ESNIE, May 2006The Emergence of Formal Institutions1 Santiago Sánchez-Pagés & Stephane Straub (University of Edinburgh)

ESNIE, May 2006The Emergence of Formal Institutions2 Introduction Institutions are key in enhancing the efficiency of economic interactions. Huge variation. Both temporal and spatial. New Political Economy: Institutions as protectors of property rights. A neglected role: Coordination devices.

ESNIE, May 2006The Emergence of Formal Institutions3 Institutions and coordination failures Institutions can help to correct the coordination failure that plague basic economic interactions. -Developing economies at early stages. Witnesses in commercial exchange (Attali, 2003). -Economies in transition to industrial stage. Japan after WWII, East Asian countries (Aoki et al, 97). -Specific markets US Cotton Market (Bernstein, 2001).

ESNIE, May 2006The Emergence of Formal Institutions4 Institutions and coordination failures Two lines of enquiry in the literature: 1.Analysis of specific institutions: -Coalitions of Maghribi traders (Greif, 1993). -Merchant courts and fairs (Milgrom et al, 1990). 2.Coexistence of formal and informal institutions: -Reciprocity vs. Markets (Kranton, 1996; Dixit, 2004). -Tribes vs. National states (Ensminger, 1992).

ESNIE, May 2006The Emergence of Formal Institutions5 Our contribution Little has been said on the emergence of institutions. We model the process through which these institutions may arise. We characterize  the factors that make possible or hinder the formation of institutions.  the level of efficiency at which they arise.

ESNIE, May 2006The Emergence of Formal Institutions6 Formal institutions as equilibria In our model an institution is a body enhancing the efficiency of economic interactions. Its emergence is the equilibrium of a game that agents play in the state of nature. That is, it is self-enforcing. If formal institutions do not arise, the economy remains in the status-quo.

ESNIE, May 2006The Emergence of Formal Institutions7 The Model N+1 identical risk-neutral agents with initial endowment ω. Agents are randomly matched and play a prisoner’s dilemma game. Payoff are returns per unit of endowment invested.

ESNIE, May 2006The Emergence of Formal Institutions8 The Model - We assume z > x > 0 and  < 1. - Two strategies: C is cooperative, NC is not cooperative. - (NC, NC) is the unique Nash-equil. and is Pareto-inferior.

ESNIE, May 2006The Emergence of Formal Institutions9 The Model In the state of nature, agents play the previous game without interference. Expected payoff is then αx. The parameter α denotes the status- quo level of coordination or trust. The institution is able to ensure that the (C,C) equilibrium is played. But someone has to run it…

ESNIE, May 2006The Emergence of Formal Institutions10 The Model A lottery among those who chose to participate in it determines who will become the central agent. She must relinquish the ability to trade. But is compensated in exchange. Agents must pay a fee a ≤ ω to become formal.

ESNIE, May 2006The Emergence of Formal Institutions11 Timing t=1 Participation decision. If none participates, the status-quo remains. t=2 Formality fee is chosen. t=4 Agents are randomly matched and play game. t=3 Formality decisions

ESNIE, May 2006The Emergence of Formal Institutions12 Formality decisions Having observed a, agents must decide whether to become formal or not. If they become formal, interacting with another formal agents yields per unit return where x a > 0, x aa 1/α. The efficiency of interactions depends on the fee paid to the institution.

ESNIE, May 2006The Emergence of Formal Institutions13 Formality decisions Interacting with an informal agent yields regardless of your status. Expected payoffs when K formal agents:

ESNIE, May 2006The Emergence of Formal Institutions14 Formality decisions Define K formal agents can be supported in equilibrium if and only if But a (K) is increasing.

ESNIE, May 2006The Emergence of Formal Institutions15 Formality decisions Proposition 1: For a given level of the fee a (i) Informality can be supported in equilibrium only if a ≥ a(1) (ii) Full formality can be supported in equilibrium only if a ≤ a (N) Moreover, a (1) ≤ a (N) if α is below a certain threshold

ESNIE, May 2006The Emergence of Formal Institutions16 The procedure of institution formation A procedure of institution formation is a lottery over the set of agents who freely participate in it. The procedure also describes the degree of commitment available at the individual and collective level. -Freedom to chose the fee. -Agents’ ability to renege ex-post of the central role.

