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Introduction to New Institutional Economics

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Introduction to New Institutional Economics Institutional Economics and Institutions TOPIC 1 G.A. OBARE Outline • Schools of thought • NIE and neoclassical economics • Core assumptions of NIE • What are institutions? • NIE examples • Critiques of NIE • Behavioural economics • Main reference: ch 2 of textbook New Institutional Economists? • Coase, North, Williamson • Stiglitz, Ostroms, Bardhan, Fafchamps, Hayami, Platteau Schools of Thought • Economics of imperfect information • Agency theory • Transaction cost economics • Property rights theory • Incomplete contract theory • Theory of collective action • Game theory? Motivation • People seeking answers to questions that neoclassical economics could not answer or could not answer satisfactorily – Why do firms exist (in the variety of forms that they do)? – Why does vertical coordination within supply chains occur? – Why does sharecropping persist in rural areas of many low income economies? – Why does underdevelopment persist? (why does technological and economic convergence not occur?) • New ways of looking at questions and phenomena that were previously the preserve of anthropologists or sociologists – Collective action • Williamson (2000): “New institutional economists are the blue-collar guys with a hearty appetite for reality.” Neoclassical economics: Assumptions of perfect competition • Behavioural assumption: profit or utility maximisation • Perfect information • Homogeneous, private products • No barriers to entry or exit (costless) • Large numbers of buyers and sellers • No economies of scale or production externalities • Complete set of markets? • Clear, enforced property rights? Core assumptions of NIE • Imperfect information about the intentions and behaviour of other economic actors – asymmetric information • Opportunism: “self-interest with guile” (Williamson 1985) – Shirking – Adverse selection – Moral hazard – Strategic default – Free-riding – Hold-up • Bounded rationality – Reliance on conventions and norms Institutions • “rules of the game” (North 1990) – Structure economic, political and social interaction – Predictability • INCENTIVES – Rewards (“carrots”) and punishments (“sticks”) – Economic, legal, social • Enforcement – third party (law enforcement, social ostracism) – second party (retaliation) – first party (self-imposed codes of conduct) Example: Ghana Cotton Sector (1990s) • Contract farming arrangements for cotton – Inputs and pre-harvest services provided to producers on credit – Repay loan at harvest time • Challenges to cotton development thro’ CF – Priority to food crops (compound system), but no support → input diversion (shirking) – Competing firms → side-marketing, strategic default • Tackle latter thro’ standardised input package and setting of common price, adjusted for “free” inputs (incentives) • common price set too low (no competition) – Exacerbated input diversion • Penalty for input diversion or strategic default (enforcement) – Blacklisting (could not take to court – cost, village solidarity) – Ineffective due to: lack of information sharing (names, relatives – imperfect information!), rotation of staff (avoid collusion – P-A!), new entry • New entrants tended to register worst offenders (adverse selection) Classifying Institutions • Institutional environment – “political, social, and legal ground rules that establish the basis for production, exchange and distribution” (Davis and North 1970) • … and institutional arrangements – modes of managing transactions (contracts etc) • Formal – legal environment and property rights (written down and enforced by the state) • … and informal – norms and conventions (unwritten and informally sanctioned) • In general, informal institutions change more slowly than formal – Exception: constitution THE ECONOMICS OF INSTITUTIONS Level Purpose Theory 1 Embeddedness: Protection, preservation, Social theory (Informal institutions, traditions, power norms, religion, culture, socio- political imperatives, etc.) 2 Institutional environment: First order economising: Economics of Formal rules of game: (property Get the institutional property rights rights, laws, constitutions, etc.) environment right Positive political theory 3 Governance: Second order Transaction Play of the game: economising: cost economics (Aligning governance structures Get the governance with transactions) structure right 4 Neoclassical analysis: Third order economising: Neoclassical Performance (Optimality, prices, Get the marginal economics quantities, incentives, etc.) conditions right Agency theory Adapted from Williamson 1999 Institutions and organisations • Institutions = rules of the game • Organisations = players of the game – “groups of individuals bound together