Introduction to the New Introduction to the New Institutional EconomicsInstitutional Economics

Christopher D. Gerrard

National TOT Workshop

Harare, Zimbabwe

October 28 to November 1, 1996

Objectives of the PresentationObjectives of the PresentationTo provide an introduction to and an

overview of the “new institutional economics”

To explain why the new institutional economics can help policy makers, managers, analysts, and consultants address agricultural policy and institutional reform issues

Background ReadingsBackground Readings Christopher Clague, “The New Institutional Economics

and Economic Development” (forthcoming) Thrainn Eggertsson, “The Economics of Institutions in

Transition Economies” in Salvatore Schiavo-Campo (ed.), Institutional Change and the Public Sector in Transitional Economies (World Bank Discussion Paper #241, 1994).

Mustapha K. Nabli and Jeffrey B. Nugent, “The New Institutional Economics and Its Applicability to Development”, World Development, 1989.

Hans P. Binswanger, Klaus Deininger, and Gershon Feder, “Power, Distortions, Revolt, and Reform in Agricultural Land Relations” (forthcoming)

The New Institutional Economics The New Institutional Economics isis

“Economics”“Institutional”“New”

The NIE is “Economics”The NIE is “Economics” Assume that individuals, households, and collectiv

ities (such as firms and other organi-zations) make rational choices subject to scarcity

Formulate models (such as perfect competition) to analyze real-world situations (such as agricultural markets)

Predict outcomes and evaluate these outcomes by means of some normative criteria such as Pareto-efficiency and equity

The NIE is “Institutional”The NIE is “Institutional” Standard neoclassical economics emphasize three basic

constraints: – Consumer preferences – Initial resource endowments of land, labor, and capital– Technology

The NIE builds upon and broadens this approach to include various kinds of institutional constraints in the analysis

In order to explain observable phenomena that the standard framework cannot explain, except by assuming individuals are acting irrationally

The NIE is “New”The NIE is “New” To distinguish it from the “old” institutional econo

mists such as Thorsten Veblen, John R. Commons, Wesley Mitchell, and Clarence Ayres

The old institutional economics was economics with institutions but without theory; standard neoclassical economics is economic with theory without institutions; and the NIE is attempting to provide economics with both theory and institutions

SummarySummary

The new institutional economics, or NIE, is a branch of economics that specifically incorporates various institutional constraints into formal economic analysis in order to explain, on the basis of rational choice, observable real-world phenomena that standard neoclassical economics (absent institutional constraints) is unable to explain, except by assuming irrational behavior on the part of individual economic agents.

Consumer preferences Resource endowments Technology No transactions costs Symmetrically distributed

information Voluntary transactions on a

level playing field Risk and uncertainty

Differentiation of individuals into different economic classes

Exogenous Variables Endogenous Variables

Level A: Neoclassical Counterfactual

Level B: Marxist Economics Imperfect or entirely absent

capital markets

E.g. Land Relations -- Levels of Analysis

With these assumptions alone, it is impossible to explain, on the basis of rational choice, virtually any of the interesting or peculiar things about land relations and land markets in the agricultural sector.

Transactions costs Asymmetric information, adverse

selection, and moral hazard Agency theory

Failure of intertemporal markets for crop insurance and credit

Accumulation of large land holdings Failure of lands sales markets to improve e

fficiency Intertemporal variations in property rights Survival of plantation crops based on wage

labor

Exogenous Variables Endogenous Variables

Level C

Level D Covariate risks Immobility of land Population density Processing characteristics of

specific agricultural commodities

Credit-rationing Sharecropping and inter-linked credit General superiority of family farms Widespread use of tenancy by large-

scale land-holders Incentive problems in collective farms

Land Relations (cont.)

Collective action Involuntary contracts Coercive power of the state Preferential playing-fields

The grand themes of historians, classical economists, and Marxist historical analysis

Establishment and breakdown of political coalitions

Demise of feudalism Abolition of slavery Land reform

Exogenous Variables Endogenous Variables

Level E

Level F Whatever changes the set of

instruments for rent-seeking or surplus extraction

Coalition building Rent-seeking Distortion s in commodity and factor markets Bondage, slavery, tribute, and corvee system

s Emergence and persistence of dualistic farms

size structures

Land Relations (cont.)

What are “Institutions”What are “Institutions” Institutions are “socially devised rules that are

recognized and frequently followed by members of a community, and which impose constraints on the actions of individual members of the community”.

