Transcript INSTITUTIONAL ECONOMICS AND ECONOMICS OF THE …

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
is divided into two inter-related parts

its first part, Institutional Economics, explains and
illustrates the substance and economic importance of
„institutions“

its second part, Economics of the Public Sector,
focuses on the main principles of the public sector of
the economy, mainly the principles of regulation,
taxation and public expenditures


the exam is a written one
each student is asked to choose a (preferably recent
and/or controversial) topic studied by „Institutional
Economics“ or „Economics of the Public Sector“
and analyze it in a short paper

The essay/paper should be at least 6 normal pages
(and preferably not more than 8 pages) in length

Topics of paper are subject to approval, but can be
chosen freely or selected from a list of topics which
will be provided

Papers should be submitted by e-mail till May 31

Institutional economics is a relatively new
interdisciplinary field that includes and puts
together aspects of economics, law, political science,
psychology, sociology, history and theory of
business organization.

It is not just „hard“ factors (labor, capital,
technology, natural resources etc.) but also
„soft“ factors or „institutions“ that matter
for economic performance or prosperity


Economics cannot be separated from the political and
social system as well as the system of public beliefs
within which it is embedded
Higher productivity requires „better institutions“

(economically important) rules of the game in a
society

incentive systems that guide/constrain human
behavior

Well-defined property rights

„Sound“ legal rules

Judiciary serving as an unbiased third-party enforcer of
contracts and agreements
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Efficient, i.e. competitive markets

knowing the kind of institutions that need
to be put in place to realize economic growth
does not tell us how to acquire/develop them in the
first place


Formal (constitutions, laws, rules and regulations put in place
by the government, contracts, markets, money etc.)
Informal, i.e. social norms, codes, conventions, habits,
traditions, customes, values, religions, rules of behavior etc.
 General, universally valid, or specific, governing certain
relationships, e.g. specific bilateral contracts
 Deliberately created or spontaneously emerging
 Public, enforced by the government, or private, sanctioned by
private organizations (e.g. expulsion)

Institutional environment - general insitutional
framework (and its development)

Institutional arrangements - instruments managing
(governing) specific economic transactions.
can be formal (the legal system), and thus
formally reinforced,

and informal (rules of social conduct),
informally reinforced, including habits and
traditions, often based on social beliefs.


Economically important institutional
arrangements include money, contracts, markets
and specific market structures, business
organizations (e.g. corporations) as well as
methods of corporate governance, trade unions,
etc, which are widely used, recognized or
followed
They are sometimes also referred to as „social
technologies“.


Economic activities or transactions, i.e. work,
consumption, trading, saving, investments,
education etc., are embedded in an institutional
environment, both formal & informal, and
governed by institutional arrangements.

Institutions, both formal and informal, can either
promote (facilitate, provide incentives to) certain
socially important economic activities
and transactions

or they can rather hamper (impose constraints to)
certain important economic activities

Economic growth requires institutions that
enable/reward productivity and creativity


In economic terms, an important characteristic
of institutions is they can influence the costs
of economic activities and transactions
(„transaction costs“) for/between individuals,
firms etc.
High transaction costs mean loss of welfare
Institutions can



make human behavior more predictable,
create mutual trust (social capital),
provide guarantee to transacting parties (usually
important for the weaker party to a transaction)
and thus lower the need for costly precautions, which
otherwise might be necessary.

Impersonal exchange requires mechanisms
for ensuring honesty and cooperation
without personal ties
In the world under personal exchange conditions:
It pays to cooperate with the other players when
• you have repeated dealings with them
• you have a small number of players
• you know a lot about the other players
You as a player will defect when
• you have no more dealings with somebody
or you deal with them only once
• you have large numbers of players
• you don't know the other players

The movement from personal exchange to impersonal
exchange is the most fundamental challenge of economic
development

It took the Western world five or six centuries to
gradually evolve institutions that made possible
a world of impersonal exchange (capital markets,
long-distance trade, worldwide exchange)

The ability to conduct personal exchanges is genetically
inherited, but impersonal exchange requires that
there is a political system that puts in place rules
and mechanisms to enforce contracts across time and space.

