1. Division of Resource Economics 21.06.2016 / 40 Institutional Resource Economics II: Selected Basics of Institutional Analysis Konrad Hagedorn Humboldt University Berlin Division of Resource Economics Philippstrasse 13, 10099 Berlin, Germany Phone: + 49-30-2093 6305, Fax: + 49-30-2093 6497 E-mail: k.hagedorn@agrar.hu-berlin.de www.agrar.hu-berlin.de/wisola/fg/ress/ DAAD Workshop on: “Developing Multi-level and Decentralized Implementation Capacity for Natural Resource Management and Environmental Policies: a contribution to polycentric governance in an emerging democracy“, Kiev, September 7-11, 2009 1

2. Division of Resource Economics 21.06.2016 / 40 Contents 1.Definitions of institutions 2.Institutional economics 3.Transactions and transaction costs 4.Property rights theory 5.Contract theory 6.Transaction cost theory 7.Markets and firms 8.Theories of institutional change 2

3. Division of Resource Economics 21.06.2016 / 40 What are Institutions? Definitions from different authors 3

4. Division of Resource Economics 21.06.2016 / 40 Institutions and Organisations (1) (North) rules „Institutions are the rules of a society, or, to put it in a more formal way, constraints on human interaction created by the people themselves“ (North 1992, p. 3.) „In order to express it in the language of economists: institutions define and limit the choices of individuals“ (North 1992, p. 4) „The main purpose of institutions is to establish a stable (but not necessarily efficient) order in order to reduce insecurity in human interaction“ (North 1992, p. 6) 4

5. Division of Resource Economics 21.06.2016 / 40 Institutions and Organisations (2) (Schumpeter) The main point is the capacity of institutions to structure people‘s behaviour in societies: „By ‚institutions‘ we mean... all the patterns of behavior into which individuals must fit under penalty of encountering organized resistance, and not only legal institutions, such as property or the contract, and the agencies for their production or enforcement” (Schumpeter, 1983, p. 191). In this way, processes of social interaction are economized: by standardising actions and responses, resources otherwise required for case-to-case decisions are saved. 5

6. Division of Resource Economics 21.06.2016 / 40 Institutions and Organisations (3) (Blaas) „’An institution is a system of rules that can be applied to recurrent (social) situations and is, in general, accepted by the members of a society. These constraints on interactions can either be explicitly fixed by laws, rights, constitutions, etc. or, so to say, imposed by the people themselves and be effective without external supervision (self-policed). The essential aspect of an institution is that it offers people the possibility to specify the consequences of individual or collective action, which can be expected by the respective actors. If such a well-established institution exists, an individual is able to predict to a certain extent, what response from other individuals will be provoked by his or her own actions‘. (Roberts und Hilden, 1972, p. 110).... “ (Blaas, 1982, p. 264). 6

7. Division of Resource Economics 21.06.2016 / 40 Institutions and Organisations (4) (Boettcher) Often the term „Institution“ is used without any differentiation if people, strictly speaking, actually mean „organisation“. Boettcher (1983, p. 9) understands institutions, at the general level, as primarily being „rules shaping relationships“. Only in a second step, such rules can also lead to more concrete forms of organisation. Accordingly, the market can lead from an institution to an organisation, if it is established at a certain location following certain rules. In other words, it is being organised, for example, as a stock market or a foreign trade agency, etc.“ 7

8. Division of Resource Economics 21.06.2016 / 40  „The term organisation refers to public bodies (political parties, the Senate, a city council, an administative authority), legal persons in economic life (firms, trade unions, family farms, cooperatives) and agencies of the educational system (schools, universities, centers for vocational training).  They consist of groups of individuals who undertaake joint action, because they want to achieve a common objective“ (North 1992, p. 5). Institutions and Organisations (5) (North) 8