While institutions may be liberating -- in the sense that the community may be better off than in the absence of rules -- the rules still impose constraints at the individual level

Macro-level institutionsMacro-level institutions Affect incentives throughout the economy Examples

– Constitution of the country– Rule of law– Legislative law, common law, and customary law– Criminal law and civil law– Well-defined property rights: Group and individual– Contract law: Enforceable contracts– Justice and police systems– Corporation law: Governing the formation of for-profit and non-

profit corporations, associations, societies, and co-operatives.– Competition law (monopolies commission)– Labor law.

Micro-level institutionsMicro-level institutions Affect incentives in individual situations in a part

of the economy Examples:

– Formal organizations (such as corporations, labor unions, trade association, and interest groups) and the rules by which such organizations operate

– Markets of all kinds, and the rules by which these markets operate

– Contracts, both explicit and implicit, such as employment contracts, tenancy contracts, loan contracts, insurance contracts, and agency contracts

Characteristics of institutionsCharacteristics of institutions Predictable, essentially stable, and applicable in

repeated situations Either formally written down and enforced

(among others) by government officials, or unwritten and informally sanctioned

With some degree -- but not necessarily an absolute degree -- of rule obedience

Origins and StrandsOrigins and Strands The NIE is the culminating intersection of a

number of different lines of investigation, disparate in origin, and differing in form.

Nonetheless, there are five major strands:– Transactions costs, markets, and hierarchies– Economics of costly and asymmetric information– Economics of property rights– Collective action– The emergence of cooperation and norms

Transactions costs, Transactions costs, markets, and hierarchiesmarkets, and hierarchies

Ronald Coase I: Why do certain economic transactions take place internally within firms, while others take place externally in markets?

Oliver Williamson: Firms are transactions-costs minimizing arrangements, which evolve over time with changes in the nature and sources of transactions costs as well as with changes in the means for minimizing such transactions costs.

In particular, “bounded rationality” and “opportunistic behavior” lead firms to internalize certain economic transactions.

Economics of costly and Economics of costly and asymmetric informationasymmetric information

This literature started with two problems in the insurance industry -- adverse selection and moral hazard.

Now applied to a large class of problems where there exists asymmetric information between the two (or more) parties to a contract.

Encompasses principal-agent models, sharecropping, optimal contracts, incentive-compatibility, the economics of screening, and the economics of lemons.

Economics of property rightsEconomics of property rights This literature views property rights as institutional mechanisms for internalizing externalities.

Douglass North: – As economies become more complex, it becomes more and more importa

nt to define and enforce property rights in order to reduce transactions costs.

– Since collective action to define and enforce property rights is a very costly process, there exists a vital role of the state in the process of defining and enforcing property rights.

Ronald Coase II: If there are no transactions costs and no asymmetric information, bargaining and negotiation will lead to efficient outcomes, independent of the initial assignment of property rights.

– Economics with transactions costs would be like the physical world without friction.

– The initial assignment of property rights affects only the distribution of income.

Collective actionCollective action Concerned with the conditions under which groups of people with a co

mmon interest perceive and act to achieve that common interest– How groups overcome non-excludabilty and the free-rider problem– The free-rider problem occurs when self-interested individuals choose not t

o participate in the provision of collective goods or to reveal false preferences about the value of the collective goods to them

Concerned not only to physical collective goods but also abstract collective goods -- such as public policies

For successful collective action, it helps to have:– Relatively small, homogenous groups with common objectives– Political entrepreneurs– Selective incentives– Leadership, organizational, and communication skills– Appropriate balance between voice and exit– Tolerance on the part of other groups

The emergence of cooperationThe emergence of cooperationand normsand norms

Concerned with how cooperation and norms emerge in order to overcome collective action problems: It helps to have institutional arrangements that will induce cooperative behavior in situations of potential conflict.

While similar to the collective action literature, this literature is more experimental and prescriptive: How to design or to craft institutions that will induce cooperative behavior.

Has been applied to the provision of common pool goods such as forests, fisheries, grazing lands, and water:

– Because of collective action problem and information costs, neither the market nor hierarchy are efficient or effective allocation mechanisms for common pool goods.

– While cooperation and persuasion are the best ways of managing common pool goods, it helps to have social customs and conventions that work to induce cooperative solutions.

Why the New Institutional Why the New Institutional Economics?Economics?

African countries are facing a crisis of sustainability.– Macroeconomic sustainability– Fiscal sustainability– Institutional sustainability– Ecological sustainability

While much macroeconomic adjustment has taken place, which has reduced the level of indirect taxation on the agricultural sector, the agricultural supply response has been disappointing.

