PPS232S.01 Microeconomics of International Development Policy

1. PPS232S.01Microeconomics of International Development Policy 8. Institutions, corruption, and governance

2. Institutions This section will focus primarily on the work of D.C. North, who won a Nobel for his work on institutions. North (1990): “Institutions 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.”

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

4. Institutions In addition, institutions can be created (e.g., the US Constitution) 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.

5. Institutions For North, the major role of institutions is to reduce uncertainty (and so 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.

6. 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), and recall our discussion of the Washington Consensus (Platteau, 1994a and 1994b).

7. Institutions Informal constraints come from socially transmitted information and are part of culture (we’ll discuss Fisman and Miguel later on in this section…) Think of a completely stateless society (e.g., Somalia, perhaps?) How is order preserved there? From anthropology, exchange in tribal societies is not simple – dense social networks lead to informal structures that are stable.

8. 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; Hamilton wanted to back out of the duel.) 3. Internally enforced standards of conduct.

9. 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.)

10. Institutions Formal Constraints Increasing complexity of societies → Increase in returns to formalization of constraints. Technological progress → Lower measurement costs and encourage precise, standardized weights and measures.

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

12. 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.

13. Institutions Generally, political rules (e.g., constitutions) lead to economic rules (e.g., property rights), but causation runs both ways – constitutions usually arise from social norms, which tend to arise so as to maximize wealth (Ellickson, 1989). In equilibrium, political and economic rules will be consistent with one another, i.e., changes in one will entail changes in the other.

14. 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.

15. 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, nonrepetitive problems (e.g., 9/11, the Great Depression, etc.) and about problems which only remotely affect them. Bottom line: democracy should not be equated with competitive markets in the economy.

16. Institutions Sequence: Rules go from the polity 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(Bellemare, 2012 on sharecropping in Madagascar).

17. 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 production.

18. 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.) Fafchamps (2004) develops a formal model to predict when we should expect transactions to occur as they are supposed to, and when we expect parties to renege.

19. Institutions 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.

20. 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.

21. Market Order Mechanisms Despite the confidence that economists display as regards markets, they spend little time studying how markets arise. As we’ve already seen, the Walrasian idea of frictionless market-clearing is a far cry from what goes on in the real world, even in industrialized countries.

22. Market Order Mechanisms Platteau (1994a, 1994b) identifies the social conditions that are conducive to efficient markets, i.e., factors that are most often taken for granted when economists discuss markets. Part I: “Embeddedness” (repeated interactions and reputation mechanisms) cannot fully explain how trust arises in market societies. Part II: Social norms.

23. Market Order Mechanisms “Washington Consensus” was that markets could be implanted anywhere and would solve the problem of underdevelopment Requires property rights, a legal framework, and fundamental liberties. “Yet […] there is no place for doubts about the […] transferability of the market system to grounds in which it did not emerge spontaneously.”

24. Market Order Mechanisms But what market order institutions or social norms arise (and why) in order to enable socially and privately beneficial exchanges? The problem is one of information collection and enforcement. Market order is the means by which transactions are regulated to reduce transactions costs and reduce uncertainty. It is notexogenous, and so cannot be imposed from the top down, since it relies on culture and history.

25. Market Order Mechanisms Four basic mechanisms underpin a market-based system: • Decentralized mechanisms (self-enforcing contracts with repeated interactions or networks) • Coordinated private order institutions • Public order institutions (external enforcement mechanisms) • Generalized morality Let’s look at each of those in turn.

26. Market Order Mechanisms Decentralized Mechanisms Feature of contracts that make them self-regulating and self-enforcing: repeated interactions with counterparties (directly or indirectly through third parties) can maintain efficient exchange. This rests heavily on the Folk Theorem. Multilateral reputation mechanisms (networks) also work.

27. Market Order Mechanisms Even without contract laws or other exogenous enforcement authority, it is possible to establish trustworthy market relations, but the space of such relations is limited. Decentralized mechanisms are limited in scale, so they work best in small, local systems. Thus, while this works well in villages, it tends to breakdown in urban areas.

28. Market Order Mechanisms Private Order Institutions Information collection and communication are individually costly, but information is non-rival. Firms thus have an incentive to coalesce so as to share information about each other and enforce collective decisions (e.g., merchant guilds, Better Business Bureau, credit rating agencies, etc.)

29. Market Order Mechanisms Public Order Institutions In much of the world, the State plays the role of such institutions and uses its power to encourage transactors to honor their contracts (e.g., commercial codes, tort and contract law, etc.) The State can thus monitor behavior, enforce compliance, sanction transgressors, as well as collect and communicate information.

30. Market Order Mechanisms Private and Public Order Institutions The larger the scale of private and public order institutions, the wider the scope and scale for exchange in an economy (e.g., grades and standards, standardized weights and measures, accounting and auditing practices, etc.) Conversely, weak states go hand-in-hand with weak markets.

31. Market Order Mechanisms Generalized Morality The three conditions mentioned above, however, may be insufficient to ensure an effective market order. Generalized morality reduces enforcement cost, encourages cooperation and coordination, and reduces the need for external sanctions (Fukuyama’s Trust.) Social norms therefore support and supplement private and public order institutions. How they emerge and evolve is the object of Ellickson (1994).

32. Market Order Mechanisms More importantly, it is useful to realize that such generalized morality might not suddenly arise after imposing a market-based system (e.g., post-communist Russia, present-day China.) Therefore, it may be possible to impose foreign order institutions (Rule of Law, property rights, etc.), but those things might not be sufficient: the social terrain must be hospitable.

33. 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.

34. 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.

35. 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.

36. 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.

37. 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.

38. 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.)

39. 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?

40. 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.

41. 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.

42. 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.

43. 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”)

44. 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.

45. 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.

46. 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.

47. 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.

48. 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.)

49. 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.

50. 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.