A related economic perspective of evaluting
institutions is their „efficiency“

Institutions may be „efficient“ or „imperfect“
(inefficient) in the sense that nation or community
may be better off in case of their presence than in
case of their absence, or vice versa


„Efficient institutions“ promote economic
activities and/or transactions that make the
community better off.
Examples include work, investment, education,
trading, labour and capital flexibility, etc. on the
one hand, and fraud, weak property rights and
expropriation, rent seeking, etc. on the other hand.

The contribution of the society's entrepreneurial
activities varies because of their allocation between
productive activities, such as innovation, and largely
unproductive or even destructive activities, such as
rent seeking or organized crime.

This allocation is heavily influenced by institutional
framework: the relative payoffs society offers to such
activities.

Members of a primitive society living in an area
with scarce water resources may either believe
that water can be gained by giving donations to
gods of rain or by buildings wells, irrigations
etc.

Similarly, members of a modern society suffering
from high unemployment may either believe that
additional jobs can be created by administrative
regulation (e.g. ban of transfers of companies to
low wage countries) or by increasing labor
productivity and/or decreasing labor costs
 Economic institutions: property rights, contracts
and their enforcement (e.g. the set of contracts that
can be enforced), market entry barriers, bans of
certain economic activities, technology regulation
etc.
 shape economic incentives, contracting
possibilities and income distribution
 impose restrictions on certain economic behavior,
e.g. production, consumption, technology use etc.
 Type of market refers to the process by which
buyers and sellers exchange their goods (terms of
exchange) and arrive at specific prices
The type of market impacts, among other things,
influences
◦ The occurance of asymmetric information
◦ Costs/time requirements of price discovery (setting
the price)
Characteristics
Example: Market institutions in agriculture
Individual
Negotiations
Group
Bargaining
Decentralized
negotiations
between
buyers and
sellers
Groups,
associations,
or cooperatives that
negotiate
on behalf of
farmers,
processors, or
wholesalers
Spot
Auctions
Competitive
bidding in
centralized
markets
(based on
physical
inspection
of commodities)
Commodity
markets
Formula
Pricing
Products are
traded on
regulated
commodity
exchanges, in
which they
are bought
and sold in
standardized
contracts
Prices based
on benchmark
prices either
in central
markets, or
according to,
say, butterfat
or protein
content
Administered
Prices
Prices
established
and
controlled
by governments,
usually for
political
reasons
 Political institutions: e.g., forms of government,
distribution of political power, separation of powers,
etc.
 They shape political incentives, e.g. incentives to
become a politician, put constraints on politicians and
elites to use their powers for personal economic goals,
govern the process of collective decision-making in
society (solving public issues), etc.

If institutions matter for economic performance,
why do societies sometimes choose or end up
with „inefficient institutions“ that do not
promote economic growth or overall economic
welfare?

Underperforming institutions do not „just
disappear“

Whoever is pursuing an institutional change in
a society, wants the results favorable to the
well-being of that person or social group

Inefficient institutions will emerge and persist,
when social groups that prefer the inefficient (nongrowth enhancing) rules, are sufficiently powerful

E.g. the „elite“ may pursue inefficient policies to
extract revenue from other groups

Revenue extraction: the group in power - the elite will set high taxes on producers in order to extract
revenue.

Because of limited resources of producers, these taxes
impede economic growth.
 Income
manipulation: powerful group can, for
example, impose market entry barriers or suppress
competition in certain markets to increase its
incomes.
 Market
barriers limit competition and hamper
economic and/or technological progress

Blocking technological change: in order to increase
the probability of staying in power the elite can block
technological development/use. The reason is that
technological change may erode its
position/advantage.
 Blocking
technological change limits growth

People often do not understand how the pursuit of
private profits can yield public benefits: they can have
an anti-market bias.

