Economic Resilience and Market Efficiency in Small States Gordon Cordina University of Malta April 2007.

Economic Resilience and Market Efficiency in Small States

Gordon Cordina

University of Malta

April 2007

Background

Vulnerability of small states is well documented Vulnerability is proneness to exogenous shocks Different degree of success of small states can be

ascribed to extent of policy-nurtured resilience Resilience is to ability to withstand and rebound

from the effects of adverse shocks Efficiency of resource allocation is a fundamental

element of resilience

Main Themes

Relationship between market efficiency and resilience

Increased incidence of market failure in small economies

Policy intervention and heightened proneness to policy failure in small economies

Imperative of enhanced efficiency and better governance in small economies

The Relationship between Market Efficiency and Economic Resilience

Vulnerability and Resilience

Vulnerability is exposure to exogenous shocks Effects of shocks are asymmetric, with negative

effects outweighing positive ones Vulnerability can hamper development if not

countered by resilience Resilience is developed through policies which

help the economy to:– withstand the effects of negative shocks– rebound quickly from the effects of negative shocks

Resilience and Market Efficiency

Resilience thus requires:– an efficient allocation of resources– an ability to quickly reallocate resources efficiently

For an efficient resource allocation, prices have to reflect the true costs and benefits from production

For an effective reallocation of resources, there needs to be flexibility and mobility of capital, labour, products and services

Resilience and Market Efficiency

Examples of market efficiency and resilience to shocks in small states:– Shocks to tourism demand– Shocks to oil prices– Globalisation, regional integration and international

competition

Resilience and Market Efficiency

Market efficiency requires:– private participation– competition between private agents

Public policy is essential to market efficiency and hence economic resilience:– securing legal and property rights– ensuring market access and proper competition– investing in public goods and institutional capacity

Market Failure in Small States

Situations of Market Failure

Markets do not achieve allocative efficiency and welfare maximisation in the presence of:– monopolistic conditions– external effects– sluggish market adjustment– missing markets– asymmetric information– uncertainty– socially undesirable distribution of resources

Monopolistic Conditions

Distort price signal through monopolistic rent-seeking

Are prevalent in small states due to:– Small size of markets– Thinness of markets– Indivisibilities in investment expenditure

External Effects

Price signal would be distorted by reflecting only private effects

Are more prevalent in small states due to:– Small land area– High density of population and economic activities

Notable consequences include:– Infringement of property rights and costs of litigation– Limited effects of positive externalities– Vulnerability to global externalities

Sluggish Market Adjustment

Response to price signal would be hampered by immobility of resources

Is more prevalent in small states due to:– High concentration of economic activities in

unrelated sectors– Thinness and shallowness of markets

Missing Markets

Not technologically possible to meet demand Concern mainly capital and insurance markets

in small states due to prevalence of shocks Resource constraints lead to reliance on

external markets, with potentially sub-optimal outcomes

Asymmetric Information

Lack of information leads to incorrect:– pricing decisions– interpretation of price signals

More prevalent in small economies due to:– presence of relatively large players in markets– weak bargaining power in international trade arena

Uncertainty

Price signals are distorted or are not followed

More prevalent in small economies due to exposure to exogenous shocks

Consequences include– lower investment– exchange rate volatility

Socially Undesirable Resource Distribution

Market access is restricted to owners of factor inputs

Socially undesirable income distribution more likely in small states due to:– Concentration of economic activities in a few

unrelated sectors– Insufficient economic development due to other

instances of market failure

Policy Failure in Small Economies

Policy Failure

Policy intervention may fail on account of:– mistakes of commission– mistakes of ommission

These may be further amplified into:– Unpredictable changes and costly mistakes– Obfuscated objectives– Implementation errors– High costs of intervention– Stifling of private initiative

Unpredictable changes and costly mistakes

These may be further compounded in small economies due to:– Large size of government– Widespread effects of individual policy interventions

Obfuscated Objectives

Obfuscation between economic, political and social objectives in small economies may be due to:– Proximity of social relationships– Concentration of power within a small group of elite

Implementation Errors

Policy implementation errors may be more widespread in small economies due to:– Insufficient human resources– Inadequate institutional capacity

High Cost of Intervention

Policy intervention may be more costly in small economies due to:– Indivisibilities in the functions of government

Stifling of Private Initiative

Government intervention may have particularly stifling effects on private sector initiative due to:– Culture of dependence on the State of employment

and income– Dependence on state for major investment

initiatives

Imperative of Better Governance in Small Economies

Imperative of Better Governance

Enhanced efficiency and better governance is the solution to rectify market failure without incurring policy failure

This is imperative for small economies with higher incidence of both market failure and policy failure

Imperative of Better Governance

There exists no single model of good governance that can be uniformly applied

Small states as a group have widely divergent governance performances

But is it probable that small states could more successfully emulate best practices in other small states with similar problems and constraints

Thank you

[email protected]