Institutions (North 1991)

1. Lecture 15Institutions, New Institutional Economics, and Environmental and Natural Resource Economics

2. Institutions (North 1991) • „Institutions are the humanly devised constraints that structure political, economical and social interaction. • They consists of both informal constraints (sanctions, taboos, customs, traditions, and codes of conduct), and formal rules (constitutions, laws, property rights) • Throughout history, institutions have been devised by human beings to create order and reduce uncertainty in exchange“ (North 1991, p. 97)

3. The Individual and the Institutional Structure Source: Vatn (2005)

4. Types of Institutions(Ellickson 1991)

5. What is New Institutional Economics? • Economic Analysis of Institutions • Institutions • Formal and informal rules at different levels • Emergence, causes, effects, evolution • Economic Analysis • Methodological Individualism • Utility maximization (benefits and costs) • Incomplete and costly information • Bounded rationality • Opportunism • Transaction costs

6. Bounded Rationality and Opportunism • Bounded Rationality • Incomplete information • Incomplete processing of information • All complex institutions are incomplete • Opportunism • Taking advantage of information asymmetries • Following self interest with the help of guile (lying, cheating) • Institutions need to be safeguarded against opportunistic behavior

7. Foundations of NIE • Ronald Coase (Law and Economics) • 1937 – The Nature of the Firm • 1960 – The Problem of Social Costs • 1974 – The Lighthouse in Economics • Douglass North (Economic History) • 1973 – The Rise of the Western World • 1981 – Structure and Change in Economic History • 1992 – Institutional Change and Economic Performance • Oliver E. Williamson (Economics and Organization) • 1975 – Markets and Hierarchies • 1985 – Economic Institutions of Capitalism • 1996 – Mechanism of Governance

8. Branches of NIE • Transaction Cost Economics (Coase, Williamson, North) • Property Rights Theory (Alchian, Demsetz, Furubotn, Bromley, Barzel) • Contract Theory • Principal Agent Theory (Stiglitz, Tirole) • Incomplete Contract Theory (Hart, Moore) • New Economic History • New Political Economy

9. Questions addressed by NIE • Effects of institutions, e.g. property rights, on • Resource allocation • Income distribution • Incentives (efforts, investments, innovation) • Transaction costs • Choice and change (evolution) of institutions • Designed or spontaneous development? • Efficiency or distribution oriented • Reduction of transaction costs

10. LEVEL FREQUENCY (YEARS) PURPOSE THEORY Embeddedness: Informal Institutions, Customs, Tradition,Norms, Religion Social Theory often noncalculative, spontaneous 10² to 10³ L1 Institutional Environment: Formal Rules of the Game – esp. Property (Polity, Judiciary, Bureaucracy) get the Institutional Environment right, 1st order economizing Economics of Property Rights, Positive Political Economy L2 10 to 10² Governance: Play of the Game – esp. Contract (aligning Governance Structures with Transactions get the Governance structure right, 2nd order economizing 1 to 10 Transaction Cost Economics L3 Resource Allocation and Employment (Prices and Quantities, Incentive Alignment) Neoclassical Economics/Agency Theory get the marginal conditions right, 3rd order economizing L4 continuous Analytical levels of New Institutional Economics Williamson (1998)

11. EFFECTS CAUSES PROCESSES Embeddedness: Informal Institutions, Customs, Tradition,Norms, Religion Embeddedness: Informal Institutions, Customs, Tradition,Norms, Religion Embeddedness: Informal Institutions, Customs, Tradition,Norms, Religion L1 Institutional Environment: Formal Rules of the Game – esp. Property (Polity, Judiciary, Bureaucracy) Institutional Environment: Formal Rules of the Game – esp. Property (Polity, Judiciary, Bureaucracy) Institutional Environment: Formal Rules of the Game – esp. Property (Polity, Judiciary, Bureaucracy) L2 Governance: Play of the Game – esp. Contract (aligning Governance Structures with Transactions Governance: Play of the Game – esp. Contract (aligning Governance Structures with Transactions Governance: Play of the Game – esp. Contract (aligning Governance Structures with Transactions L3 Resource Allocation and Employment (Prices and Quantities, Incentive Alignment) L4 Resource Allocation and Employment (Prices and Quantities, Incentive Alignment) Resource Allocation and Employment (Prices and Quantities, Incentive Alignment) Econometrics/Experiments Econometrics/Case studies Case studies/Historical narratives Research questions (Alston 1996 & Williamson 2000)

12. MEASURMENT VARIANCE DATA SOURCES Small to medium (e.g.. 12 main religions, 6.800 main languages) Poorly developed Some official statistics International surveys Simple discrete to complex often intangible (e.g. religion, belief system) L1 Small to medium (e.g. 5 legal origins, 192 states, 2005) Less developed Historical records Documents Official statistics International Surveys Simple discrete to very complex (e.g. parliamentary vs. presidential system, proposal for EU constitution) L2 Large (e.g. 2 915 482 firms in Germany, 2003) Developed Official statistics Accounting Simple discrete to complex: (e.g. make or buy, complex contracting, modern corporations) L3 Large to very large (e.g. annual GDP, daily prices and quantities at the stock market) L4 Simple continuous (e.g. compensation rules, prices and quantities) Well developed Official statistics Accounting Data constraints

