Role of Non-Market Resource Allocation : Theory and Evidence

Kanchan Chopra

Institute of Economic Growth

Delhi, India

Outline of the talk:

• The Theory: What are NMRAMs; how do they relate to economic behavior of humans as part of social systems

• The Context: The management and use of natural resources

• Empirical Evidence : we shall use empirical studies from different parts of the world to illustrate.

• Finally, Some observations on evolutionary theorizing in Economics

Four In-depth Studies

– Initiating and Sustaining a New Institution of Resource Management

– Evolution of Social Norms in CPR use– Pollution Control and sub-Coalitions– Extraction of Timber and Biodiversity Levels – in multi-species Forests

What are NMRAMs:

• Social Norms, Beliefs

• Laws

• Institutions

• The understanding of this can make a great difference to the interpretation of formal theorems in Economics.

• First Fundamental theorem of Welfare economics:“If individuals maximize their own utility, then (given that certain technical conditions are satisfied), the competitive equilibrium that arises is always Pareto-optimal. “

Economic Activity is embedded in social institutions

An Alternative Interpretation

• Individuals are free to choose any point from within their budget sets.

• In fact their freedom is very restricted. An alternative interpretation of the fundamental theorem is:

• “Society attains optimality if individual choice is severely restricted to points within the budget set”.

• There is a number of strategies available out there, far more than the theorem takes into account.

Three kinds of Social Norms

• Rationality limiting social norms

• Preference Changing Norms

• Equilibrium Selection Norms

Rationality limiting social norms

• This kind of norm implies that the feasible set of alternatives is not defined only by technological or budgetary feasibility: the existence of norms limits the domain over which the rationality calculus can be applied

• Can this be interpreted to mean that a normatively infeasible option is described as one that gives very low utility?Redefine the utility function

• Doing so invariably and all the time runs the risk of reducing utility theory to a tautology

Preference Changing Norms:

• Main reason for recognizing this as a separate conceptual category is that it examines how preferences are formed

• Such understanding is particularly significant for natural resource management and use.

From utility limiting to preference changing norms• Example of a norm: a more general one: the

example of “being on unemployment benefit” or “”welfare” .

• There is a lower utility from income obtained in this manner, presumably because of the stigma attached to it. However, the larger the number of people who are on it, the lesser the stigma.

• The amount of unemployment in the economy (a macro level phenomenon) can cause change in individual preferences.

Preference changing norms and multiple equilibria• This raises the possibility of multiple equilibria in

an economy. • A high and a low employment can both be

equilibria. • The bottom line is that preferences are not

primitives but depend on the economy wide-output.

• Proved formally by Lindbeck et. al in QJE (1999)

From the theory of club goods and associations• Value of the Membership of an Association

depends on who the others are who are part of that association. If this membership were allocated by the price rule, its value would be a diminished one: theory of club goods

• The above implies that equilibrium may exist for a profit maximizing entrepreneur with excess demand.

Discounting the future

• How individuals discount the future in resource dependent economies is a preference changing norm. If the number of people having low rates of discount is large, others also fall in line

Equilibrium Selecting Norms

• Two states of the world are possible and the norm acts as a “co-ordination device”.

• It is in people’s interest also to follow a norm: drive on one side of the road.

• It is not always in everyone's interest to follow the norm. Stop sign rule or the speeding rule is broken more often than the one mentioned earlier.

Equilibrium selection norms

These are useful when:

– When the strategic behaviour of others is not known

– When they lead to self-organisation of systems: these may encourage different levels of stability at different scales: Akerloff (1976) on the economics of the caste system, the rat race etc

– When there exists great uncertainity with respect to eco-system characteristics: semi-arid regions; drought prone areas and other such regions

• Laws:the usual understanding is that law changes the set of options available to an individual and the pay-off from these actions.

• This would be correct if “law” were a game played by only the non-governmental individuals in a society

• the implementers of the law are also individuals with their own motivations, aspirations: they are also players.

Law and Economics

Law and Human Behavior

• Law and the state are self-organising outcomes, interpreted as a set of Nash-equilibrium outcomes

• Laws help in choosing from multiple outcomes by creating “a focal point”of reference

• This influences the outcome by creating expectations in peoples' minds about others' behavior

• Law’s empire is founded on beliefs.

Core Theorems

• Core Theorem: Whatever behavior and outcomes in society are legally enforceable are also enforceable through social norms.

The above can be divided into two corollaries:• What can be achieved through the law can be

achieved without the law • If a certain outcome is not an equilibrium of the

economy, no law can achieve it• Basu, K. Prelude to Political Economy 2000

NMRAMs: An Evaluation of their role

• Illustrate the role of norms in this evolution through two in-depth studies which highlight their role within traditional economic models of inter-temporal maximisation

• Effect of interaction of market and non-market resource allocation mechanisms in the context of timber extraction and bio-diversity interlinkages

• Use of Evolutionary game theoryl • Laws on Pollution Control: what they can do and

what they cannot?

