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The Impact of Incomplete Contracts on Economics

Edited Book
Philippe Aghion, Mathias Dewatripont, Patrick Legros, Luigi Zingales
Oxford University Press

The 1986 article by Grossman and Hart “A Theory of Vertical and Lateral Integration” has provided a framework for understanding how firm boundaries are defined and how they affect economic performance. The property rights approach has provided a formal way to introduce incomplete contracting ideas into economic modeling.

The Impact of Incomplete Contracts on Economics collects papers and opinion pieces on the impact that this property right approach to the firm has had on the economics profession. It shows that the impact has been felt sometimes in significant ways in a variety of fields, ranging from the theory of the firm and their internal organization to industrial organization, international trade, finance, management, public economy, and political economy and political science. Beyond acknowledging how the property rights approach has permeated economics as a whole, the contributions in the book also highlight the road ahead—how the paradigm may change the way research is performed in some of the fields, and what type of research is still missing. The book concludes with a discussion of the foundations of the property rights, and more generally the incomplete contracting, approaches and with a series of contributions showing how behavioral considerations may provide a new way forward.

Demand-Driven Integration and Divorcement Policy

Peer Reviewed Article
Patrick Legros, Andrew Newman
International Journal of Industrial Organization, in press

Traditionally, vertical integration has concerned industrial economists only insofar as it affects market outcomes, particularly prices. This paper considers reverse causality, from prices – and more generally, from demand – to integration in a model of a dynamic oligopoly. If integration is costly but enhances productive efficiency, then a trend of rising prices and increasing integration could be due to growing demand, in which case a divorcement policy of forced divestiture may be counterproductive. Divorcement can only help consumers if it undermines collusion, but then there are dominating policies. We discuss well-known divorcement episodes in retail gasoline and British beer, as well as other evidence, in light of the model.

(revised version of  CEPR DP 10914, November 2015)

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Audit Competition in Insurance Oligopolies

Peer Reviewed ArticleWorking Paper
Nicolas Boccard, Patrick Legros
Frontiers of Economics in China, forthcoming,

We provide a simple framework for analyzing how competition affects the choice of audit structures in an oligopolistic insurance industry. When the degree of competition increases, fraud increases but the response of the industry in terms of investment in audit quality follows a U-shaped pattern. Following increases in competition the investment in audit quality will decrease if the industry is initially in a low competition regime while it will increase when the industry is in a high competition regime. We use these results to show that firms will benefit from forming a joint audit agency only when the degree of competition is intermediate and that cooperation might improve total welfare we also analyze the effects of contract innovation on the performance of the industry.

(This is a revised version of CEPR DP 3478, July 2002)

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Industrial Policy and Competition

Peer Reviewed Article
Philippe Aghion, Jing Cai, Mathias Dewatripont, Luosha Du, Ann Harisson, Patrick Legros
American Economic Journal: Macroeconomics, Vol. 7 No. 4 , October 2015, Pages 1-32

(Lead paper)

Using a comprehensive dataset of all medium and large enterprises in China between 1998 and 2007, we show that industrial policies allocated to competitive sectors or that foster competition in a sector increase productivity growth. We measure competition using the Lerner Index and include as industrial policies subsidies, tax holidays, loans, and tariffs. Measures to foster competition include policies that are more dispersed across firms in a sector or measures that encourage younger and more productive enterprises.

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Smithian Growth Through Creative Organization

Peer Reviewed Article
Patrick Legros, Andrew Newman, Eugenio Proto
Review of Economics and Statistics, Volume 86, Issue 5, December 2014, 796-811

We consider a model in which appropriate organization fosters innovation, but because of contractibility problems, this benefit cannot be internalized. The organizational design element we focus on is the division of labor, which as Adam Smith argued, facilitates invention by observers of the production pro- cess. However, entrepreneurs choose its level only to facilitate monitoring their workers. Whether there is innovation depends on the interaction of the mar- kets for labor and for inventions. A high level of specialization is chosen when the wage share is low. But low wage shares arise only when there are few en- trepreneurs, which limits the market for innovations and therefore discourages inventive activity. When there are many entrepreneurs, the innovation market is large, but the rate of invention is low because there is little specialization. Rapid technological progress therefore requires a balance between these oppos- ing effects, which occurs with a moderate relative scarcity of entrepreneurs and workers. In a dynamic version of the model in which a credit constraint limits entry into entrepreneurship, this relative scarcity depends on the wealth distri- bution, which evolves endogenously. There is an inverted-U relation between growth rates driven by innovation and the level of inequality. Institutional im- provements have ambiguous effects on growth. In light of the model, we offer a reassessment of the mechanism by which organizational innovations such as the factory may have spawned the industrial revolution.