9. Division of Resource Economics 21.06.2016 / 40 Institutions and Organisations (6) (Bromley) The difference between institutions and organisation is particularly emphasised by Bromley (1989a, p. 42), who also differentiates between „conventions“ und „entitlements“: „That is: A convention is a regularity (R) in human behavior in which everyone prefers to conform to R on the expectation that all others will also conform to R. A convention is a structured set of expectations about behavior, and of actual behavior, driven by shared and dominant preferences for the ultimate outcome as opposed to the means by which that outcome is achieved. On the other hand: An entitlement is a socially recognized and sanctioned set of expectations on the part of everyone in a society with regard to de jure or de facto legal relations that define the opportunity sets of individuals with respect to the opportunity sets of others“. 9

10. Division of Resource Economics 21.06.2016 / 40 Institutions and Organisations (7) (Bromley) It is not adequate to call organisations „institutions“. They are not the institutions themselves but reveal how instititutions define concrete governance structures that form the (inter)actions of humans as individuals and collectives. For example, „schools, corporations, and futures markets obtain their meaning from institutions; such organizations only exist because there is a set of working rules which defines them. A corporation only exists as a separate legal entity by virtue of a set of working rules (entitlements) which defines what is and what is not, a corporation. The same holds for futures markets, for schools, and for hospitals. Institutions define certain organizations or social programs, but these programs and organizations are best thought of as being not institutions, but as being defined by institutions” (Bromley, 1989: 43). 10

11. Division of Resource Economics 21.06.2016 / 40 Impact of Institutions (North) Institutions „... shape incentives in exchange processes between people, which can be political, societal or economic in nature“ (North 1992, p. 3) „Institutions reduce insecurity by providing us with a certain degree of order in our every day life (North 1992, p. 4) „Institutions affect the cost of exchange and production and, in this way, have an influence on the performance of an economy“ (North 1992, p. 6) 11

12. Division of Resource Economics 21.06.2016 / 40 Economic Institutions Structure by Oliver Williamson „markets“ „hierarchies“ „ hybrid forms“ = governance structures 12

13. Division of Resource Economics 21.06.2016 / 40 Social Institutions Structure by Kenneth Boulding „exchange“ „threat“ „love“ Structure of New Political Economy Market- and price mechanisms Democracy (voting) Bureaucracy (hierarchy ) Interest groups (collective action) Negotiations (interaction processes) 13

14. Division of Resource Economics 21.06.2016 / 40 Social Institutions in Public Choice Theory (Bruno Frey) Polyarchy: democratic government based on elections and party competition; Economic Theory of Democracy Oligarchy: governance by powerful groups; problem: not all groups have the capacity to organise; Economic Theory of Collective Action Hierarchy: centralised and bureaucratic governance; discrepancy between self-interest of bureaucrats and public interest; Economic Theory of Bureaucracy Negotiations: in connectiion with communication and contracts, efficient mechanism of cooperation; difficult to operationalise scientifically; Game Theory 14

15. Division of Resource Economics 21.06.2016 / 40 Institutions – meanings Rules and coordination mechanisms Institutions and organisations Conventions and entitlements Institutional environment and institutional arrangements Property rights and governance structures Formal and informal institutions Formal and effective institutions Intentional and non-intentional institutional change Design and evolution of institutions 15

16. Division of Resource Economics 21.06.2016 / 40 What is Institutional Economics? Basic assumptions and notions 16

17. Division of Resource Economics 21.06.2016 / 40 Focus of Institutional Economics Economic analysis of institutions Institutions –Formal and informal rules that structure interactions –Rules of the game, contracts, cooperation, and more Economic analysis –Methodological individualism –Utility maximisation –Bounded rationality –Opportunism –Imperfect information 17

18. Division of Resource Economics 21.06.2016 / 40 Assumptions in New Institutional Economics 18

19. Division of Resource Economics 21.06.2016 / 40 Four Levels of Institutional Analysis (Williamson) 19

20. Division of Resource Economics 21.06.2016 / 40 Games, Players and Rules of the Game – a useful analogy Players (individual and collective actors) Games (coordination vs. conflict, non-cooperative vs. cooperative Rules of the game (intended or non-intended, imposed or negotiated) Results of the game (winners, loosers) 20

21. Division of Resource Economics 21.06.2016 / 40 An Analogy: the Game Players Results of the game Game Rule of the game 21

