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)

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 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 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)

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

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, 6.800 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

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) Excludable Non-Excludable Private good Common pool resource Club good Public good 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 Rules Player Actions Results (Payoffs) Environment

Changing the terms Institutions Actors Interactions Allocation, Distribution 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 B B i j i j i A j Pure coordination Pure conflict

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) B B i j i j i A j Prisoners Dilemma Chicken Game

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 B B i j i j i A j Prisoners dilemma with sanctions s Prisoners Dilemma

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

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

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

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

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?

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?

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)

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

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 S+TC P - price S – supply without TC p+ p D - demand X+ X X - quantity Source: Furubotn and Richter (2000)

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)

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

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

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

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