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

2. 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)

3. The Individual and the Institutional Structure
Source: Vatn (2005)

4. Types of Institutions (Ellickson 1991)

5. 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

6. Bounded Rationality and Opportunism
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

7. 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

8. 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

9. 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

10. Analytical levels of New Institutional Economics
FREQUENCY (YEARS)
PURPOSE
LEVEL
THEORY
often noncalculative, spontaneous
10² to 10³
Embeddedness:
Informal Institutions, Customs,
Tradition,Norms,
Religion
Social Theory L1 L2 L3 L4
10 to 10²
get 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 10
get the Governance structure right, 2nd order economizing
Governance:
Play of the Game – esp. Contract (aligning Governance Structures with Transactions
Transaction Cost Economics
In his simple contracting framework Williamson (1985: 34) emphasises that ”technology (k), contractual governance/safeguards (s) and price (p) are fully interactive and determined simultaneously”. Three testable propositions are derived: (1) Transactions that are not supported by specific investments need no protective governance structure. Spot markets suffice and goods or services are traded at competitive prices. (2) Transactions in which specific investments are involved, in contrast, need some kind of price premium and contractual safeguards in order to be undertaken. If no contractual safeguard is provided the price premium has to be higher compared to the safeguarded alternative. (3) Transactions that are supported by specific investments, but without any contractual safeguard, are apt to be unstable and tend to be replaced either by a general-purpose technology or a contractual safeguard.
Empirically we should observe, then, that suppliers without specific investments trade on spot markets and receive a comparatively low price. Hence, suppliers who invested in specific assets are likely to govern trade in some type of contractual safeguard at a significant higher price. Finally, suppliers with specific investments but no contractual safeguard are expected to be few in numbers, but if they can be observed, the price may be expected to be the highest.
In our paper we extend this framework a little bit. We take two different kinds of safeguards in to consideration. (1) the formal written contract, and (2) the oral relational contract. Up to know it is not very much explored when which type of safeguard will be chosen and how these safeguards will affect the price of the good or service traded. Will the price be higher or lower in the oral or relational contract is chosen? Are the investments higher or lower in in the relational contract?
These question we will also explore in the following.
Resource
Allocation and Employment
(Prices and Quantities, Incentive Alignment)
continuous
get the marginal conditions right, 3rd order economizing
Neoclassical Economics/Agency Theory
Williamson (1998)

11. Research questions (Alston 1996 & Williamson 2000)
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 L1 L2 L3 L4

12. Data constraints DATA SOURCES Poorly developed
Some official statistics
International surveys
Less developed
Historical records
Documents
Official statistics
International Surveys
Developed
Accounting
Well developed
Simple discrete to complex
often 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, main languages)
VARIANCE
(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) L1 L2 L3 L4

13. 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

14. 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)

15. 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)

16. 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

17. Typology of goods (Ostrom 1990)
Excludable
Non-Excludable
Private good
Common pool resource
Club good
Public good
Rivalry
Non-Rivalry

18. Environmental Economics vs. Ecological Economics
Source: Vatn (2005)

20. The Systems Perspective

21. 2 Coordination and Conflict – Game Theory and Institutional Analysis

22. 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)

23. Assumptions in Games Theory
Rules
Player
Actions
Results (Payoffs)
Environment

24. Changing the terms Institutions Actors Interactions
Allocation, Distribution
Environment

25. 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)

26. Actor constellations (Scharpf 2000) Cooperation vs. ConflictB B i j i j i A j
Pure coordination
Pure conflict

27. 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

28. Prisoners Dilemma and Chicken Games (cooperation games)B B i j i j i A j
Prisoners Dilemma
Chicken Game

29. 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)

30. Institutions, Games and EnforcementB B i j i j i A j
Prisoners dilemma with
sanctions s
Prisoners Dilemma

31. Institutions and Enforcement IIj i A j
Comply with the rules or not
Sanction non-compliance or not

32. Emergence of Conventions - the Crossroad Game (evolutionary game theory
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

33. Actors-oriented Institutionalism (Scharpf)
Games real actors play
Actors-oriented Institutionalism (Scharpf)
Political Environment
Institutional Context
Acteurs
Orientations and capacities
Action situa- tion
Forms of inter-action
Pro-blems
Political decision

34. A Framework for Institutional Analysis (Ostrom 1998)
Attributes of
Physical World
Action Arena
Patterns of
Interaction
Attributes of
Community
Action Situations
Actors
Outcomes
Rules-in-use
Evaluative
Criteria:
Social Auditing
Cost-Benefit
Equity
Environment

35. Literature and Sources
Fehr, E. and Gächter, S. (2000) Cooperation and Punishment in Public Goods Experiments. American Economic Review 90(4),
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 (

36. 3 Transaction Costs

37. 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?

38. What is a Transaction? II
(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?

39. What is a transaction? III
Transfer I1 I2
Property Rights
Over a good or service
Definition of Property Rights of I1 over ai
Definition of Property Rights of I2 over ai+1
Goods or services ai
ai+1
Technological - separable Interface
Source: Beckmann (2000)

40. Markets vs. Hierarchy Market Hierarchy I4 I1 I2 I3 I2 I2 I3
Flow of goods
Money flow

41. Centralized vs. Decentralized Resource Management
Source: JAHAN et al (undated)

42. 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

43. 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

44. 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

45. 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

46. 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

47. 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

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

49. 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

50. Modeling effects of transaction costs I
Market transaction costs II
S+TC
P - price
S – supply without TC p+ p
D - demand X+ X
X - quantity
Source: Furubotn and Richter (2000)

51. Modeling effects of transaction costs II
Transactions costs inside the firm
Y =F(Z)
Y - Output F
Y =F+(Z) B D E
Z - Input A
Source: Furubotn and Richter (2000)

52. Modeling Causes and Effects, Optimality I Transaction and production costsMC
MTC
MPC
Division of Labor
MC-Marginal Costs
MTC-Marginal Transaction Costs
MPC-Marginal Production Costs

53. Modeling Causes and Effects, Optimality II Optimal monitoring frequency
Costs
Monitoring costs
Utility losses
MF*
Monitoring frequency (MF)

54. Modeling Causes and Effects, Optimality III Optimal searching activities
Costs
Search costs
Utility loss S*
Search activities S

55. Modeling Causes and Effects, Optimality II Transaction costs and institutional choice
I1 and I2 differ with regard to fix and variable transaction costs TC I1 I2
Frequency