Definitions

• Common Pool Resource: Any resource to which multiple users have joint access

• Common Property Resource: A property rights regime with well-defined rules of management, use, entry and exit: a la Ostrom

• The latter is in the center of the continuum the two extremes of which are state and private property.

I.Resource Management : Land Pooling

• Operationalisation of resource management and use for development requires a built-in institutional framework that can make it implementable.

• Deriving the conditions for sustainability is not enough. The rules that make it work need to be laid down.

• The above is illustrated from a model based on community land and labour pooling

• Pre-Existing Condition: Private Ownership of Land did not yield full use

due to scale diseconomies and migration of ownersDegraded private land could be Pooled• Pooling and withdrawal of land resources is

permitted in the process• Leadership to initiate change is available

Model of evolution of the institution • Model: N(0): Number of individuals in

initial period

• L(0): Land to be pooled in initial period

• K(0): An initial one time investment

• W, wage rate<W*the market rate

• Income Y(t) = f[ K(t),N(t),L(t)]

• Surplus income after paying stipendary wage is [Y-WN]

• This is divided into three parts,the return to pooled labour, capital and land

• The steady state values of N(t), L(t) and N(t) over time found. Required land-man ratios and initial levels of capital stock are also found. Three points in this trajectory are of interest

r*L

r(Y-wN)

Institutional factors in land pooling: Stable and Unstable equilibria

L(0) L(t) L*

A

B

C

Nature of the Process

– The initial starting point, where L(0) , the land put together has to be more than a minimum L(0).

– The marginal conditions for sustainability are limits on the values of the distributive parameters and their being higher than opportunity cost.

– The initial point, when interpreted is found to have characteristics of an unstable equilibrium.

– The difference between L(0) going down to zero and the process getting off to a start up is made by factors such as :leadership, trust in the rule re-enforcing mechanisms etc.

– With similar levels of opportunity costs, the process gets initiated at one place, at another it does not.

Model Characteristics

• Taken together, the steady state conditions indicate that in the long run, the levels of capital stock, land pooled, extent of participation and resulting income gains depend on the sharing mechanism and vice-versa.

• This indeterminateness can be resolved only through a process of negotiation. However, too many adjustments in the sharing mechanisms are also not conducive to the on-going and strengthening of the process.

• Chopra and Kadekodi (1999), Operationalising Sustainable Development.

Lessons for NMRAMs

• The essential moral of the story is that in setting up non-market resource allocation mechanisms such as participation, the nature of the movement towards equilibrium depends on rules set up for distribution of gains and the element of trust in the long run continuation of these rules.

• Further, similar ranges of values of the threat levels of significant variables may lead to different outcomes for the sustainability of the process depending on what these process related outcomes are.

II. CPR Management: Theory and Empirical Evidence

• The received wisdom on CPR management maintains that it has a unique equilibrium which is inefficient with higher levels of extraction than the efficient equilibrium but implies lower levels of extraction than open access.

• There will be over extraction• But empirical evidence shows that some

communities do control extraction• An evolutionary dynamics approach helps us to

see why

An evolutionary theory of individual behavior

• Assume two levels of effort put in by individuals to extract from CPRs: low and high: Effort: X

• Players adopting high effort: defectors: Adopting low effort: May be cooperators or enforcers who sanction defectors

• Xe<Xl< Xh< Xn

• Three kinds of actors:, defectors, enforcers and cooperators I=1,2,3 with proportion S in the population

• Pay-off (Pi)differentials exert evolutionary pressure on the population. Replicator dynamics of the following nature: Si dot = Si (Pi-P*)

Further conditions

• Assume that if a person punishes another, he incurs a cost, c and inflicts a loss, l on the other.

• At an equilibrium point, all surviving strategies earn equal pay-offs

• The steady state in which defectors alone are present is called the D-equilibrium and the steady state in which no defectors are present is the C-E equilibrium.

Characteristics of equilibrium states

• The nature of pay-offs to the three kinds of actors ensures that a state in which all three are present cannot be an equilibrium point since enforcers do worse than co-operators

• A state consisting only of enforcers and defectors can also not be an equilibrium since the latter do better

Characteristics of the equilibria

• In the simple case (in which resource dynamics over time are not taken into account):

o Defector equilibrium, which involves non-cooperative resource allocation, is asymptotically stable for all parameter values

o For some values of the loss of individual n, the subset of stable points in the C-E continuum constitute a non-empty interval

o This last implies that there exists a set S of stable states consisting of co-operators and enforcers

Implications

• CE equilibria of the CPR game represent a departure from fully self-interested behaviour

• The result establishes that there are conditions under which such a norm guided population will be immune from invasion by a small group of self interested players

Other results

• The size of the set of stable states: length of the set is independent of the cost of sanctioning

• However the size of the basin of attraction depends on the cost of sanctioning

• A temporary change in pay-offs can bring about irreversible change in behaviour: if it moves to D-equilibrium, that is asymptotically stable

Implications and links with empirical studies

• Explains the continued existence of cooperative management of CPRs in some conditions

• Also points towards its fragile nature• As long as model parameters ensure that

population composition remain within the basin of attraction of the set of stable states, cooperation shall last.