13. What is „Institutional Environmental and Resource Economics“? • Not Neoclassical Economics? • Not Ecological Economics? • Neoclassical Economics • Rational choice as maximzing individual or social utility • Stable preferences • Equilibrium outcomes • No information costs • No transaction costs • Private property rights for all goods which are exchanged in competetive markets

14. Neo-classical Environmental and Resource Economics • Externalities (Pigou 1920: The Economics of Welfare) • Exhaustible resources (Hotelling 1931: The economics of exhaustible resources) • Public goods (Samuelson 1954: The Pure Theory of Public Expenditure ) • Commons (Hardin 1968: The tragedy of the commons)

15. Institutional Environmental and Resource Economics I • Problem of Social Costs (Coase 1960) • Property Rights (Demsetz 1967) • Lighthouse in Economics (Coase 1974) • Problem of Externalities (Dahlman 1979) • New Classics • Environment and Property Rights (Bromley 1991) • Governing the Commons (Ostrom 1990)

16. Institutional Environmental and Resource Economics II • Challen (2000): Institutions, Transaction Costs and Environmental Policy • Young (2002) The Institutional Dimension of Environmental Change • Hagedorn (2002) Institutional Change and Cooperation • Saleth, Dinar and Saleth (2004) Institutional Economics of Water • Vatn (2005) Institutions and Environmental Policy

17. Typology of goods(Ostrom 1990) Excludable Non-Excludable Rivalry Non-Rivalry

18. Environmental Economics vs. Ecological Economics Source: Vatn (2005)

20. The Systems Perspective

21. 2 Coordination and Conflict – Game Theory and Institutional Analysis

22. Game Theory -Games, Players, Strategies, Rules and Payoffs • Games (coordination vs. conflict, non-cooperative vs. cooperative) • Player (individual and collective actors) • Strategies (set of conditional actions) • Payoffs (benefits and costs, individual vs. social) • Rules (intended or unintended, imposed or negotiated)

23. Assumptions in Games Theory Rules Player Actions Results (Payoffs) Environment

24. Changing the terms Institutions Actors Interactions Allocation, Distribution Environment

25. Simple game theoretic modeling • Two players A and B • Each player has two strategies i and j • The payoffs are a function of the interactions (combinations of strategies) AiBi, AiBj, AjBi,AjBj • Each player chooses the strategy the maximizes her/his expected utility, max E(U (AiBi, AiBj, AjBi,AjBj)) • Each player build expectations about the behavior of the other player, she/he assigns probabilities p and 1-p to the other players strategies, max U (pAiBi + (1-p) AiBj, pAjBi + (1-p)AjBj)

26. Actor constellations (Scharpf 2000)Cooperation vs. Conflict B i j B i j i A j Pure coordination Pure conflict

27. Analysis of strategies and equilibrium • Each player builds expectations about the behavior of the other player and assigns probabilities p und 1-p to the strategies of the other player, max U (pAiBi + (1-p) AiBj, pAjBi + (1-p)AjBj) • Each player choose the strategy that maximizes her/his utility , max U (AiBi, AiBj, AjBi,AjBj) • Example: • A: UAi(p3+(1-p)0), UAj(p0+(1-p)0) -> Strategy i • B: UBi(p3+(1-p)0), UBj(p0+(1-p)0) -> Strategy i • Nash-Equilibrium: where no player has anything to gain by changing only his or her own strategy. If each player has chosen a strategy and no player can benefit by changing his or her strategy while the other players keep theirs unchanged, then the current set of strategy choices and the corresponding payoffs constitute a Nash equilibrium. • Social Optimum: Sum of the individual utilities UA+UB • Coordination: Nash-Equilibrium is social optimum • Conflict: no single social optimum in a zero-sum game

28. Prisoners Dilemma and Chicken Games (cooperation games) B B i j i j i A j Chicken Game Prisoners Dilemma

29. Analysis of strategies and equilibrium II • Prisoners Dilemma (Assumption: p, 1-p = 0,5) • A: UAi(0,5*2+0,5*0)=1, UAj(0,5*3+0,5*1)=2 -> Strategy j -> don’t pay • B: UBi(0,5*2+0,5*0)=1, UBj(0,5*3+0,5*1)=2 -> Strategy j -> don’t deliver • Nash-Equilibrium is not a social optimum, social Optimum is pay and deliver, trade (cooperation)

30. Institutions, Games and Enforcement B B i j i j i A j Prisoners dilemma with sanctions s Prisoners Dilemma

31. Institutions and Enforcement II C i j i A j Comply with the rules or not Sanction non-compliance or not

32. Emergence of Conventions- the Crossroad Game (evolutionary game theory • Rules or convention may also emerge spontaneously, example: • At a crossroad two drivers may stop or continue to drive • For each driver it is beneficial to continue to drive while the other stops • The worst case is that both drivers continue and cause and accident • A convention right before left of left before right may emerge spontaneously