22. Division of Resource Economics 21.06.2016 / 40 Actors constellations (Scharpf 2000) Pure coordination Pure conflict Cooperation versus conflict 22

23. Division of Resource Economics 21.06.2016 / 40 What is the difference between institutional and conventional (neo-classical) economics? An institutionalist‘s view 23

24. Division of Resource Economics 21.06.2016 / 40 Neo-classical economics – a world without transaction costs? Main attributes of markets in neoclassical economics? – Perfect market Homogeneous goods No personal or temporal preferences Spot market Full market transparency Response of market participants extremely fast Unique price –Number of participants: Polypoly, Oligipoly, Monopoly –Transaction costs not taken into account but seen as market imperfectness or market failure As a consequence, institutions, for example different market rules, are not analysed. 24

25. Division of Resource Economics 21.06.2016 / 40 Concentional economics fails to cover the main economic problem! 1/2 It is implicitly assumed that coordination of (inter)actions and organisation of processes is possible without rules and governance. However, finding such institutions (institutional innovation) and adjusting human behaviour to them (institutional performance) does not occur without any effort and investment. This requires resources and creativity, and both of them are scarce (Richter: 70 % transaction cost). 25

26. Division of Resource Economics 21.06.2016 / 40 Concentional economics fails to cover the main economic problem! 2/2 As economics is the science of scarcity, excluding institutions means to neglect the main issue of scarcity in real societies. In other words, conventional economics excludes the more complex part of economics and politics. Reason: economics have become too „technical“, therefore concentrates on clear- cut tools instead of exploring and understanding unknown complex phenomena and their context. 26

27. Division of Resource Economics 21.06.2016 / 40 And: What is a transaction? What are transaction costs? 27

28. Division of Resource Economics 21.06.2016 / 40 28 What is an economic transaction? (Williamson) Background industrial organisation (not ecosystems) (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) Or (2) A transaction is the „alienation and acquisition between individuals of the rights of future ownership of physical things“ (Commons 1935, S.58) (incl. services and knowledge) A transaction is a transfer of property rights! ÜHow do Commons’ and Williamson’s perspective differ? Costs emerge from coordination due to change of assumptions of neoclassical economics!

29. Division of Resource Economics 4/11/08 / 2429 What is an economic transaction? aiai a i+1 I1I1 I2I2 Technological - separable Interface Governance structure: institutional matrix in which transactions are completed Property Rights Over a good or service Goods or services Definition of Property Rights of I 1 over a i Definition of Property Rights of I 2 over a i+1 Source: Beckmann (2000) Transaction costs emerge because actors need to coordinate for production/consumption

30. Division of Resource Economics 21.06.2016 / 40 30 Definitions of transaction costs I „Cost of establishing, using, maintaining and changing institutions...“ Richter und Furubotn 1996, p. 49  Resources spent on initiating, negotiating, safeguarding, monitoring, enforcing and adjusting transactions (Dahlman, 1979) ( “direct” TC) or Costs of running the economic system (Arrow 1969)  Includes utility losses (“direct + indirect” TC)

31. Division of Resource Economics 21.06.2016 / 40 Categories of Transaction Costs II 31

32. Division of Resource Economics 21.06.2016 / 40 Categories of Transaction Costs II 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 32

33. Division of Resource Economics 21.06.2016 / 40 Categories of Transaction Costs III Market transaction costs –Costs of market organisation –Searching, preparation, agreement, supervision, monitoring, controlling, enforcement, adjustment Transaction costs in firms –Costs of firm organisation –Instruction, controlling, enforcement, adjustment Political transaction costs –Costs of the establishment and maintanance of a political order –Decision making, implementation, administration, enforcement 33

34. Division of Resource Economics 21.06.2016 / 40 34 Measuring Transaction Costs Why measure transaction costs? Indirect measurement Direct measurement Most difficult to measure indirect TC! Problems of measuring transaction costs (Benham und Benham 2000) –Problem of definition –Problem of separation –Problem of missing observations –Problem of subjectivity –Measurement costs

35. Division of Resource Economics 21.06.2016 / 40 And: What are the Coase Theorem and the Tragedy of the Commons? What are Property Rights? 35

36. Division of Resource Economics 21.06.2016 / 40 Property Rights I 36 Definition: Property rights refer to the sanctioned behavioural relations among actors that arise from the existence of physical entities and focus on the cost and benefit streams from using them. Effectively, property rights assignments specify the norms of behaviour with respect to these cost and benefit streams that each person must comply with, or bear the cost for non- compliance. Categories: The right to use the asset (usus) The right to appropriate the return from the asset (usus fructus) The right to change its form, substance and location (abusus) Attenuation: Property rights are weak if transaction costs are high!