 

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The Economics of Copyright Levies on Hardware

Peer Reviewed Article
Victor Ginsburgh, Patrick Legros
Review of Economic Research on Copyright Issues, Volume 10, Issue 1, 2013, 20-35

(Winner of 2013 RERCI Best paper)

The fight against illegal music downloading has taken many forms. Beside legal prosecution (Hadopi in France, for example), many countries have chosen to tax blank tapes and CDs, both to reduce their use for illegal copying, but also to redistribute the proceeds to content providers. This has become less effective, since now illegal copying is stored on hardware devices, such as smartphones, computers, MP3 players, and external hard disks. We provide an economic analysis of the effects of copyright levies on hardware used to access original content. A first effect is to decrease the consumption of both illegal and legal content. We show that in a static model, content providers can hardly be compensated, and therefore are made worse off by the levy. We also consider a dynamic model where current sales contribute to the reputation of the content provider, and to his future revenues. A levy on hardware tends to penalise `young’ content providers in terms of reputation acquisition.

 

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A Price Theory of Vertical and Lateral Integration

Peer Reviewed Article
Patrick Legros, Andrew Newman
The Quarterly Journal of Economics, Volume 128, Issue 2, May 2013, 727-770

This article presents a perfectly competitive model of firm boundary decisions and study their interplay with product demand, technology, and welfare. Integration is privately costly but is effective at coordinating production decisions; nonintegration is less costly but coordinates relatively poorly. Output price influences the choice of ownership structure: integration increases with the price level. At the same time, ownership affects output, because integration is more productive than nonintegration. For a generic set of demand functions, equilibrium delivers heterogeneity of ownership and performance among ex ante identical enterprises. The price mechanism transmutes demand shifts into industry-wide reorganizations and generates external effects from technological shocks: productivity changes in some firms may induce ownership changes in others. If the enterprise managers have full title to its revenues, market equilibrium ownership structures are second-best efficient. When managers have less than full revenue claims, equilibrium can be inefficient, with too little integration.

 

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"Essential Patents", FRAND Royalties, and Technological Standards

Peer Reviewed Article
Mathias Dewatripont, Patrick Legros
Journal of Industrial Economics, Volume 61, Issue 4, 2013, 913-937

Standard Setting Organizations have developed FRAND agreements in order to prevent firms from holding-up other participants once a standard is created. We analyze here the consequences of such agreements — in particular the requirements of fairness and non-discrimination — for the creation of technological standards that require the participation of existing patent holders. We abandon the usual assumption that patents bring known benefits to the industry or that their benefits are known to all parties. When royalty payments are increasing in one’s patent portfolio, as is implicitly the case in FRAND agreements, private information about the quality of patents leads to a variety of distortions, in particular the incentives of firms to “pad” by contributing patents that are `inessential’ for the given standard, a phenomenon that seems to be widespread. Several results emerge from the analysis: (i) the number of inessential patents co-varies positively with the number of essential patents; (ii) there is over-investment relative to the second-best, that is when padding cannot be avoided and (iii) the threat of disputes reduces incentives to pad but at the cost of lower production of strong patents; (iv) mitigating this undesirable side-effect calls for a simultaneous increase in the cost of padding, through a better filtering of patent applications.

 

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Trade Liberalization and Organizational Change

Peer Reviewed Article
Paola Conconi, Patrick Legros, Andrew Newman
Journal of International Economics, Volume 89, Issue 2, August 2013, 197-208

We embed a simple incomplete-contracts model of organization design in a standard two-country perfectly-competitive trade model to examine how the liberalization of product and factor markets affects the ownership structure of firms. In our model, managers decide whether or not to integrate their firms, trading off the pecuniary benefits of coordinating production decisions with the private benefits of operating in their preferred ways. The price of output is a crucial determinant of this choice, since it affects the size of the pecuniary benefits. Organizational choices also depend on the terms of trade in supplier markets, which affect the division of surplus between managers. We show that, even when firms do not relocate across countries, the price changes triggered by the liberalization of product markets can lead to changes in ownership structures within countries. The removal of barriers to factor mobility can also induce widespread restructuring, which can lead to increases in product prices (or declines in quality), hurting consumers worldwide.

 

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On the Incidence of Commissions in Auction Markets

Peer Reviewed Article
Victor Ginsburgh, Patrick Legros, Nicholas Sahuguet
International Journal of Industrial Organization, Volume 28, Issue 6, November 2010, 639-644http://www.sciencedirect.com/science/article/pii/S0167718710000329

We analyze the welfare consequences of an increase in the commissions charged by inter- mediaries in auction markets. Commissions are similar to taxes imposed on buyers and sellers, and standard economics suggests that both sellers and buyers are made worse off by the tax. However, we show that when the buyers’ participation constraint binds and when sellers set optimal reservation prices, the level of commissions correlates participation and reservation prices in such a way that participating buyers strictly gain from higher commissions.

