3 rd Lecture, STV4346B: “States and markets I”

1. 3rd Lecture, STV4346B: “States and markets I” Carl Henrik Knutsen, Department of Political Science, UiO 17/11-2008

2. Some general points • It is not whether production takes place in the public or private sector per se that matters for economic outcomes, it is the incentives economic agents face • There is no such thing as a market operating alone independent of institutional structures • “Market failures and government failures” • Incentives for “production” or “predation”? • The structure of states and bureaucracies and their relations to social groups • Existence of stable property rights? • Existence of complementary public goods?

3. Some points from Datta-Chaudhuri • State and market failures • Comparative analysis: Logic of difference/Most similar systems design • Early development economics and the importance of capital accumulation • Economic growth theory and the importance of capital for income level. However in the long run: Only technological change can drive economic growth (Solow, 1956; Romer, 1990) • Rosenstein&Rodan (1943) and the problem of “external economies” in developing countries • Nobody wants to invest if they are the only ones (demand for product, supply of production factors). • Nobody wants to invest if there is a lack of infrastructure and other public goods • Implication: Government must invest heavily in public goods and coordinate investment efforts in private sector The “Big Push”: Get the economy out of the development trap.

4. Some more points from D-C • Externalities and economies of scale One solution is vertical and horizontal integration of firms into large companies to internalize externalities and reap economies of scale • But: potential political economic problems. Lobbying power and rent seeking from large firms? Depends on state’s autonomy and state-society relations. • Important question: What are the incentives of rulers when dealing with such firms? What if the rulers’ political power depend on them? • Stay in power traded for rents to firm  Inefficiencies, both static (allocation of resources) and dynamic (innovation, growth) • The negative effect of the landlord class having political power: Incentives to keep status quo  No industrialization. No land reform and lacking agricultural efficiency • The role of the state in identifying and creating markets when these are not perceived or “opened” by potential entrepreneurs. Why are profitable markets not opened? • Risk • Lacking knowledge • Credit constraints: Poor people are not able to lend in credit marketNo money for initial investments • Cultural norms • Externalities, and need for complementary sectors (government and coordination) • Lacking public goods (infrastructure etc)

5. Fukuyama Ch 1. • The rise of the modern state: centralized bureaucracy, large army, taxation powers • The role of wars and the rise of the modern state (Tilly, 1975) • Weber’s definition (1946): “a human community that (successfully) claims the monopoly of the legitimate use of physical force within a given territory” • Fukuyama: The essence of stateness is enforcement. The state can send someone with a gun to enforce laws • Is the US a weak or a strong state? It depends on the definition The problem of unidimensionality!

6. Two dimensions of degree of “stateness” • Scope and strength/capacity of state power as two dimensions • Scope of state activities • “different functions and goals taken on by governments” • Strength of state power • the ability of states to plan and execute policies and to enforce laws cleanly and transparently — what is now commonly referred to as state or institutional capacity.”

7. Scope of state functions

8. An interesting table…

9. Capacity to do what?

10. The four quadrants

11. The quadrants and efficiency • Fukuyama: Economists believe in the economic benefits of being in quadrant I.. • Other benefits than efficiency from being in quadrant II, relative to I • Many would claim that its also beneficial for efficiency to move towards II • disputed topics: the effectiveness of industrial policy, redistribution and efficiency • Fukuyama: You don’t want to be in quad IV! (but III is probably equally bad..) • Fukuyama: State capacity more important than scope for efficiency.

12. Factors behind the supply of institutions (institutional capacity more specifically) • 1) Organizational design and management • 2) Political systems design • Different designs promote different goods, trade-offs between representativeness and governability f.ex? PR vsMajoritarian systems • Presidential vs parliamentary systems • 3) Basis of legitimization • Democracy, legitimacy and the possibility of successfully implementing reforms (lack of legitimacy and resistance in autocratic regimes) • 4) Cultural and structural factors • Making possible or constraining certain types of formal institutions. • Ex. Mandarin bureaucracy, history and Confucian values,Development of well-functioning bureaucracy today (valid argument?)

13. Transferability of knowledge about institutions

14. Demand for institutions • Every new institutional arrangement produces winners and losers, even if society as a whole gains • The role of power • Reform and veto-players • Demand factors: • Domestic demand for institutions from crucial groups (who are in power) • Threat of war • Conquest • Crisis and need for response (plus weakening of powerful groups that support status quo..financial crisis?) • External pressures related to conditionality (aid, trade, multilateral organizations like the EU)

15. Douglass North: The chapters of part I (Institutions) • 1) An introduction to institutions and institutional change • 2) Cooperation: the theoretical problem • 3) The behavioral assumptions in a theory of institutions • 4) A transaction cost theory of exchange • 5) Informal constraints • 6) Formal constraints • 7) Enforcement • 8) Institutions and transaction and transformation costs

16. Institutions • “Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction.” • “In consequence they structure incentives in human exchange, whether political, social, or economic” • North and the broad definitions of: institutions, exchange, transaction costs, relative prices etc. • To understand North, you need to know his definitions of these concepts! • Part 2: Theory of institutional change () • Part 3: (Institutions and) economic performance ()

