PPS231S.01 Law, Economics, and Organization

PPS231S.01Law, Economics, and Organization Spring 2012 II.1. Institutions

Institutions We will focus primarily on the work of D.C. North, who won a Nobel for his work on institutions. For North (1990), “[i]nstitutions are the rules of the game in a society (…), the humanly devised constraints that shape human interaction. In consequence they structure incentives in human exchange (…) Institutional change shapes the way societies evolve through time and (…) is key to understanding historical change.”

Institutions For an economist, institutions define the choice set of individuals. Think about a norm observed by many religions, viz. that of not eating pork. In the usual two-good graph of consumer choice, say chicken and pork, what would the choice set look like? Institutions can be both formal and informal – we’ll be looking at both shortly.

Institutions In addition, institutions can be created (e.g., Constitution of the United States) or they can evolve over time (e.g., the Common law.) Institutional constraints include both what individuals can and cannot do, so an essential part of their functioning is the costliness of ascertaining violations as well as the severity of punishment.

Institutions The major role of institutions is to reduce uncertainty (and thus transactions costs) by establishing a stable (but not necessarily efficient) structure to interactions. This stability of interactions does not mean that institutions themselves are stable, although they often evolve very slowly.

Cooperation We know from first principles that in a static Prisoner’s Dilemma, players will deviate. Institutions Player 2 Player 1

Institutions What is less well-known, however, is that when the game is repeated infinitely (or when there is no end in sight), cooperation very often can be sustained as a Nash equilibrium (“Folk Theorem”) There is something tremendously important here: repeated interactions can be the source of good (i.e., cooperative) behavior, usually under a tit-for-tat strategy (Axelrod, 1964).

Institutions Game theory provides us with good insights about cooperation and defection, but it tells us nothing about the costs of transacting. Coase (1960): When it is costless to transact, an efficient competitive solution obtains. But transactions costs are to economics what friction is to physics.

Institutions Informal Constraints In our daily interactions, our behavior is often dictated by codes of conduct, norms of behavior, and conventions. To see how they matter, witness what happens when the same formal rules (e.g., laws, constitutions) are imposed on different societies (or, for example, how Japanese culture survived US occupation after World War 2.)

Institutions Informal constraints come from socially transmitted information and are part of culture. Think of a completely stateless society (e.g., Somalia) How is order preserved there? (North, 1990, pages 37 and 39.) From anthropology, exchange in tribal societies is not simple – dense social networks lead to informal structures that are stable.

Institutions Thus, informal constraints are: 1. Extensions, elaborations, and modifications of formal rules (e.g., Congressional committees.) 2. Socially sanctioned norms of behavior (e.g., Burr vs. Hamilton, who wanted to back out.) 3. Internally enforced standards of conduct.

Institutions So how do we explain the emergence and persistence of informal constraints? They really are conventions that solve coordination problems and which are in everyone’s interest to keep (Nash equilibria.)

Institutions Formal Constraints Increasing complexity of societies → Increase in returns to formalization of constraints. Or: social norms work well in a small, close-knit environment. They don’t work well with millions of people. Technological progress → Lower measurement costs and encourage precise, standardized weights and measures.

Institutions Formal legal systems to handle more complex disputes → formal rules. Hierarchies in more complex organizations → formal structures to specify principal-agent relationships.

Institutions Formal rules: political rules, judicial rules, economic rules, and contracts (e.g., constitutions, statutes, common laws, specific bylaws, individual contracts.) All these define constraints, and constraints define the choice set. (How so for the consumer in her utility-maximization problem?)

Institutions Generally, political rules (e.g., constitutions) lead to economic rules (e.g., property rights), but causation runs both ways. In equilibrium, political and economic rules will be consistent with one another, i.e., changes in one will entail changes in the other.

Institutions The move from a single, absolute ruler to a democratic government is usually synonymous with a greater political efficiency. That is, democratic governments give a greater percentage of the population access to decision-making, eliminate arbitrary wealth confiscation, and develop third-party contract enforcement with an independent judiciary.