 

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Introduction to the Symposium on Advertising and Disclosure

Editorial Introduction
Patrick Legros
Journal of Industrial Economics, Volume 57, Issue 1, February 2009, 1-16

Introduction to a special issue of Journal of Industrial Economics.

 

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EU Competition Policy in a Global World

Book Chapter
Mathias Dewatripont, Patrick Legros
in

This chapter reviews the forces that have shaped current competition laws and initiatives, in particular those that may ease convergence and cooperation between the US and the EU. Even if convergence is eased when countries are developed, the objectives and the means put in place to attain these objectives may differ across countries. Differences may in turn generate tensions, and therefore shape further developments of the law. Subsequently, this chapter discusses the specific case of state aid control, an EU specificity which has on the one hand helped insure the primacy of competition policy over industrial policy, and has prevented potential wasteful “subsidy wars” between member states. However, on the other hand, this policy has been accused at times of hurting the competitiveness of “European champions.” Finally, the chapter looks at current challenges facing competition policy; focusing first on new developments as far as State Aid control is concerned, namely the State Aid Action Plan, and the special case of aid to innovation. Here, the focus will be on the pros and cons of this policy, namely its potential ability to better address market failures, but also the potential risk of lax enforcement in the name of ‘aid to innovation.’ This danger might be particularly problematic in an era which has witnessed the fast rise to prominence of some emerging-economy powers (like the BRICs) which do not necessarily share the competition-policy philosophy of the EU and US. While the chapter discusses how the common ground reached by these two players could serve as the basis for a global competition policy, it also stresses the potential tensions that could arise from the assertiveness of State interests by public corporations and sovereign funds from these emerging countries.

Edition scientifique et pouvoir de marché

Book Chapter
Mathias Dewatripont, Victor Ginsburgh, Patrick Legros, Alexis Walckiers
in

This chapter is the outgrow of a report written for DG Research at the European Commission.

 

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Libérer la musique sur internet

Newspaper Article
Victor Ginsburgh, Patrick Legros
L'Echo, 24-26 November

(in French)

Study on the Economic and Technical Publication Markets in Europe

Scientific Report
Mathias Dewatripont, Jean-Pierre Devroey, Pierre Dubois, Jéroöme Foncel, Victor Ginsburgh, Marc Ivaldi, Dominique Heusse, Patrick Legros, Françoise Verdooren, Alexis Walckiers
Final Report - Commissioned by Dg-Research, European Commission, January 2006

Dissemination and access to research results is a pillar in the development of the European Research Area. Aware of current public debates that reveal worries about the conditions of access and dissemination of scientific publica- tions, the European Commission’s Directorate- General for Research has commissioned a study that seeks: (i) to assess the evolution of the market for scientific publishing; and (ii) to discuss the potential desirability of European- level measures to help improve the conditions governing access to and the exchange, dissemination and archiving of scientific publications (taking into account all actors/ stakeholders of the sector).

The report builds on a voluminous existing literature. It therefore updates the “state of the art” in terms of reports, studies, surveys, and articles. It has also benefited from considerable interaction with various actors/stakeholders of the sector, policy bodies, corporate associations and interest groups. Discussion meetings took place as well as participation and exchange in scientific conferences and policy forums. Three ‘consultation days’ were also organized, where preliminary results were discussed with publisher representatives, scholarly societies, research-funding organizations, and library representatives.

The report considers the specificities of the market for current journal issues. In doing so, it discusses the broad facts about the market; it undertakes a quantitative analysis of journal prices; it discusses the implications of technological innovation on pricing strategies and the dynamics of entry; and it analyzes the implication of these developments in terms of competition policy.

It also discusses the various alternatives for disseminating and accessing scientific publica- tions. This includes the question of access to research results on individual web pages or in public repositories, the development of open- access journals as well as other alternatives, such as pay-per-view, the question of the long- term preservation of electronic publications and the use of standards to ensure interopera- bility between systems.

The attention of public decision makers is required for two reasons. First it is well-establi- shed that science has a key role in fostering economic growth, and because scientific journals are an essential means of disseminating new knowledge in the academic community but also beyond. Secondly, much of scientific activity is publicly funded: the output of research is typically not bought by journals but ‘donated’ by publicly-funded researchers; so are to a large extent refereeing services for the evaluation of research; and finally, journals are bought by publicly-funded researchers or, more often now, by publicly-funded libraries. It is therefore crucial for public authorities to form a view on the relative efficiency of the scientific publication process.

Public Private Partnerships: Contract Design and Risk Transfer

Book Chapter
Mathias Dewatripont, Patrick Legros
in

This paper critically assesses the implications of contract design and risk transfer on the provision of public services under public-private partnerships (PPPs). Two results stand out. First, the alleged strength of PPPs in delivering infrastructure projects on budget more often than traditional public procurement could be illusory. This is – to put it simply – because there are costs of avoiding cost overruns and, indeed, cost overruns can be viewed as equilibrium phenomena. Second, the use of external (i.e., third-party) finance in PPPs, while bringing discipline to project appraisal and implementation, implies that part of the return on efforts exerted by the private-sector partner accrues to outside investors; this may undo whatever beneficial effects arise from ‘bundling’ the construction and operation of infrastructure projects, which is a hallmark of PPPs.

