The Tyranny of the Inefficient: An Enquiry into the Adverse Consequences of Power Struggles

Abstract

There are many instances where two closely related parties do not agree to mutually advantageous transactions even when there are simple enforceable contracts, and side transfers of fungible resources, that would implement them. Peace treaties are not signed, inefficient regulations are not altered, and possibilities for investment are frittered away. One reason, which has been extensively analyzed in the literature, is the presence of informational asymmetries. In this paper we focus on another potential explanation: the externality generated by the transfer of fungible resources. Unlike in a one-off transaction among unrelated parties, related parties will interact in the future. The very fungibility of the resources that are transferred to facilitate the immediate transaction can make it hard to restrict their use. As a result, if future interactions are influenced by the distribution of current resources, an externality can endogenously arise from the current transaction. Under some circumstances, even transactions that considerably enhance value can be inhibited by the endogenous externality. Agreement typically breaks down when the required transfer is large and the proposed recipient of the transfer is relatively unproductive or poor. The paper examines the implications for a theory of property rights, and for competitive strategy.