Institutions This does not mean efficient political markets! Rational ignorance often increases the role of subjective perceptions. Even the most informed constituents will be in the dark making choices about complex, non-repetitive problems, once-in-a-lifetime (e.g., 9/11, current financial crisis, etc.) Bottom line: democracy should not be equated with competitive markets in the economy.

Institutions Sequence: Rules go from polities to property rights to individual contracts. Sometimes, rules can be inherited from several sources Example: In most of the developing world, “rules” are typically a mixture of traditional norms and colonial law. More on this next lecture, when talking about property.

Institutions To define and protect property rights and to enforce agreements, it takes resources (e.g., lawyers, judges, police, army, etc.) Institutions determine those transactions costs, but also the costs of transforming resources. As a result, institutions play a key role in the costs of productions.

Institutions To see the effect of ineffective or poorly-defined property rights, we only need to contrast the organization of production in a Third World country with that of an advanced industrial economy (North, 1990, page 65.) Example: Bribes in Madagascar for water and Air France cargo.

Institutions Thus, costs per exchange are much greater in a Third World country – sometimes so high as to have no exchange occurring. In other words, the institutional structure in the Third World lacks the formal structure (and enforcement!) that underpins efficient markets.

Institutions To remedy this situation, there often exist informal sectors that attempt to provide a structure for exchange, but the lack of property rights mean these structures are costly. Thus, exchange is restricted to personalized transactions and self-enforcing contracts. Another, perhaps more important problem, is that this type of institutional framework tends to perpetuate under-development. We’ll be discussing Platteau (1994a) this week in our discussion section.

Markets and Traders Fafchamps (2004), Market Institutions in Sub-Saharan Africa, MIT Press. Fafchamps writes about what he has worked on, but the findings apply to most, if not all, developing and transition economies.

Markets and Traders In the 1980s and 1990s, we experience a period of renewed faith in markets. Liberalization, market reform, privatization, etc. in the developing world and in former socialist economies, even in industrialized countries. Paradoxically, little is known about the institutions supporting market exchange and how markets structure themselves over time.

Markets and Traders “The time is not far when Africa was widely thought to escape the rules of the market” (page 4) Pre-colonial realities were idealized as gift economics or pre-capitalist collectivism; pan-African socialism.

Markets and Traders In truth, Sub-Saharan Africa is probably more market-oriented than the US. Very little resource allocations take place within firms and hierarchies, so market transactions are the dominant mechanism to allocate resources. More transactions required to get grain from the farm gate to the consumer in Africa than in the US.

Markets and Traders Yet, little is known about markets themselves, even after the theoretical contributions of North and Platteau. But what escapes our understanding does not necessarily defy explanation.

Markets and Traders The problems that indigenous (i.e., informal) institutions try to solve are the usual ones: commitment failure, asymmetric information, and transactions costs. The solutions, however, are often original (e.g., market for corpses.)

Markets and Traders Just as Sub-Saharan Africa is probably more market-oriented than the US, the entrepreneurs probably represent a higher proportion of the population in Africa than in industrialized economies. This includes the self-employed, people who own their own small business, head their own firm, etc. Many people have several small businesses. But then, why are large firms so conspicuously absent from the African landscape? Why several businesses instead of a large one?

Markets and Traders Allocations and Markets Three ways of allocating resources: gift exchange, markets, hierarchies. Gift exchange takes places within households and families and sometimes among friends and neighbors. It involves no explicit obligations, but involves some kind of reciprocity.

Markets and Traders Allocations and Markets Market exchange is based on reciprocity (either spot transactions or contracts.) But because trade is voluntary, what one receives must be greater or equal to what one gives up. Thus, market exchange depends on the existence of gains from trade. In gift exchange, reciprocity is implicit and the trade is often unequal.

Markets and Traders Allocations and Markets To minimize problems, many sales transactions are organized such that compensation is immediate. The only institutions required are money and a police force, although the latter is not strictly necessary.

Markets and Traders Allocations and Markets Hierarchies are the third mechanism: firms, government agencies, banks, parastatals, etc. Hierarchies rely on command and control to allocate resources. These use internal accounting (“transfer pricing”)

Markets and Traders Allocations and Markets Hierarchies centralize the allocation of resources. Because allocations often contradict the self-interest of agents, hierarchies require incentive systems to ensure compliance. This often requires enforcement mechanism. But what is the advantage of hierarchies over markets? Returns to scale in production/ownership; search costs; contract enforcement; conflict arbitration; etc.