 

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Subventions et politique de concurrence

Peer Reviewed Article
Patrick Legros
Reflets et Perspectives, XLIII, 2004/1, pages 11-24.

Transfers to firms and regions are made both at the level of member states (state aids) and at the level of the European Commission (Structural Funds). State aids can take different forms: direct (transfers, tax exemptions) or indirect (e.g., the definition of the reserved area in network industries). There are significant cross-country differences both in the magnitude and the type of instruments used for state aids. The European Commission acts as a de-facto regulator by using competition law to approve state aids. We analyze the rationale of this two step process by pointing out the benefits of decentralizing redistributive decisions to the member states and the costs linked to reduced coordination (the use of structural funds, viewed as a complement to state aids, reduces some of these costs). We then point out that in a second best world objectives of redistribution are not incompatible with competition but that their relationship is less straightforward than with perfect markets; this has consequences for the rationale of having block exemptions, and for the effects of structural funds.

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Quality Incentives in Network Industries: a Case Study and a Model

Book Chapter
Mathias Dewatripont, Patrick Legros
in

We analyze the REIMS II agreement in the European postal industry. The agreement about prices for delivery was accompanied by quality constraints on time for delivery. Data suggest that: (i) quality does improve significantly over time; (ii) but costs (and therefore prices) differ a lot between PPOs and this is not just the result of differences in universal service obligations or quality differences, but rather strongly indicate that some PPOs suffer from a significant lack of efficiency. This is due to the fact that we are very far away from a fully liberalized market with e?ective competition. This leads us to observe that there has not been a serious cost-benefit analysis of the quality incentive scheme, especially since the existing quality incentive is distortive: it is higher the higher the domestic prices/costs (which might come at the expense of cost reduction incentives).

Auditing and Property Rights

Peer Reviewed Article
Elisabetta Iossa, Patrick Legros
The Rand Journal of Economics, Volume 35, Issue 2 , Summer 2004, 356-372

In a regulatory setting, audit provides incentives to an agent whose actions affect the future value of an asset. The principal does not observe the audit intensity nor the audit outcome and audit generates soft information. We show that with interim participation constraints, the principal may strictly prefer not to use the information of the agent but to rely only on the information given by the auditor. When this occurs, the auditor obtains property rights on the asset when he reports that the future value of the asset is high, while the agent is compensated by a monetary payment.

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Auction House Settlements - Winning Twice?

Newspaper Article
Orley Ashenfelter, Victor Ginsburgh, Kathryn Grady, Patrick Legros, Nicholas Sahuguet
The Art Newspaper, N° 141, November 2003

The Economic Consequences of Legislative Oversight: Theory and Evidence from the Medical Profession

Working Paper
Shawn Kantor, Patrick Legros
NBER WP 4281, 1983

This paper provides a positive analysis of how formal, periodic legislative oversight of regulatory agencies can influence market outcomes and the welfare regulated industries. Whereas previous research has focused on the political distinction between passive and active legislative oversight, this paper shows that there exists an important economics difference between the two mechanisms as well. We develop a principal-agent model that describes how a regulatory agent’s incentives are influenced if its actions are publicly scrutinized. our empirical analysis supports our claim that formal oversight leads to measurable economic effects.

 

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Disadvantageous Syndicates and Stable Cartels: the Case of the Nucleolus

Peer Reviewed Article
Patrick Legros
Journal of Economic Theory, Volume 42, Issue , 1987, 30-49

This paper considers a bilateral market with two complementary commodities and gives a rationale for Aumann’s paradox. The relationship between the notion of strong stability of a syndicate, i.e., the property that no group of players wants to exit or to enter the syndicate, and the notion of disadvantageous syndicates is summarized in two results. If the two sides of the market are balanced in terms of endowments, every syndicate is strongly stable. If the two sides of the market are not balanced in terms of endowments, then being advantageous, in Aumann’s definition, is necessary and sufficient for a syndicate to be strongly stable.

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Allocating Joint Costs by Means of the Nucleolus

Peer Reviewed Article
Patrick Legros
International Journal of Game Theory, Volume 15, Issue 2 , 1986, 109-119

This paper presents a sufficient condition for the nucleolus to coincide with the SCRB method vector and for nonemptiness of the core. It also studies the reasonableness and the monotonicity of the nucleolus under this condition. Finally it analyses the class of games satisfying the condition and compares it with the classes of convex games, subconvex games and the classQ of Driessen and Tijs.

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