ESNIE, May 2006The Emergence of Formal Institutions17 The fully decentralized procedure In this procedure, the institution must emerge in the most decentralized way possible. First, the fee is freely chosen by the central agent: The institution is a revenue- maximizer. So it will “tend” to set the maximum fee compatible with formality, a (N).

ESNIE, May 2006The Emergence of Formal Institutions18 The fully decentralized procedure Second, the agent that runs the institution can renege ex-post. For the institution to arise then

ESNIE, May 2006The Emergence of Formal Institutions19 The fully decentralized procedure Ex-ante participation constraint given the fee a because either all agents or none participate in the lottery. With a 1 (N), the institution arises iff the (stronger) ex-ante constraint is met. It rewrites:

ESNIE, May 2006The Emergence of Formal Institutions20 The fully decentralized procedure Proposition 2: If the ex-ante constraint holds, there exists a SPE of the fully decentralized procedure that implements formality under a (N).

ESNIE, May 2006The Emergence of Formal Institutions21 Two sources of inefficiency Corollary 1: There exists a range of parameters for which a potentially welfare enhancing institution does not arise. This is more likely for economies of intermediate size and relatively high levels of status-quo trust. Small populations make informality dominant, big ones makes formality more likely. High trust undermines the position of the institution: in societies with high , outside option of informality is more attractive, so formality is not individually IC despite being socially efficient.

ESNIE, May 2006The Emergence of Formal Institutions22 Two sources of inefficiency Corollary 2: The utilitarian first best fee can be implemented in a SPE of the fully decentralized procedure only for high enough or low enough levels of status-quo trust α. When status-quo trust is high, revenue and welfare maximisation are aligned. For low enough α, trigger-like strategies can endogenously limit the ability of the central agent to choose the fee.

ESNIE, May 2006The Emergence of Formal Institutions23 The role of commitment Inefficiencies are the result of the lack of commitment along two dimensions: individual and collective. Introducing commitment would mean: 1.Individual: Agents cannot renege ex-post whatever their role. 2.Collective: The fee is chosen collectively before the lottery takes place.

ESNIE, May 2006The Emergence of Formal Institutions24 The role of commitment Imposing individual commitment alone has no effect. Collective commitment alleviates the second type of inefficiency. Only when commitment is imposed in both dimensions, the institution arises whenever it is welfare enhancing.

ESNIE, May 2006The Emergence of Formal Institutions25 Problem: how to enforce this? We consider two ways to endogenize commitment: 1.Trigger-like strategies. 2.Threat of secession. Endogenous commitment

ESNIE, May 2006The Emergence of Formal Institutions26 Secession When there is no commitment, secession is an issue. No group in society should be able to improve its situation by withdrawing and forming its own mini-society. We study when the institution will be secession-proof and the impact of this threat on welfare.

ESNIE, May 2006The Emergence of Formal Institutions27 Secession Definition: Denote by a N the fee set by the institution. A coalition of S interacting agents is said to be blocking if and only if Note that when a group secedes, it sets a self-enforcing fee. A fee is secession-proof (it is in the core of the procedure of institution formation) if it does not spawn any blocking coalition.

ESNIE, May 2006The Emergence of Formal Institutions28 Secession Proposition 4 : The set of secession-proof fees is non- empty if and only if N is low enough. The reason for blocking is the prospect of becoming the central agent in the new mini society. When the level of status-quo trust is low enough, the threat of secession can tame the central agent.

ESNIE, May 2006The Emergence of Formal Institutions29 Secession N

ESNIE, May 2006The Emergence of Formal Institutions30 Inequality (in progress) Inequality of endowments can generate intermediate levels of formality. A revenue-maximizer institution may leave an inefficient amount of agents informal. In fact, as the level of status quo trust increases, the equilibrium level of formality drops.

ESNIE, May 2006The Emergence of Formal Institutions31 Inequality (in progress) How does this change as the distribution of endowments changes? Preliminary results with uniform distributions show that more inequality tends to generate lower levels of formality.