by some common purpose to achieve certain objectives” (North 1993) – Examples: political parties, regulatory bodies, firms, family farms, cooperatives, churches, schools • Institutions within organisations • Dynamic interaction between institutions and organisations – Institutional environment influences which organisations appear/exist – Organisations create new institutional arrangements and lobby for changes in institutional environment North’s theory of development • Wealth is created through trade (transacting) and specialisation (as per Adam Smith) • Gains from specialisation offset by rising transaction costs as trade becomes longer distance and more complex – Within village: everyone knows everyone else (low cost of information), social norms, arbitration by elders – c/w rural-urban or international trade • Secret of development is to establish institutions that reduce transaction costs of trade – Formal institutions become more important as trade becomes longer distance, larger volume and more complex • Institutions are created by the powerful to further their own interests – May or may not benefit the poor – Powerful may perceive their interests either as pro-trade or rent- seeking Binswanger et al. on “Behavioural and material determinants” • Land-abundant, semi-arid tropics – Low population density (high information costs) – Rainfed agriculture (covariant risk, seasonality) – Plenty of sources of idiosyncratic risk (e.g. illness) • No insurance markets – covariant risk – high information costs (moral hazard) • No credit markets – No collateral – covariant risk – high information costs (strategic default) – No insurance • Social institutions to protect against idiosyncratic and, to a lesser extent, covariant risk – E.g. Compound system Critiques of NIE • Efficiency vs power – Institutional arrangements vs environment – Radical critique even of institutional arrangements (whose transaction costs are minimised?) • Measuring transaction costs – Specific to individual players – If transaction costs are too high, no transactions occur, so cannot be observed • Predictive power – Human agency – Politics – Peculiarities of local context What NIE is and isn’t IS ISN’T Departure from neoclassical Total rejection of economics neoclassical economics Source of importantly Radical critique of different answers to pressing mainstream theory or questions development practice Source of analytical tools Ideology and new ways of looking at the world Behavioural Economics • Insights from psychology, neuroscience etc • Modify the assumption of the rational, utility maximizing behavior of economic agents • Self-interested, others-interested • Amplifies importance of peer influence (embeddedness) NIE concepts: Transaction Cost Economics (TCE) TOPIC 2 Outline • What are transaction costs? • Exchange, contract enforcement and property rights • Coordination – Vertical – Horizontal – Complementary • Techno-economic attributes of goods • Key references: chs 4 and 5 of textbook Transaction costs • “the costliness of information is the key to the costs of transacting” (North 1990) • Steps in the contracting process – searching – Screening – Negotiating – Monitoring – Enforcement • Costs = time, transportation, third-party services • Additional transaction costs – Credible commitments – Transaction losses and/or renegotiation • If transaction costs are too high, no transaction will occur Transaction vs transformation costs • Transformation costs = costs of production – Land, labour, capital • Transaction costs = “the costs of doing business” (transacting) – Not conceivable in a “Robinson Crusoe” economy – They arise due to the existence of institutions • What about: labour supervision and Transport costs? Example: Rural microfinance • Consider: i* = (a + k) / (1 – d) • “a” are largely transaction costs (staff time, transport) – Searching, screening (training) – Processing applications, record keeping – Repayment visits (monitoring, enforcement) – Non-transaction costs: office rental • Structure contract so as to reduce “d”? – Regular repayments (increases “a”!) – Group liability • Neither group liability nor regular repayments work well for seasonal agriculture – Covariant risk, seasonality • Transaction costs and risk prohibitive – Micro-finance does not serve most smallholder farmers in SSA (no transactions occur) Exchange, contract enforcement and property rights • North (1990): “The inability of societies to develop effective, low- cost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment in the third world.” • Development entails move to longer-distance, more complex trade – From personalised to impersonal? • Institutions must evolve to support this (keep transaction costs down) – Contract enforcement is critical: protecting property rights during transactions
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