Ugo PaganoUniversità di Siena and Central European

University.

Institutional Complementarities

ESNIE 2004

Overview of the argument

Institutional Economics and Scarcity.

Institutional Substitution and Institutional Complementarity.

Weak and Strong Institutional Complementarities.

Cases of Institutional Complementarity.

Institutional Diversity and Institutional Change.

Economics and Scarcity

Even if we accept the orthodox definition of Economics as Scarcity,

Institutional Economics is more general than standard Neoclassical Economics because it does not rely on the restrictive assumptions

that: only physical resources are scarce and rationality, social positions and institutions are

free goods.

Additional Dimensions of Scarcity and Institutional

Economics1) Cognitive Scarcity and Bounded Rationality

2) Social Scarcity and Positional Goods

3) Institutional Scarcity and Incomplete Orderings

Samuelson’s statement:

"In a perfectly competitive economy it doesn't really matter who hires whom...." (1975 p. 894)

expresses well the view that:in a world of perfectly rational individuals (no cognitive scarcity),unaffected by power and status (no social scarcity) and organized by a complete market ordering (no institutional scarcity) the problem of natural scarcity will be solved in equivalent and efficient waysby capital hiring workers and by workers hiring capital.

If an individual is hired by another individual, she is always able to protect her investments in human capital in all the perfectly known future circumstances by the means of a complete contract. The status and power that are directly involved in the relation do not concern her.

1) Bounded rationality as constrained maximization?

If we include maximization costs in the maximizationapproach we apply consistently the general paradigm of scarcityto our limited rational capabilities but the maximization assumption becomes logically contradictory.

Assume that maximization activity is costly.Reformulate a new (second order) maximization problem in which an individual decides:- how many resources to allocate to the maximization activity - and how many resources to employ in the other activities

Unfortunately this involves a new maximisation problem withnew (second order) maximization costs.

A reformulation of a (third order) maximization problem would run in the same problem and so on ad infinitum.

(Scarcity and bounded rationality)

The idea that one could deal with maximization costs by simplyadding new constraints is wrong. A problem with more constraintsis computationally more complex. The individual, who could notsolve the rationally unbounded maximization problem, cannot solve thebounded rationality problem.

Unbounded outside observers (God) could tell us which one is the best solution for us without being bounded by our own constraints. Butwe are not God and we must face the problem of cognitive scarcity.

If we ignore the maximization costs faced by the different individualswe are assuming a strange economy where individuals face costly resources and “free” rationality (as well as “free” institutions).Under this assumption the maximization hypothesis is savedbut the general neo-classical paradigm of scarcity is abandoned

2) Positional Goods and Social Scarcity (Veblen)

Positional Goods like power and status imply a social scarcity constraint that is different from the standard economic constraint that characterises private and public goods. The standard scarcity constraint concerns limited positive amounts of resources. Positional goods are scarce because positive consumption must go together with negative consumption. Pure private goods: other individuals consumes a zero amount of what each individual chooses to consume.

Pure public good: each agent must consume the same positive amount that other agents decide to consume

Pure positional good: given the consumption choice of an agent, the other agent must consume a corresponding negative amount of what the other agent chooses to consume.

(Legal Relations and Social Scarcity)

Legal relations are characterised by some form of social scarcity in the sense that: no increase in rights is possible without some increase in duties and some decrease in liberties and no increase in powers is possible without some increase inliabilities and some decrease in immunities (Commons).

While public goods are typically undersupplied,positional goods are typically oversupplied.Legal goods such as rights, liberties and powers may sharethis problem and some form of legal disequilibrium maytypically arise.

3)Institutional Scarcity and Incomplete Orderings

Both Cognitive Scarcity (for obvious reasons) and Social Scarcity (because of legal disequilibrium) imply that well functioning consistent institutions are scarce.Independently of these types of scarcity, also standard economic scarcity implies that institutions, absorbing time energy and many other resources, are scarce.Public orderings are necessarily incomplete and market contracts arealso necessarily costly and incomplete.In such a situation, public orderings and market transactions may be substituted by firms and private orderings and vice versa. The extension of the economic problem of scarcity to institutional scarcity and the importance of the problem of institutional substitution has been the great path-breaking contribution of Ronald Coase.

Institutional Substitution and Institutional Complementarity

Scarcity does not only involve substitution but also complementarityproblems.This is true for both standard economic resources and for institutions.Two different questions arise:a) Which institutions can replace other institutions?b) Which institutions can favour some institutions instead of other institutions?