37. Division of Resource Economics 21.06.2016 / 40 Absolute property rights which have to be recognised by everybody, for example, private property in land, intellectual property rights, human rights Relative property rights which specify the relationship between two parties involved in an economic transaction, for example, in a purchase contract or a labour contract Other property rights which refer to relationships which are not protected by formal laws, for example, customer relations or friendship Property Rights II 37

38. Division of Resource Economics 21.06.2016 / 40 Two Important Discourses that are Related to Property Rights The Coase Theorem The Tragedy of the Commons 38

39. Division of Resource Economics 21.06.2016 / 40 39 The Coase Theorem If transaction costs are zero, the distribution of private property rights is irrelevant for economic efficiency since negotiations between the parties will always result in the same Pareto-efficient level of the externality  Normative conclusion: What matters is that private property rights are fully assigned, not how they are assigned to achieve pareto efficient outcome! Preconditions –No transaction costs –Well defined property rights –No „Income Effects“

40. Division of Resource Economics 21.06.2016 / 40 The bargaining solution to an externality MB MC £ a b c d 11 22 33 Marginal benefit of music to saxophonist Marginal cost of music playing to neighbour Source: Perman et al. (1997) 40

41. Division of Resource Economics 21.06.2016 / 40 Common Pool Resources Attributes of CPR: Excudability is difficult, but rivalry exists, also called subtractability (example: fish in a lake) Hardin‘s tragedy of the commons: privatisation is recommended as the only reasonable solution Counter movement: results from Daniel Bromley and Elinor Ostrom, for example, based on empirical studies Example: „Generations of Swiss and Japanese village inhabitants (e.g.) have got long experience on the relative costs an benefits of private property and common property as regards the various types and uses of land. In both countries, people have preferred to maintain the institution of common property as a basis for land use and similar important areas of decision making in their village economy“ (Ostrom 1990, p. 61) 41

42. Division of Resource Economics 21.06.2016 / 40 A Brief Overview What are Contracts? 42

43. Division of Resource Economics 21.06.2016 / 40 Elements of economic contract theories Complete „classical“ contract All conditions of the exchange relationship have been completely soecified. There are no gaps, no surprises, opportunistic behaviour is excluded Incomplete „relational“ contract Many conditions of the exchange relationship are incomplete: There are gaps, surprises and there is scope for opportunistic behaviour ÜBonded rationality of the contract partners and insecurity of the environment let all complex contracts become incomplete 43

44. Division of Resource Economics 21.06.2016 / 40 Types of contracts Complete or incomplete Classical or relational Explicit oder implicit Binding or non-binding Formal oder informal Short-term or long-term Simple or complex Standard oder non-standard Enforcement with support from third parties or self- enforcing Individual or collective contract 44

45. Division of Resource Economics 21.06.2016 / 40 Contract Theories Principal-Agent-Theories (moral hazard, adverse selection) Theories of self-enforcing contracts Theories of incomplete contracts Transaction cost economics 45

46. Division of Resource Economics 4/11/08 / 2446 Transaction Cost Economics Transaction costs are dependent on: Behavior of actors (v) Attributes of the transaction (t) Institutional Arrangement: governance structure (g) Institutional environment (u) TC = TC (v, t, g, u)

47. Division of Resource Economics 21.06.2016 / 40 Transaction behaviour Bounded rationality –Incomplete information –Incomplete processing of information All complex contracts are incomplete Opportunism –Exploitation of information assymetries –Self-interest is persued by means of inhonest behaviour like lying and cheating ÜContracts must protect against opportunistic behaviour 47

