The Economic Theory of Social Institutions

1. The Economic Theory of Social Institutions Sergio Beraldo (University of Naples “Federico II” & ICER) Lectures delivered at the University of Prague (VSE) October 2011 I

2. OUTLINE OF THE COURSE • I: Institutions • II: Coordination • III: Cooperation 1 • IV: Cooperation 2 • V: Institutional structure and economic performance

3. I LECTURE • Institutions

4. Some basicquestions • What are institutions? • Why do economists have dedicated so much attention to institutions in the last decades? • Was this widespread interest in institutions justified? • Have we learned anything valuable? • Is there any criterion to assess institutions? • Should economists feel in charge of giving any advice concerning the “optimal” design of institutions?

5. What are institutions? - I • Institutions are the humanly devised constraints that structure political, economic and social interaction. They consist of both informal constraints (sanctions, taboos, customs, traditions, codes of conduct), and formal rules (constitutions, laws, property rights) • D.C. North, The Journal of Economic Perspectives, 1991.

6. What are institutions? - II • A shorter definition by Douglass North: [Institutions are] the rules of the game…or…humanly devised contraints • D.C. North, Institutions, Institutional Change, and Economic Performance, 1990.

7. What are institutions? - III • Institutions are systems of established and prevalent social rules that structure social interactions • [language, money, law, systems of weights and measures, table manners, and firms (and other organizations) are thus all institutions] • The term rule is broadly understood as socially transmitted and customary normative injuction or immanently normative disposition, that in circumstances X do Y • [G.M. Hodgson, Journal of Economic Issues, 2006]

8. What are Institutions? - IV • [Instituions are]…settled habits of thought common to the generality of men • Veblen, Journal of Political Economy, 1909

9. Are the abovedefinitions satisfactory? • You might find the above definition unsatisfactory! • This may partly depends on the fact that any definition is tailored on the basis of the purpose followed by the scholar who makes the definition! • Thus, you might either partially or totally reject the above definition

10. Are the abovedefinitions satisfactory? • Consider for example the first definition, due to North: “Institutions are the humanly devised constraints that structure political, economic and social interaction. They consist of both informal constraints (sanctions, taboos, customs, traditions, codes of conduct), and formal rules (constitutions, laws, property rights)” • A first flaw of the above definition: speaking of institutions as “humanly devised constraint” gives too much emphasis to intentionality

11. Are the abovedefinitions satisfactory? • The above definition puts too much emphasis on the “institutions as a constraint” view – In a different (personally favourite) perspective, institutions define what a society can achieve • [e.g.: starting from the extreme situation of an Hobbesian state of Nature in which mutually beneficial agreements do not take place, institutions enlarge the set of possible activities that individuals may wish to perform: before an institutional structure emerges, some exchanges are simply not possible]

12. Are the abovedefinitions satisfactory? • The above distinction between formal and informal institutions gives rise to a certain ambiguity – It is much better to use more precise terms such as legal rules (enforced by courts) and nonlegal rules (enforced by one’s peers) [as suggested by Hodgson, 2006]

13. Are the abovedefinitions satisfactory? • Consider the first part of Hodgson (2006)’s definition: • Institutions are systems of established and prevalent social rules that structure social interactions. • [language, money, law, systems of weights and measures, table manners, and firms (and other organizations) are thus all institutions]

14. Are the above definition satisfactory? • In Hodgson’s view (Hodgson, JEL, 1998) :each individual is born into, and molded by, a world of pre-existing institutions: even if these institutions were made by others and can be changed • Also the way in which individuals frame problems, their mental habits, are institutions • Criticism: if every thing is an institutions, explaining institutions would imply to explain everything! • Moreover: is this way of looking at institutions useful from an heuristic point of view?

15. Why do economists have dedicated so much attention to institutions in the last decades? • “Institutions (have been designed by human beings) to create order and reduce uncertainty in exchange” (D.C. North, Journal of Economic perspectives, 1991) • “Institutions form the incentive structure of a society, and the political and economic institutions, in consequence, are the underlying determinants of economic performance” (D.C. North, AER, 1994, Nobel Prize Lecture)

16. Why do economists have dedicated so much attention to institutions in the last decades? • The neo-classical result of efficient markets only obtains when it is costless to transact; requirements necessary to achieve a Pareto optimum are very stringent • When transaction costs are non-zero, then institutions matter! • [transaction costs are those costs born when making economic exchanges: • search and information costs; • costs of negotiating and writing contracts; • enforcement costs] • Neo-classical theory is concerned with the operation of markets, not with how markets develop (so it cannot address neither the problem of development nor the rise and decline of communism and Soviet Union) – D.C. North, AER, 1994.

17. Institutions to capture the gains from social exchange • Before reconsidering the problem of defining institutions, let us address some key problems related to economic (or more generally, social) exchange; let us do it in game theoretical terms • Two different settings: • The Prisoner’s dilemma game • The Stag-Hunt game

18. The Prisoner’s Dilemma Player 2 Player 1

19. The Stug-hunt game Each player may be tempted to follow a smaller prey instead of obeying to a concerted plan suitably devised to catch a deer - the relevant player does better by cooperating only if the opponent cooperates too. Player 2 Player 1

20. What makes it necessary to have appropriate institutions? • In both settings there are gains to be made by resisting the temptation of deviating from the strategy each player would play if binding agreements where possible • There is a surplus which could be generated if selfishness or lack of confidence were put aside

21. What makes it necessary to have appropriate institutions? • Individuals will usually find it worthwhile to cooperate with other players when: • the play is repeated • they possess complete information about the other player's past performance • there is a small number of players • [Think at earliest economies characterized by local exchange within a village --reputation ensures compliance]

22. What makes it necessary to have appropriate institutions? • Cooperation is difficult to sustain when: • the game is not repeated (or there is an endgame); • information on the other players is lacking; • there is a large number of players. • The productivity gains coming from specialization and division of labour can only be reaped if there emerges an institutional structure solving the problem of human cooperation under the latter conditions • In other words: anonymous exchange requires a suitable institutional structure

23. What makes it necessary to have appropriate institutions? • Creating the institutions that will alter the benefit/cost ratios in favor of cooperation in impersonal exchange is a complex process, because it not only entails the creation of economic institutions, but requires that they be supported by appropriate political institutions [D.C. North, AER, 1994]

24. Is there any criterion to assess institutions? • The criterion is the capacity of a given institutional structure to foster cooperation among individuals • Notice that an institutional structure can be highly inefficient yet persisting over time

25. Should economists feel in charge of giving any advice concerning the “optimal” design of institutions? • It is worth remembering what North (1994) point out [see also Dixit, AER, 2009]: • “It is the admixture of formal rules, informal norms, and enforcement characteristics that shapes economic performance. While the rules may be changed overnight, the informal norms usually change only gradually. Since it is the norms that provide “legitimacy” to a set of rules...economies that adopt the formal rules of another economy will have very different performance characteristics than the first economy because of different informal norms and enforcement”