Markets and Traders Transactions Costs and Markets In the US, the domain of gift exchange has almost vanished and is limited to certain occasions (e.g., Christmas, birthdays, anniversaries, “just because”, etc.) Household production is also very limited (e.g., meals and cleaning.), and social protection is provided through a mix of markets and governments.

Markets and Traders Transactions Costs and Markets In developing countries, however, households provide a wide variety of services for themselves: food, shelter, fuel, child care, training, food preparation, and numerous crafts. Risk-sharing networks (usually at the level of the village, sub-caste, household, etc.) are the dominant form of social insurance.

Markets and Traders Transactions Costs and Markets Market transactions (and firms) are usually very small, and most market participants are usually individuals or very small firms. As a consequence, very little collateral, and courts are not credible. Sales are cash-and-carry, and the placement of orders, invoicing, supplier credit, and warranty provision are limited to larger, urban firms.

Markets and Traders The Role of Traders Micro theory has focused mostly on the study and modeling of producers and consumers, but it has failed to identify a separate role for traders. Usually, the intermediation provided by traders is assumed trivial, but traders have existed for a long time, in all societies, and today still (Lebanese traders in West Africa, Indian traders in East Africa, Chinese traders in Southeast Asia, etc.)

Markets and Traders Trust and Relationships Fafchamps’ work contends with traders and their relative economic prosperity. Markets are thought of as decentralized allocation mechanisms, but they cannot exist without coordinated action, if only to protect and define property rights – the topic of our next lecture.

Markets and Traders Trust and Relationships When such services are not provided by the state, mafias and private armies arise, thriving on protection money. But even when property rights are properly defined and protected, there still exist opportunities for cheating.

Markets and Traders Trust and Relationships Indeed, all economies are characterized by information asymmetries, which generate adverse selection and moral hazard. They also generate contract enforcement problems, since compliance is hard to verify by agents not party to the contract (e.g., courts.)

Markets and Traders Trust and Relationships The consequence is that enforcement of contracts through courts is necessary imperfect and requires other forms of enforcement. Without suitable cheating deterrents, exchange becomes rudimentary (“flea market economy”): no order placement, no invoicing, no payment by check, no credit, and no warranty…

Markets and Traders Trust and Relationships In every day business, personal trust is often an effective substitute for the security normally provided by (costless) legal enforcement. But where does trust come from? It must necessarily derive from a history of successful exchanges – relational contracting is thus the norm between manufacturers and suppliers when institutions are weak (e.g., Sub-Saharan Africa.)

Markets and Traders Trust and Relationships On average, the length of the relationship exceeds seven years, and most supplies of a particular input come from a single supplier. (Do you expect monopoly pricing or not?) Thus, repeated exchange economizes on the cost of establishing personal trust. In certain markets, repeated exchange is so prevalent that it is the norm. Those are the markets where the scope for abuse is the greatest and screening costs are the largest.

Markets and Traders Trust and Relationships Thus, relationship-based networks are expected to arise in markets where screening costs are high and personal trust is a substitute for external enforcement through lawyers and courts. (Recall Toyota’s long-term contracting strategy with its suppliers, rather than in-house production.)

Markets and Traders Reputation Another mechanism for enforcing contracts is reputation (or “multilateral punishment strategy”.) Cheaters are subjected to coordinated punishment by all (or a subgroup of) other agents. Typically, “punishment” is exclusion from economic exchange or from other social interactions, but this can also mean physical harm or death in extreme cases.

Markets and Traders Reputation The effectiveness of reputation depends on the speed with which information about cheaters is disseminated and on the extent to which it circulates among all agents.

Markets and Traders Reputation The reputation mechanism itself is affected by the difficulty for strangers to assess what went wrong between parties to a dispute. Information provided by one party can be false, and so disinformation is likely. As a result, reputation alone is unlikely to be a sufficient enforcement mechanism.

PPS231S.01 Law, Economics, and Organization