, both the fi rm and its franchisees may expect to succeed in a given location. But the market reaction may be quite the opposite even if the contacting parties operate at their maximum effi ciency and in conformity with their agreement. The second source is the residual loss due to adverse selection and/or moral hazard. Such risks are internal to the design and execution of the contract. Another aspect of behavior has come into prominence. Suppose markets are the predominant form of transactions. Given the effi cient costs of operation, the nature of demand will place limits on output to maximize profi ts and/or assure positive profi ts. However, in their greed to surpass rivals, each fi rm tends to emphasize the market share and cross these limits. In their quest to augment market shares, fi rms may also produce goods of lower quality that tend to fail well before the durability stipulated. The market demand may be reduced once this behavior is discovered. They will not be able to repay their loans. A similar behavior on the part of fi nancial institutions may induce them to subprime lending. This phenomenon leads to the kind of fi nancial crisis experienced in recent times. Preface ix Will the switch to contracts reduce such risks? In the contract mode each of the participants may feel that their own losses, if any, are a small part of the loss to the fi rm. Basically the risk-sharing arrangements generate greater risks by spreading risks. This propensity to risk sharing in all markets, including the fi nancial markets, has the origins of a fi nancial crisis. In other words, risk sharing will emerge as another dimension of greed of the contracting parties. Some studies suggest that a risk-averse agent tends to take action to modify his behavior. Similarly, the principal may create an atmosphere (monitoring) to suggest to the agent that his risks can be kept under control. Preventive maintenance of durables, deductible insurance, and sharing costs are examples of this nature. Risk reduction arrangements may be embedded into the analysis of risk sharing. This will have important implications for contract design and execution. Effi cient regulation, either by the participants in a contract or outside regulatory agencies, examines several means of ensuring the lowest possible cost of conduct- ing transactions as well as enabling effi cient risk sharing and minimizing the losses that arise due to risk spreading. The principal agent models emphasize these fundamental dimensions of con- tracts. They tend to place a signifi cant emphasis on the agent’s participatory con- straint (the conditions under which the agent can be drawn into the contract). In other words, these models postulate that both the agent and the principal can enforce their effi cient choices on contract design. Several observed empirical contexts appear to suggest that contract design is dominated by the agent’s choice rather than that of the principal. This is in contrast to the expectations of the transaction cost logic. Several empirical studies have been designed to test the principal agent models in various practical contexts. Limitations of data haunt these studies. However, the more important diffi culty is with respect to the appropriate econometric methods. One chapter of this book proposes a new technique to estimate all the parameters of principal agent models in various settings. T hree fundamental weaknesses of the principal agent models have come to light. First, the specifi cation of agency costs lacks a proper theoretical justifi cation. Many approximate, but useful, specifi cations persist. Second, the participatory constraints may be conditioned by the monopoly power of one participant. Such monopoly power may be simply a result of the contracting parties becoming specifi c to the transaction and increasing their mutual dependence once they are locked in. Third, there is an inadequate acknowledgment of the risk-spreading phenomenon and its control. In particular, much more attention is necessary to examine asset and/or cost sharing mechanisms in case of premature dissolution of a contract. Hence, some empirically observed contracts may not be effi cient though the principal agent model postulates this. Despite some limitations much progress has been made in the specifi cation and implementation of principal agent problems in a variety of practical contracting contexts. T hey offer very valuable insights into the contracting process. The chapters in this book are organized along the following lines: generation and transfer of scientifi c
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