New public policies alone have not been sufficient:– Liberalization and privatization– Decentralization and participation

To be effective, these policies require new legal and institutional frameworks to support them -- that is, a “second generation” of adjustment issues.

E.g. Agricultural marketingE.g. Agricultural marketing Price determination vs. price discovery

– Price determination refers to the way in which the economic forces of supply and demand influence prices under various market structures

– Price discovery refers to the process by which buyers and sellers arrive at specific prices and other terms of exchange

While economists typically discuss price determination without reference to institutions, it is not possible to discuss price discovery without reference to institutions:

– Price discovery occurs in an institutional context.– Price discovery is a costly process,– Which is often characterized by asymmetric information,– And by collective action problems.– Price discovery involves three dimensions: Time, place, and form.

IndividualNegotiations

GroupBargaining

SpotAuctions

CommodityFutures

FormulaPricing

AdministeredPrices

Ch

arac

teri

stic

sE

xam

ple

s

Decentralizednegotiationsbetween buyers andsellers

Individualmaizemarketingin Kenya

Most fooditems inmostcountries

Groups,associations,or cooper-atives thatnegotiateon behalf offarmers,processors, orwholesalers

Kenyansugar

KenyaCooperativeCreameries

Contractbarley andtobacco

Competitivebidding incentralizedmarkets based onphysicalinspectionof com-modities

Coffee andtea auctionsin Kenya

Pugulivestockmarket inDar es Salaam

Organizedexchanges forstorablecommoditiesbased onstandardizedcontracts withrespect tograde, time,and location

Prices basedon benchmarkprices eitherin centralmarkets, oraccording to,say, butterfator proteincontent

Fertilizerpricing inKenya before1991

Milk pricingin the U.K.and theNetherlands

Pricesestablishedandcontrolledby govern-ments,usually forpoliticalreasons

Maizemarketingin Kenyabefore Decem-ber 1993

EuropeanCommonAgriculturalPolicy

Grainmarketingin SouthAfrica

Price discovery institutions in agriculture

Policy and Institutional ReformPolicy and Institutional Reform Requires a vision: A picture of where you want to be Requires special efforts in a whole range of areas:

– E.g. The lifting of price controls and the liberalization of trade does not automatically bring forth the required economic and social institutions.

– The demand for efficient institutions does not necessarily create its own supply on a timely basis.

Requires a theory of policy and institutional reform:– Policy makers, managers, and analysts could use some theoretical

guidance.

What is the vision?What is the vision? Rural growth is widely shared, with private and competitive agricultur

e and agribusiness as the main engines of growth Family farms and nonfarm enterprises provide ample remunerative em

ployment opportunities to men and women Rural people manage the soils, water, forests, grasslands, and fisheries

in a sustainable manner Rural people are linked to well-functioning markets for products, input

s, and finance Rural people have access to medical care, clean water and sanitation, e

ducational opportunities, and sufficient nutritious foods Essential legal frameworks, public investments, productive and social

services are provided and financed in a pluralistic, decentralized, and participatory manner

The The Vision?Vision?

Family farms provide

income, ample employment

Rural growth is widely-shared Decision-making

is decentralized,

participatory

Markets

function wellResources are

managed

sustainably

No urban bias in health

education, safe water

Where are special efforts required? Where are special efforts required? II

Rural strategy and policy formulation– Macroeconomic and sector-wide pricing policies– Food security and nutrition policy– Markets and agribusiness– Land policy and land reform

Local and community development– Rural finance– Rural infrastructure

Intensification of agricultural systems– Agricultural research– Extension and rural information systems

Where are special efforts required? Where are special efforts required? IIII

Management of natural resources and forestry– Managing soil productivity– Mainstreaming biodiversity– Environmentally sound pest management– Livestock, rangelands, and pasture management– Fisheries and aquaculture– Forestry and agroforestry

Water allocation, irrigation, and drainage

What theoretical guidance is What theoretical guidance is available?available?

Small, open economy macroeconomicsMarket and price analysisThe new institutional economicsEnvironmental and natural resource

economics

Frontiers of the Economic Frontiers of the Economic SystemSystem

Production frontier: Maximim output withno transactions.

Transactions frontier: Maximum output,subject to transactions costs. State hasprovided an ideal institutional framework.Firms use incentive contracts, monitoringand other methods to minimizecosts.

Social frontier: Maximum output,subject to transactions cost and collective action problems.

Commodity A

Com

mod

ity B