NEW INSTITUTIONAL ECONOMICS FOR PUBLIC POLICY:

AN OVERVIEWPROF WIHANA KIRANA JAYA

FACULTY OF ECONOMICS AND BUSINESS

UNIVERSITAS GADJAH MADA

INSTITUTIONS

Institutions are the humanly devised constraints that structure political, economical

and social interaction.

They consists of both informal constraints (idioelogy, 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)

NEW INSTITUTIONAL ECONOMICS

New Institutional Economics

incorporates a theory of

institutions - laws, rules, customs,

and norms - into economics. It

builds on, modifies, and

extends neoclassical theory.

New Institutional Economics objects to the

notion that the "laws" constructed by

Neoclassical economists were timeless

generalizations and contended instead that

the economic behavior of men, like any

other human activity, had to be analyzed in

terms of the social context in which it was

imbedded.

NeoclassicalEconomics New

Institutional Economics

allocation of scarce

resources among

alternative uses

how the institutional structure

evolved and how institutions

reflected the prevailing

social/political/economic

structure

THEORETICAL BUILDING BLOCKS

Principal-Agent Theory

Formal-Informal Institutions Theory

Transaction Cost Theory

Property Right Theory

Social Capital Theory

THE INDIVIDUAL AND THE INSTITUTIONAL STRUCTURE

Source: Vatn (2005)

TYPES OF INSTITUTIONS

Rules Enforcement mechanism Example

1. Convention Self enforcement Language

2. Ethics Imperative self binding Being a veterinatian

3. Norms Social enforcement Social codes of conduct

4. Formal private rules Organized private enforcement

Self imposed rules inside organisations

5. Law Organized state enforcement

Business Law

Source: Ellickson, 1991

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

Bounded Rationality

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

ANALYTICAL LEVELS OF NIE

L1

L2

L3

L4

often noncalculative,

spontaneous10² to 10³

Embeddedness:

Informal Institutions, Customs,

Tradition,Norms,

Religion

Social Theory

FREQUENCY

(YEARS)

PURPOSELEVEL THEORY

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 10get the Governance

structure right, 2nd order

economizing

Governance:

Play of the Game – esp. Contract

(aligning Governance Structures

with TransactionsTransaction Cost

Economics

Resource

Allocation and Employment

(Prices and Quantities, Incentive

Alignment)continuous

get the marginal conditions

right, 3rd order

economizing

Neoclassical

Economics/Agency

Theory

Source: Williamson (1998)

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

RESEARCH QUESTIONS FOR UU SJSN DAN JKN ???

L1

L2

L3

L4

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 narrativesSource: Alston 1996 and Williamson 2000)

DATA CONSTRAINTS

L1

L2

L3

L4

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

Small to medium

(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)

DATA

SOURCES

Poorly developed

Some official statistics

International surveys

Less developed

Historical records

Documents

Official statistics

International Surveys

Developed

Official statistics

Accounting

Well developed

Official statistics

Accounting

GETTING PUBLIC POLICY EXAMPLE:

TAX AMNESTY INTO NIE PERSPECTIVE

The Four Levels of Institutional Analysis

These rules, norms and customs take a long time to change and are generally

found to have a strong underpinning in the religion, culture, and tradition of

society sense of belonging towards nation through tax payment

This level is concerned with the contractual relations (contract

laws and enforcement) transaction cost of tax amnesty

It deals with the lack of well-defined and secure property rights

property right conflict over tax amnesty

It emphasizes the nature of individual incentives to participate

in different levels of decisions making and activities and to

comply with rules incentive to participate in tax amnesty

CONT’D

Transaction Cost

Andreoni (1991): the possibility of a tax

amnesty actually decreasing, rather than

increasing, the efficiency and equity of the tax

system.

Property Right

As the probability of an amnesty rises, and thus

the future opportunity to declare any

dishonesty free of penalty, people report less

income.

Contract

Stella (1991): if taxpayers are in expectation for

an amnesty, this situation may risk tax

compliance in the long term and also it may

cause negative outcomes on honest taxpayers’

perceptions about justice.

CONT’D

Distributive Justice

Social Contract

CRITICAL ASPECT

Incentive Compatible Contract

Costly State Verification

Incentive to Comply

FRAMEWORK OF ANALYSIS

CONT’D

On Distributive Justice …

John Rawls

A Theory of Justice(1971)

The distribution of economic benefits and burdens could be affected by government.

Governments continuously make and change laws and policies affecting the distribution of economic benefits and burdens in their societies.

Distributive justice is concerned with the fair allocation of resources among diverse members of a community.

Tax as a means of resource reallocation in society.

Is it justified to forgive the non-compliance party over the taxpayer?

CONT’D

On Social Contract …

Jean-Jacques Rousseau

Du contrat social ouPrincipes du droit politique

(1750)

While each individual has a particular will that aims for his own best interest, the sovereign expresses the general will that aims for the common good.

Man is born free, but he is everywhere in chains.

John Locke

Second Treatise of Government (1689)

Social contract occurred when men would transfer some or all of their rights to the government in order to ensure a comfortable living.

Tax compliance serves as a route for state-society relations.

CONT’D

Taxpayers are encountered with

various factors that cause tax

incompliance:

Educational level

Age intervals

Income level

Religious perspective

What affects tax paying culture?

appropriate conditions for tax evasion and tax

avoidance

existence of policies designed with short-term

approaches

regulations for satisfying some certain groups

belief that tax systems are unfair and unequal,

psychological factors

inadequacy of inspection and audits by tax authorities,

immature moral obligation

inefficiency of coercion and deterrence mechanisms

the lack of state legitimacy

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