48. Division of Resource Economics 4/11/08 / 2448 Transaction Cost Economics (Williamson 1975, 1985, 1996) Transaction as unit of analysis Any contracting problem can be investigated in terms of transaction cost economising  Assign transactions to governance structures Define a) attributes and b) incentive and adaptive attributes of alternative governance structures Comparative institutional assessment of discrete institutional alternatives – extreme: classical market / hierarchy; mixed modes in-between

49. Division of Resource Economics 4/11/08 / 2449 Institutional Arrangement Institutional arrangements: arrangement between economic units that governs the ways in which these units can cooperate and/or compete. It..[can] provide a mechanism that can effect a change in laws or property rights. Governance structure: –Markets: identity of parties is irrelevant, little trust, no (inter-) dependence, parties can go own way at negligable cost, legalistic contract law –Hierarchies: high relevance of identity, strong interdependence whose details are contractually unregulated –Hybrid modes: forms of long-term contracting, reciprocal trading, franchising, more elastic than markets and more legalistic than hierarchies

50. Division of Resource Economics 4/11/08 / 2450 Transactions as unit of analysis - attributes of transactions Asset specificity (specific investments) Frequency (Williamson 1985) Uncertainty

51. Division of Resource Economics 4/11/08 / 2451 Asset Specificity Specificity –Value of the asset in the first best allocation minus the value of the asset in the second best allocation divided by the value of the asset in the first best allocation (V 1st -V 2nd )/V 1st =>1: fully asset specific 0: non asset specific Site specificity Specificity of physical assets Human asset specificity Dedicated investment (e.g. stocks) ÜSpecific asset creates valuable relationships on BOTH sides (idiosyncratic) > fundamental transformation!

52. Division of Resource Economics 4/11/08 / 2452 Asset specificity, institutional arrangement and transaction costs 0 k k1k1 k2k2 TC Asset specificity Market Hybrid Hierarchy

53. Division of Resource Economics 4/11/08 / 2453 Frequency Frequency of similar transactions in a defined time period TC constant BUT Costs of contracting per transaction decrease if more transactions take place!

54. Division of Resource Economics 4/11/08 / 2454 E. g.: Commercial transactions Investment Characteristics FREQUENCyFREQUENCy Non-specificMixedidiosyncratic Occasional Purchasing standard equipment Purchasing customized equipment Constructing a plant Recurrent Purchasing standard material Purchasing customised material Site-specific transfer of intermediate products across successive stages

55. Division of Resource Economics 4/11/08 / 2455 Asset specificity, frequency and institutional arrangements

56. Division of Resource Economics 4/11/08 / 2456 Uncertainty Primary Uncertainty –Uncertainty concerning the future state of (exogenous) nature Secondary uncertainty –Uncertainty concerning the behavior of the contracting partner that is due to communication problems between actors (not strategic/non opportunistic) Behavioral uncertainty –Uncertainty concerning the behavior of contracting partners that is due to strategic behavior

57. Division of Resource Economics 4/11/08 / 2457 Asset specificity, uncertainty and institutional arrangements 0k Θ Market Hierarchy Hybrid Uncertainty Specificity

58. Division of Resource Economics 21.06.2016 / 40 Institutional analysis of markets and firms An increasing number of theories, concepts and studies However, these will not be discussed here Very relevant for the agricultural sector (e.g., understanding the family farm or the agricultural cooperative) 58

59. Division of Resource Economics 21.06.2016 / 40 What are the driving forces of institutional change? How do Institutions Change? 59

60. Division of Resource Economics 21.06.2016 / 40 Theories of Institutional Change  Neoclassical theories (Demsetz, Hayami und Ruttan)  Evolutionary theories (Alchian, Hayek, Sudgen)  Marxist theory (Marx, Engels)  Transaction cost theories (North, Eggertson, Williamson)  Public Choice Theory (Olson, Downs, Tullock)  Distributional theories (Knight, Libecap)  Actors-oriented Institutionalism (Fritz Scharpf)  Institutional Analysis and Development Approach (Ostrom)  Institutions of Sustainability Framework (Hagedorn) 60

