In the realm of national security, we are accustomed to thinking about the role of power. But, in a range of situations, power is important in the economic sphere as well.

Economists often emphasise the importance of decentralised markets – and we’re right to do that. But there is a range of other economic settings where considerations well beyond commercial matters, or supply and demand, take centre stage.

Modern economics emphasises the role of the “hold-up problem” in determining what activity takes place in firms versus market.

When contracts are incomplete – when there are things that are hard to foresee, or describe to a court – it’s preferable to do things inside the firm. This is more than a theory of the firm, it’s a theory of economic power. And it’s just the thing for understanding Australia’s relationship with China.

What we are witnessing in the modern era is hold-up between countries, not just between firms.

China accounts for more than 40 per cent of our exports. And, because of its political and economic system, it is acting like a large, strategic player, rather than a collection of disparate corporate interests.

For instance, China has set up a government platform for iron ore purchases and is forcing global suppliers to sell via that platform, giving it pricing power.

China’s Ministry of Education has similar influence over education exports of other countries because it can influence where Chinese nationals are permitted to study.

Of course, Australia has some power over China as well. Since 2015, more than 60 per cent of China’s iron ore has come from Australia. And Chinese consumers want to access Australian agriculture and education exports in ways that are not so easily replaced by those from other countries.

The best outcome for Australia is to neither overplay nor underplay our hand.

The possibility of mutual hold-up informs our trading relationship with China. It has power over us and we – at least for now – have some power over China due to our mining, education, and agriculture exports.

The best outcome for Australia is to recognise this and neither overplay nor underplay our hand.

And it tells us that our economic future with China will be determined, in no small part, by our power in that relationship. Let’s not make ourselves subject to hold-up problems with rare earth elements, batteries, or important electronics.

This framework also informs our foreign investment rules with all countries, especially and including China. This has been usefully applied to government ownership generally. Should the NSW government own poles and wires? Should governments outsource hotel quarantine security during a pandemic to private contractors?

The basic answer was developed in a classic paper by economists Oliver Hart, Andrei Shleifer and Robert Vishny. The key insight is that government ownership becomes more appealing when it’s hard to contract on very important details of a deal.

For instance, preventing viral leaks from quarantine hotels during the pandemic was super important, and so shouldn’t have been left to private contractors. Purchasing office supplies or cleaning services should obviously be outsourced because of cost advantages.

Similarly, one might wonder whether it’s possible to write a complete and enforceable contract about the use of an Australian port. Hint: it is not. And so, signing at 99-year lease over a key strategic asset like the port of Darwin makes very little sense.

A range of other Chinese investments are appropriate and important. But there are limits – and those are more qualitative than quantitative.

Economists have long understood that when one is in a strategic interaction, it is the incentives and relative power of the parties in the particular situation that determine the outcome. And, anticipating this informs when to avoid certain interactions, and embrace others.

China is an important trading partner for Australia, and it will remain so. But we should be mindful of hold-up on both sides. Foreign investment from China is also beneficial, but we cannot lose control of crucial strategic assets.

Albanese’s reset with China is important, and welcome. But ultimately, it is power – both economic and political – that will govern our relationship.