• Sethi and Somanathan AER, 1994.

III Law and its enforcement

• Water pollution by industry is an important issue in a large number of countries

• Laws exist but typically they are not implemented due to collusion between industry and bureaucracy.

• Laws create a “focal point” and changes peoples expectations of others’ behaviour: if those expectations are not fulfilled, they do not change anything

An analysis of law, coalitions and water pollution abatement

• Law( in the form of a per unit tax on effluent of level t) backed up by social norms creates a dent on pollution through the emergence of coalitions of interested parties

• Stakeholders: industry, bureaucracy, (implementers), people affected by pollution of ground water (say) and elected representatives

Coalitions of Interest Groups

• A model is set up with pay-off to each party in the presence of:

• Cost of political organization,c and varying probability with which people perceive damages, p

• Over reporting of environmental quality (EQ)by implementers of the law results in a payment from industry, b

• An under-reporting of EQ attracts a penalty for implementers, urp

Coalitions of interest groups

• Strategic Behaviour of two coalitions (industry and implementers on one side and people and courts/ their representatives) is modelled in the form of reaction functions with different characteristics to obtain the level of environmental quality under different conditions

• Some results:• Preposition 1:When penalties on industry and

implementers are raised, environmental quality for given level of cost of political activity increases

Results from industrial pollution model for collective action

• Proposition 2: Optimal Environmental quality with a positive cost of political activity is lower than environmental quality with zero costs of collective action.

• Any laws or interventions initiate expectations, change the ground rules and the outcome depends on different factors

• Political Activity can produce the same result as a law introduced by a benevolent government

• Murty (1995)

IV Market and non-market mechanisms: Resource extraction• In a large number of situations in

developing countries, both kinds of mechanisms coexist, often impacting the same resource

• Forests are exploited within a large variety of regimes; Timber extraction is driven by the market; a range of non-timber products is exploited within non-market regimes

Timber Extraction and Forest Biodiversity

• This co-existence of different regimes has implications for relative levels of extraction of the two products and in the long run, the biodiversity of the stock of the resource

• Illustrated using the example of timber extraction and forest biodiversity

Bio-diversity Indices: A digression

• Alternative indices capture different aspects of biodiversity

• Species richness and species diversity indices: treat all species as equally significant

• Species Area Relationships: Island Biogeography Theory

• Functional Measures: Function for the Eco-system: taxic and functional diversity

Functionality in relation to human use: Bio-Economic

Indices of diversity• These are measures with reference to

human use• Use of forests for timber, a commodity with

well defined markets: directed at one commodity

• Non-timber forest product extraction is a diversity based use:bio-economic indices capture this diversity

Bio-economic Diversity Indices

• These are product diversity based: related to the use value of forests

• Weighted by value: as measured by market price or otherwise

• An year wise index weighted bymarket prices for timber and value determined outside of direct markets for non-timber

• Index ranges from 0 to 1 and is inversely related to biodiversity levels

The model

• Timber extraction is driven by market price and forests have been managed “sustainably”for timber: not for other products and services

• Start from the simple Gordon-Schaeffer Model: Y= f(E,X)

Y: extraction E: Effort X: stock of timber

The Model Continued

• Xdot = rX(1-X/K)-qEX where Xdot= change in stock at a given time, r: regeneration rate, q: coefficient depicting availability of timber species

• With Xdot = 0 for sustainable management for timber, Y=qEK(1-qE/r)

• We introduce two modifications: Biodiversity Index B and ecological feature of forests as measured by the ratio of natural forests to plantation forests

The Model continued

• With the two new variables,

Extraction Y=qKBE(1+eW-qBE/r)

• Defining extraction per unit effort as U (Y/BE), we get an expression for Udot/U

• Reduced form of the equation estimated using 25 years time series data

Tentative Results

• In the model without B and W, extraction is impacted by effort but explanatory power is low

• A rising trend in extraction is accompanied with decreased biodiversity

• Increased biodiversity implies a lower level of timber stocks and leads to a lower level of extraction

• Higher extraction with higher proportion of plantation area

Conflicts in Multi Species Systems

• Interaction of Markets with non-market based extraction results in loss of product diversity

• In the end, changed nature of the forest may reduce timber extraction capacity

• It will reduce outflow of other products and the eco-system services.

• Chopra and Kumar (2003).

Concluding Remarks

• Formal models of Evolutionary Theorising in Economics

• Applications to learning by doing

• Applications to firm survival in industry

• Nelson and Winter: Journal of Economic Perspectives, Spring, 2002