Lecture 15
Institutions, New Institutional Economics, and
Environmental and Natural Resource Economics
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)
Types of Institutions (Ellickson 1991)
Rules Enforcement mechanism Example
1. Convention Self enforcement Language
2. Ethics Imperative self binding Being a veterinatian
3. Norms Social enforcement Social codes of conduct
4. Formal private rules Organized private enforcement
Self imposed rules inside organisations
5. Law Organized state enforcement
Business Law
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
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
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
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
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
Analytical levels of New Institutional Economics
L1
L2
L3
L4
often noncalculative, spontaneous10² to 10³
Embeddedness:Informal Institutions, Customs,
Tradition,Norms,Religion
Social Theory
FREQUENCY (YEARS)
PURPOSELEVEL THEORY
10 to 10²get the Institutional Environment right, 1st order economizing
Institutional Environment:Formal Rules of the Game – esp.
Property (Polity, Judiciary, Bureaucracy)
Economics of Property Rights,Positive Political Economy
1 to 10get the Governance structure right, 2nd order economizing
Governance:Play of the Game – esp. Contract (aligning Governance Structures
with TransactionsTransaction Cost Economics
Resource Allocation and Employment
(Prices and Quantities, Incentive Alignment) continuous get the marginal conditions
right, 3rd order economizing
Neoclassical Economics/Agency Theory
Williamson (1998)
Research questions (Alston 1996 & Williamson 2000)
L1
L2
L3
L4
EFFECTS
Embeddedness:Informal Institutions, Customs,
Tradition,Norms,Religion
Institutional Environment:Formal Rules of the Game – esp.
Property (Polity, Judiciary, Bureaucracy)
Governance:Play of the Game – esp. Contract
(aligning Governance Structures with Transactions
Resource Allocation and Employment
(Prices and Quantities, Incentive Alignment)
Econometrics/Experiments
CAUSES
Embeddedness:Informal Institutions, Customs,
Tradition,Norms,Religion
Institutional Environment:Formal Rules of the Game – esp.
Property (Polity, Judiciary, Bureaucracy)
Governance:Play of the Game – esp. Contract
(aligning Governance Structures with Transactions
Resource Allocation and Employment
(Prices and Quantities, Incentive Alignment)
Econometrics/Case studies
PROCESSES
Embeddedness:Informal Institutions, Customs,
Tradition,Norms,Religion
Institutional Environment:Formal Rules of the Game – esp.
Property (Polity, Judiciary, Bureaucracy)
Governance:Play of the Game – esp. Contract
(aligning Governance Structures with Transactions
Resource Allocation and Employment
(Prices and Quantities, Incentive Alignment)
Case studies/Historical narratives
Data constraints
L1
L2
L3
L4
Simple discrete to complexoften intangible
(e.g. religion, belief system)
MEASURMENT
Simple discrete to very complex(e.g. parliamentary vs.
presidential system, proposal for EU constitution)
Simple discrete to complex:(e.g. make or buy, complex
contracting, modern corporations)
Simple continuous(e.g. compensation rules, prices
and quantities)
Small to medium(e.g.. 12 main
religions, 6.800 main languages)
VARIANCE
Small to medium(e.g. 5 legal origins,
192 states, 2005)
Large(e.g. 2 915 482 firms in Germany, 2003)
Large to very large(e.g. annual GDP, daily prices and
quantities at the stock market)
DATA SOURCES
Poorly developedSome official statisticsInternational surveys
Less developedHistorical records
Documents Official statistics
International Surveys
DevelopedOfficial statistics
Accounting
Well developedOfficial statistics
Accounting
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
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)
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)
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
Typology of goods(Ostrom 1990)
Private good Common pool resource
Club good Public good
Excludable Non-Excludable
Rivalry
Non-Rivalry
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)
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)
Actor constellations (Scharpf 2000)Cooperation vs. Conflict
Englisch Spanish
Englisch 3,3 0,0
German 0,0 0,0
Don’t steal Steal
Don’t steal 0,0 -3,3
Steal 3,-3 0,0
Pure coordination Pure conflict
A
B
i
j
i jB
i j
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
Prisoners Dilemma and Chicken Games (cooperation games)
Deliver Don’t-Deliver
Pay 2,2 0,3
Don’t-Pay 3,0 1,1
Sign Kyoto Treaty
Refuse Kyoto Treaty
Sign Kyoto Treaty
3,3 2,4
Refuse Kyoto Treaty
4,2 1,1
Prisoners Dilemma Chicken Game
Bi j
Bi j
Ai
j
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)
Institutions, Games and Enforcement
Deliver Don’t Deliver
Pay 2,2 0,3
Don’t Pay 3,0 1,1
Prisoners Dilemma Prisoners dilemma with sanctions s
Bi j
Bi j
Ai
j
Deliver Don’t Deliver
Pay 2,2 0,3-s
Don’t Pay 3-s,0 1,1
Institutions and Enforcement II
Sanction Don’t sanction
Comply Ui,0 Ui,0
Don’t comply Uj-s,s Uj,0
Comply with the rules or not Sanction non-compliance or not
Ci j
Ai
j
• 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
Emergence of Conventions- the Crossroad Game (evolutionary game theory
stop continue
stop 0, 0 2, 3
continue 3, 2 -10, -10
Political Environment
Institutional Context
ActeursOrientations
and capacities
Action situa-tion
Forms of
inter-action
Pro-blems
Political decision
Source: Scharpf (2000: 85)
Games real actors playActors-oriented Institutionalism (Scharpf)
A Framework for Institutional Analysis (Ostrom 1998)
Attributes of Physical World
Attributes of Community
Rules-in-use
Action Arena
Action Situations
Actors
Patterns of Interaction
Outcomes
Evaluative Criteria:
Social AuditingCost-Benefit
EquityEnvironment
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/)
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?
• (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?
What is a Transaction? II
What is a transaction? III
aiai+1
I1I2
Technological - separable Interface
Transfer
Property RightsOver a good or service
Goods or services
Definition of Property Rights of
I1 over ai
Definition of Property Rights of
I2 over ai+1
Source: Beckmann (2000)
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
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
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
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
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
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
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
Modeling effects of transaction costs I• Market transaction costs II
X - quantity
P - price S – supply without TC
D - demand
S+TC
XX+
p
p+
Source: Furubotn and Richter (2000)
Modeling effects of transaction costs II• Transactions costs inside the firm
Z - Input
Y - OutputY =F(Z)
Y =F+(Z)B
A E
F
D
0
Source: Furubotn and Richter (2000)
Modeling Causes and Effects, Optimality ITransaction and production costs
0Division of Labor
MTC
MPC
MC
MC-Marginal CostsMTC-Marginal Transaction CostsMPC-Marginal Production Costs
Modeling Causes and Effects, Optimality IIOptimal monitoring frequency
Monitoring frequency (MF)
CostsMonitoring costs
Utility losses
MF*
Modeling Causes and Effects, Optimality IIIOptimal searching activities
Search activities S
CostsSearch costs
Utility loss
S*