33. Institutional Context Acteurs Orientations and capacities Action situa-tion Forms of inter-action Pro-blems Political decision Political Environment Games real actors play Actors-oriented Institutionalism (Scharpf)

34. A Framework for Institutional Analysis (Ostrom 1998) Attributes of Physical World Action Arena Patterns of Interaction Attributes of Community Action Situations Actors Outcomes Rules-in-use Evaluative Criteria: Social Auditing Cost-Benefit Equity Environment

35. Literature and Sources • Fehr, E. and Gächter, S. (2000) Cooperation and Punishment in Public Goods Experiments. American Economic Review 90(4), 980-994. • Scharpf, Fritz (1998) Games Real Actors Play. Actor-centered Institutionalism in Policy Analysis. • Ostrom, Elinor (2005). Understanding Institutional Diversity. Princeton: Princeton University Press. • Institut für Empirische Wirtschaftsforschung (http://www.iew.unizh.ch/home/fehr/)

36. 3Transaction Costs

37. What is a Transaction? I • (1) „A transaction occurs when a good or service is transferred across a technological separable interface. One stage of activity terminates and another begins.“ (Williamson 1985, p.1) • A transaction is an elementary coordination problem connected with the question how to solve this problem institutionally (and technically) • Example: Somebody wants to get a transfer of 1000 Euro. What’s the problem? How can it be solved?

38. What is a Transaction? II • (2) A transaction is the „alienation and acquisition between individuals of the rights of future ownership of physical things.“ (Commons 1935, S.58) • A transaction is a transfer of property rights • Example: Somebody acquires the right to get 1000 Euro transferred. What’s the problem? • How do both perspectives differ?

39. What is a transaction? III Transfer I2 I1 Property Rights Over a good or service Definition of Property Rights of I2 over ai+1 Definition of Property Rights of I1 overai Goods or services ai+1 ai Technological - separable Interface Source: Beckmann (2000)

40. Markets vs. Hierarchy Market Hierarchy I4 I1 I2 I3 I2 I2 I3 Flow of goods Money flow

41. Centralized vs. Decentralized Resource Management Source: JAHAN et al (undated)

42. Transactions Costs • Costs of running the economic system (Arrow 1969) • „Cost of establishing, using, maintaining and changing institutions...“ Richter und Furubotn 1996, S. 49 • Resources spend on initiating, negotiating, safeguarding, monitoring, enforcing and adjusting transactions • Utility losses due to imprecise arrangements, inefficient safeguarding, monitoring, enforcement or adjustment

43. Types of Transaction costs I • Search and information costs • Cost of searching for suppliers, customers, products, technologies, etc. • Information about qualities, prices, etc. • Function of the distribution of information and the information and communication technology • Negotiation and decision making costs • Negotiation, balancing diverse interests • Decision making costs, time and resources spend on decision making, cost of wrong decisions (bounded rationality) • Function of differences in preferences, number of people involved and the decision making rule

44. Types of Transaction costs II • Monitoring- and Enforcement Costs • Costs of monitoring, identification of non-compliance with the rules • Costs of enforcement, sanctioning non-compliance • Function of the measurability and verifiability of activities and the monitoring and enforcement technology • Adjustment costs • Costs of adjusting the rules to changing environmental circumstances • Costs of maladaptation • Function of the environmental uncertainty and the flexibility of rules

45. Categories of Transaction Costs I • Sunk and running transaction costs • Sunk: lost inputs, no opportunity costs • Running: inputs for which opportunity costs exist • Fixed und variable transaction costs • Fixed – not depending on the size and the frequency of transaction • Variable - depending on the size and the frequency of transaction • Ex-ante and ex-post transaction costs • Ex-ante costs: before the contract has been made • Ex-post costs: after the contract has been made

46. Categories of Transaction Costs II • Market transaction costs • Costs of market organization • Searching, preparation, agreement, supervision, monitoring, controlling, enforcement, adjustment • Transaction costs in firms • Costs of firm organization • Instruction, controlling, enforcement, adjustment • Political transaction costs • Costs of the establishment and maintanance of a political order • Decision making, implementation, administration, enforcement

47. Measuring Transaction Costs • Market transaction costs • Mediator, broker, stock exchange • Difference between buying and selling price • Advertisement • Transaction costs of firms • Management • Administration, Accounting • Political Transaction Costs • Parliament, government, bureaucracy, courts, police • parties, interest groups

48. Measuring transaction costs – the example of agricultural policy (Rorstad et al.2005)

49. Problems of measuring transaction costs (Benham und Benham 2000) • Problem of definition: different definitions of transaction costs exists • Problem of separation: transaction costs are sometimes difficult to separate from other costs, such as production costs, transportation costs • Problem of missing observations: if transaction costs are very high no transaction can be observed • Problem of subjectivity: estimations of transaction costs are often subjective • Measurement costs: measuring transaction costs is often costly

50. Modeling effects of transaction costs I • Market transaction costs II S+TC P - price S – supply without TC p+ p D - demand X+ X X - quantity Source: Furubotn and Richter (2000)