The questions a) and b) are related:When following Coase we say that, under some circumstances, there is tendency to replace markets with firms we should not forgetthat this tendency may be favoured by the fact that the public ordering has very incomplete rules and poor enforcement. Markets and the public ordering are complementary institutions.(Fuller L. L. 1969, Pagano IRLE 2000)

Strong Complementarities and Social Scarcity.

In some cases the existence of some arrangements in certain domains is a necessary condition for the feasibility of other arrangements in other domains.

These extreme cases of complementarity are more common than one may expect. Legal relations are cases of strong complementarity related to the problem of social scarcity.

Ex-ante an individual may expect to have a right even if nobody else perceives the corresponding duty. However, ex-post, one can benefit from a right only if somebody else is accepting to perform the corresponding duties and give up the related liberties.

First order jural positions

Right of i Duty of j

Exposure of i Liberty of j

Example 1: boat in danger.Boats that are in danger enjoy some legal right to be helped by other ships. This right is necessarily correlated with the duty of other boats not to leave when another ship is in danger. This duty does also necessarily entails that other boats do not have the liberty to leave and that boat that is danger is not exposed to the liberty of other boat of refusing help.Hohfeld W. N. (1919) Fundamental Legal ConceptionsCommons J. R.(1924) Legal Foundations of Capitalism

Second order jural positions

Power of i Liability of j

Disability of i Immunity of j

Example 2: liberty of speechIf, because of the existence of a Bill of rights the State has no power to change legal entitlements and restrict my liberty of speech (Simmonds, 1986 p. 132), this means that in this respect I have no liability towards the state or, in other words, an immunity against its power that is correlated to the corresponding disability of the State.

Private property and institutional complementarities

1) The right of exclusive use of assets by some individuals has to be correlated to the duties of others not to consume these resources.

2) The liberty that the owners have to choose among different uses of the resources is to be correlated to the exposure of others to these liberties.

3) The power that the private owner has to transfer her title has to be aligned to the liability that the other agents have towards these transfers of property.

4) The immunity of the owner against having his title altered or transferred by the act of another is to be aligned to the disability of others to perform these acts.

1,2,3,4 arise from the fact that the institution of private property is subject to social scarcity

Ex-ante expectations and ex-post identities.

A more general definition of institutional complementarities.

It is desirable to capture the case of complementarities by referring to a more general case where the institutional arrangements occurring in one domain are simply favouring the institutional arrangement in another domain but they are not a necessary condition for their (ex-post) existence.

Let us go back to Samuelson statement. Recall that it implies a double neutrality. Technology does not influence rights. Rights do not influence technology.

One may want challenge this statement by observing that some technological arrangements do simply favour some property rights and other organizational safeguards and vice versa (and not that the former are impossible when the latter do not exist).

The Notion of Institutional Complementarity (Aoki, 2001)• Economic agents face different domains of games in selecting their choice

in a given institutional framework; choices in one domain act as exogenous parameters in other domains and vice-versa

EXAMPLE:• two domains of choices X and Y; {X1, X2} and {Y1, Y2}, with agents i

choosing in X and agents j choosing in Y, according to their utilities (respectively, u for i and v for j).

• a) for agent i

• b) for agent j

• There can be one Nash equilibrium, but also two pure Nash equilibria (institutional arrangements) for the system as (X1,Y1) and (X2,Y2).

• When such multiple equilibria exist, we say that (i) X1 and Y1 are institutional complements; (ii) X2 and Y2 are institutional complements.

);();();();( 22211211 YXuYXuYXuYXu −≥−

€

v(Y2;X2) − u(Y1;X2) ≥ v(Y2;X1) − v(Y1;X1)

New Institutional theory has emphasized that owners of specific and hard-to-monitor resources tend to acquire rights and safeguards more than the owners of general purpose and easy-to monitor resource. This claim can be stated as:

(1) In the property right domain, a property right system PC is marginally better than another property right system PL if the corresponding technology Tc instead of the technology TL prevails in the technology domain. WhereTc : a technology where capital is intensively used as a specific and hard to monitor resource TL : technology where labour is intensively used as a specific and hard to monitor resourcePC : a governance system where the owners of capital have strong rights and safeguardsPL : a governance system where workers have strong rights andSafeguards.