61. Division of Resource Economics 21.06.2016 / 40 „ Objectives“ and „Results“ of Institutional Change May Differ! „ Institutional change is an incremental process in which the short-run profitable opportunities cumulatively create the long-run path of change. The long-run consequences are often unintended for two reasons. First, the entrepreneurs are seldom interested in the larger (external to them) consequences. (...) Second, there is frequently a significant difference between intended outcomes and actual outcomes. Outcomes frequently diverge from intentions because of the limited capabilities of the individuals and the complexity of the problems to be solved“ (North 1997: 5) 61

62. Division of Resource Economics 21.06.2016 / 40 Efficiency Theories of Institutional Change Changes in resource scarcities and competition between actors are seen as driving forces of institutional change Actors adjust to new scarcities, being external factors to them, by seeeking efficient institutional solutions „Naive“ form of Property Rights Theory (Demsetz): transaction costs are considered the only determinants of institutional change, politics are neglected Institutional change then results from cost-benefit comparisons between institutional arrangements New property rights are responses to (changing) positive or negative externalities to be internalised North (1992: 112ff.): efficiency less relevant; three factors: transaction costs, ideology and path dependency 62

63. Division of Resource Economics 21.06.2016 / 40 Public Choice Theory of Institutional Change Political actors offer institutional changes to clientele groups, for example, economic actors or groups of citizens They are motivated to do so by self-interest: win elections, become leader of an association, a bureaucracy, etc. Accordingly, this institutional change is a political process that changes formal institutions mostly by legislation Bundle of approaches of Public Choice Theory: Economic Theory of Constitutions Economic Theory of Democracy Economic Theory of Collective Action Economic Theory of Bureaucracy 63

64. Division of Resource Economics 21.06.2016 / 40 Distributional Theory of Institutional Change I (Jack Knight) Distributional gains and losses of actors are relevant Actors negotiate for institutional changes Outcomes are not necessarily efficient Power of actors involved as the main driving force New rules reflect power assymetries Relevant sources of power assymetries are availabiliy of resources, capability to accept risk and time preferences Include spontaneous & decentral change of institutions Emphasize informal networks, conventions, norms Institutions are a by-product of strategic interaction Intended and non-intended outcomes 64

65. Division of Resource Economics 21.06.2016 / 40 Distributional Theory of Institutional Change II (Jack Knight) „On this bargaining account, social institutions are a by-product of strategic conflict over substantial social outcomes. By this I mean that social actors produce social institutions in the process of seeking distributional advantage in the conflict over substantive benefits. In some cases they will create institutional rules conciously. In other cases the rules will emerge as unintended outcomes of the persuit of strategic advantage. I each case the main focus is on the substantive outcome; the development of institutional rules is merely a means to that substantive end“ (Knight 1995: 1077f.) 65

66. Division of Resource Economics 21.06.2016 / 40 Actors-oriented Institutionalism (Fritz Scharpf) „ Rational choice“: actors behave rationally (not perfectly) Different orientations of actors: cognitive orientations (= knowledge) and motivational orientations (interests) They make choices in an institutional context (e.g., laws) Their choices also depend on the political environment Actors have different capacities: information, influence Actors constellation are crucial for their relationships Forms of interaction emerge: e.g. cooperative, competetive 66

67. Division of Resource Economics 21.06.2016 / 40 Political Environment Institutional Context Acteurs Orientations and capacities Action situa- tion Forms of inter- action Pro- blems Political decision Actors-oriented Institutionalism (Scharpf) 67

68. Division of Resource Economics 21.06.2016 / 40 Institutions of Sustainability (Konrad Hagedorn) This is an “analytical framework” that will be explained on Monday afternoon 68

69. Division of Resource Economics 21.06.2016 / 40 Institutional Analysis and Development (IAD) Framework (Elinor Ostrom) 69 This is an “analytical framework” that will be explained on Tuesday morning

70. Division of Resource Economics 21.06.2016 / 40 THANK YOU for your attention! --------------------------- Institutional Resource Economics II: Selected Basics of Institutional Analysis 70