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

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)

The Individual and the Institutional Structure

Source: Vatn (2005)

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

Environmental Economics vs. Ecological Economics

Source: Vatn (2005)

The Systems Perspective

2

Coordination and Conflict – Game Theory and

Institutional Analysis

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)

Assumptions in Games Theory

Player

Results (Payoffs)

Actions

Rules

Environment

Changing the terms

Actors

Allocation, Distribution

Interactions

Institutions

Environment

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/)

3

Transaction Costs

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)

Markets vs. Hierarchy

I1 I2 I2 I2

I4

I3 I3

Flow of goodsMoney flow

Market Hierarchy

Centralized vs. Decentralized Resource Management

Source: JAHAN et al (undated)

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

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

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*

Modeling Causes and Effects, Optimality IITransaction costs and institutional choice

• I1 and I2 differ with regard to fix and variable transaction costs

0

TC

Frequency

I1

I2