In a word of positive transaction costs the owners of resources enjoying rights and safeguards tend to become more specific and hard to monitor than those without rights and safeguards. This claim can be stated as:

(2) In the technology domain a technology TL is marginally better than a technology Tc if a property right system PL instead of property right system PC prevails in the property right domain. This is an argument that has been typical emphasized by radical economists against the efficiency predictions of NIE. However, it is consistent when NIE when one assumes positive transaction costs.

Inverting the Argument.

(1) In the property right domain a property right system PC is marginally better than another property right system PL if the corresponding technology Tc instead of the technology TL prevails in the technology domain. (2) In the technology domain a technology TL is marginally better than a technology Tc if a property right system PL instead of property right system PC

WhereTc : a technology where capital is intensively used as a specific and hard to monitor resource TL : technology where labour is intensively used as a specific and hard to monitor resourcePC : a governance system where the owners of capital have strong rights and safeguardsPL : a governance system where workers have strong rights andsafeguards.We can have multiple equilibria (PC, Tc) and (PL, TL )PC and Tc and PL and TL are, in this case, institutional complements.

Pagano Rowthorn 1994(2) Inverted argument: Under capitalist ownership (PC) firms maximise: Rc = Q (k,K,l,L) - [rk + RK +wl + (H+W)L] (1) ----->(Tc)

Under labour ownership (PL) firms maximise:RL = Q (k,K,l,L) - [rk + (Z+R)K + wl +WL] (2) ----- >(TL)

(1) Original NIE argument: Capitalist property rights PC can prevail if Rc RL or,

ZK - HL 0 (3) <----- (Tc)

workers' property rights PL can prevail if RL Rc, or: HL - ZK 0 (4) <----- (TL)

We can have multiple self-enforcing equilibria (PC, Tc) and (PL, TL ) that are institutional complements.

Institutional Complementarity between ownership of intellectual property rights and firms capabilities.

(Pagano, Rossi EJLE 2004)

The argument can again be inverted: If transaction costs prevent property rights from being attributed to the “efficient owner”, whoever is the current owner will find it more convenient to invest in human capital specific to the assets.

A double relation of causation should be considered. If property rights are chosen on the basis of given technologies and abilities, also the opposite is true: abilities and technologies are chosen on the basis of existing property rights

HIGH FIRM CAPABILITIES AND A RICH PORTFOLIO of IPR are institutional complements. And, unfortunately also low firm capabilities and a poor portfolio of IPR are institutional complements.

Firms Capabilities Intellectual Property

We interpret the NPR approach as a model of allocation of IPR. The firms and individuals that that are more capable to make investments specific to the

improvement of these assets should acquire them.

Williamson (1988) describes a direction of causality moving from asset specificity to firm’s financial structure, and then to firm’s governance:Prevalence of specific assets ------> Equity FinancePrevalence of general-purpose assets -----> Debt Finance

In the language of institutional complementarites:Equity finance is marginally better than Debt Finance in the financial domain when a technology characterised by a prevalence of specific assets over general-purpose assets is adopted in the technology domain.

Institutional Complementarity between financial and technological structures. (Nicita-Pagano ALEA 2003, revised 2004 )

Equity Finance ------> Prevalence of specific assets Debt Finance -----> Prevalence of general-purpose assets

In the language of institutional complementarites:An asset-specific intensive technology is marginally better than a general purpose technology in the technology domain when a financial structure with equity funding over debt funding is adopted in the financial domain.

A high degree of equity finance and a prevalence of specific assets are institutional complements and, similarly, also a high degree of debt funding and general purpose assets are institutional complements.

In word of positive transaction costs the argument can again be inverted:

Institutional diversity and institutional change.

In natural history the substitution of one species by one that is better adapted to the environment is limited by the epistatic relations among genes.These epistatic relations, which are the biological equivalent of institutional complementarities explain the long period of stasis and the sudden changes (punctuated equilibria) that characterises complex species.Economic systems are similar: institutional change is constrained by institutional complementarities. The relations of complementarity explain why we have different varieties of capitalism - a variety that the globalization of the economy may increase by allowing each variety to exploit its comparative institutional advantage.

We have started by pointing out that institutional economics deals with additional dimensions of the scarcity problem and we have considered complementarities arising from social and institutional scarcity.

Perhaps a future analysis should include the complementarities existing in our own thoughts. Cognitive scarcity implies that we can only improve on one argument over another taking for granted that in other domains we have chosen other arguments.

North’s stress on ideology and Kuhn’s scientific paradigms are perhaps related to this point.

But, having referred to our limited capacity to pay attention to many things at the same time, the best thing, that I can do, is to stop talking…..

Thank you!