17. Institutions continued • Defines and limits the set of choices for actors • Both formal and informal • Formal: Laws, regulation etc • Informal: Conventions, codes of behavior (norms) • Institutions vs organizations (political, economic, social) as “rules” vs “players”, separate rule from actors and their strategies! • Important when it comes to institutions: What are the gains and costs for actors of violating rules? • Monitoring, enforcement etc as crucial

18. Cooperation • Game theory and repeated games, reputation mechanisms and the shadow of the future: Self-enforcing cooperation • Tit for tat and Axelrod’s experiments on repeated Prisoners’ Dillemma • The number of players, information and feedback on cooperation breaches, and knowledge of other actors matter • Knowledge about others, community and cooperative norms (informal institutions) • Circles of trust and cooperation? Trustcooperationtrust.. • How to enhance cooperation if one-shot games or large number of players, little information and impersonal exchange?Institutions • Institutions and the alteration of relative pay-offs to cooperation vs non-cooperation. Structure the pay-offs so that self-interested actors will cooperate. • The role of the state (formal institutions): Enforcement and punishment

19. Behavioral assumptions discussed by North • “Violations” of rational choice model relevant for North’s theory • Dynamic preferences • Cognitive systems and processing of information about the world. The actors’ reliance on “models”. The role of ideology and beliefs about causal mechanisms. • Evolutionary economics and rational choice: People do not go through calculation processes, but 1) those who act like they are rational will succeed and survive. 2) Others will copy the successful. As if rationality (Alchian 1950). • Reciprocity, punishment of free-riders and the impetus to cooperate • Cognitive imperfection and the increased need for institutions to shape human interaction (rules of thumb)

20. Formal vs informal institutions • Institutional change: Changes in formal rules, informal constraints and effectiveness of enforcement • Formal institutions often easier to change than informal • Incremental change is often the case for informal institutions • Because exchange is more complex in modern economies need for increasing formalization of institutions • Specialization in modern economies (lower transformation costs higher transaction costs) • Impersonal exchange in modern economies • Weaker communities in modern economies increasing need for formalized enforcement

21. Formal vs informal institutions cont’d • Order in stateless societies: social networks, kinship ties, • Socialization; internalization of norms • Morality of cooperation and evolutionary arguments (which groups survive?) • But tendency to follow norms/ideologies is higher if costs of following them are low.. (claim: formal institutions often lower cost of following personal convictions) • reputation and threats of punishment • High cost of punishment and monitoring in large societies and dynamic societiesNeed for formal apparatus • Modern society many political and social groups need for formal institutions to solve coordination problems (parliaments, committees and bargaining/logrolling). Representative democracy.

22. Transaction costs and exchange • Cost of production= Cost of transformation + Costs of transacting • Transaction costs make up a very large proportion of total economic costs, particularly in advanced economies. d(TC/Y)/dY>0 • This is because of the nature of production. In developing countries, potential TC is very high  rather stick to simpler production tasks with lower TC. • Contracts, property rights and transaction costs: Defining, measuring, monitoring, enforcing, protecting and solving disputes about unclarities. • Neoclassical economics and the ignoring of TC.

23. Institutions and the economy • Institutions affect both the costs of production/ transformation and exchanges/transactions • The latter is particularly focused on in North • Institutions and reduction of TC. Make exchanges more productive and in some cases even possible. Institutions: • Provide information • alleviation of asymmetric • reduction “pure” uncertainty • Make enforcement, policing etc cheaper • But: Some institutional constraints increase TC • Institutions and the incentive to develop technology that reduces transaction costs

24. Institutions, inertia and efficiency • Key question: Are particular institutions efficient when it comes to providing a desired outcome? • Path dependency and the inertia of inefficient institutions • Efficient for whom? Society or particular actors.. (“Africa Works” by Chabal and Daloz, my paper: “Enlightened rule and Tyranny”) • Increasing returns and institutional inertia: • Lock-in effects, because of symbiotic relationship institutions and organizations • Feedback processes (Relate to Pierson!) • Socially inefficient institutions might be stable due to these features, even if there might be forces drawing institutional change towards more efficient structures (North’s earlier work, relative prices (f.ex land/labor), plus learning and adaptation as well as selection mechanisms) • Lack of informational feedback (are we doing right?), lack of competition, complex world The push towards efficient institutions might not be as strong as “functionalism” assumes.

25. Property rights • Definition: “Rights individuals appropriate over own labor and goods and services they possess”. (+ideas) • Includes “fruits” of labor and “fruits” from goods and services. • Includes rights to trade property. • Property rights: Structure and stability as two important aspects • Property rights, residual claimant and incentives (increases expected value of economic activity) • Stable PR and reduction of uncertainty Increases incentives to invest, educate, innovate, work for risk averse actors

26. Democracy and property rights • Democracy and property rights, positive effects. Who guards the guardians under autocracy: The role of checks and balances, and the importance of having “vested interests” protecting the system of PR (Olson, 1993). • Dictators might violate PR because a) in their own interest or b) in their important backers’ interest (North, 1981). • An example: The King, the Parliament and loans in 17th Century Britain vs Spain, France (absolutist monarchies). • Credible promises! Why would a King not confiscate in the future even if he promises not to do so? (North and Weingast, 1989) • Availability of capital to King in Britain (low interest rates), because of Parliament’s role: The King could not confiscate in t+1. Spanish and French Kings could confiscate and default because of concentrated power • The importance of making promises credible allows exchange over time: How to devise institutions in a way that makes promises credible