People often tend to underestimate the benefits of
interactions with foreigners: they have an anti-foreign
bias.

People often tend to equate prosperity with
employment rather than production

Laws, rules, norms, and beliefs inherited from the
past constrain the introduction of new institutions

The inherited institutions tend to be very
conservative (path dependent): you need to
understand where you've been in order to know
where you are going.

Explain and evaluate impact of institutions
(institutional environment, institutional
arrangements) on economic performance, efficiency
and distribution

Evaluate social, historical etc. determinants of
institutions and study evolution of institutions over
time

“Its goal is to explain what institutions are, how they
arise, what purpose they serve, how they change and
how, if at all, they should be reformed.” Peter Klein
at http://encyclo.findlaw.com/0530book.pdf

to describe how specific economic behavior is
influenced by institutions

show how (why) specific economies develop
institutions that produce growth and development,
while other develop institutions leading to high
costs, economic problems and stagnation
Suggestions of essays topics

Analysis/illustration of factors facilitating
development of efficient institutions (preferably in
specific industry)

Analysis/illustration of factors impeding development
of efficient institutions (in specific industry)

Analysis/illustration of voters beliefs demanding
ineffiecient institutions (in specific industry)
Main components
of Institutional Economics
Transaction Costs Economics
Property rights theory
IE
Theory of contracts
Economics of information
Theory of Public Choice
Institutional Economics
on Transaction costs
 Economy
as a whole is a complex of transactions
potentially increasing well-being of their participants
Transactions arise due to division of labor, which
increases productivity
 Market exchanges, however, are not costless,
transaction costs may be considerable
 Transaction costs – „frictions“ in transactions,
costs of trading, arise mainly due to imperfect
information and opportunism of economic
subjects (occurance of fraud)
Examples of transaction costs:
 Cost of screening and selecting a buyer or
seller
 Cost of obtaining information on a good or
service
 Cost of bargaining & negotiating a contract
 Cost of monitoring & enforcing the contract

Search and information costs are incurred in
determining that the required good is available
on the market, who has the lowest price, etc.

Bargaining costs are the costs required to
come to an acceptable agreement with the other
party to the transaction, drawing up an
appropriate contract, etc. Among other things,
bargaining costs may depend on distance
between the bid and ask.

Policing and enforcement costs are the costs
of making sure the other party sticks to the
terms of the contract, and taking appropriate
action (often through the legal systém) if this
turns out not to be the case
 Institutions regarded as „economically efficient“
if substantially reducing transaction costs
(increasing predictability, building trust, decreasing
risk/uncertainty of transactions etc.)
 Evolution (development)
of institutions often leads
to transaction costs reduction
 Institutions that evolve to reduce transaction costs
are key to the performance of economies
 Not all institutions that emerge are efficient
 The
inability of societies to develop effective,
low-cost institutions, e.g. enforcement of
contracts, is the most important source of both
historical stagnation and contemporary
underdevelopment (e.g. in the third world).
 Explaining the choice of contracts between
different market participants
 Analyzing the type of institutional innovation
needed
 Understanding the role of the government in
supporting the development of institutions

Lowest price quarantee (guarantee of the best price)
is a marketing measure that at same time reduces
information costs of consumers
 Why
do certain economic transactions take place
internally within firms, while others take place
externally, in markets?
 Markets:
interactions between firms, coordinated
through competition, prices and contracts
 Hierarchies:
interactions within firms, coordinated
by command and cooperation
 Forms of prevailing economic transactions (from
vertical integration to cash markets) depend
largely on the nature and magnitude of transaction
costs
 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, incomplete information and
“opportunistic behavior” (i.e. danger of fraud,
absence of trust) can lead firms to internalize certain
economic transactions.
 How
do persons (individuals, traders) respond to high
transaction costs in terms of screening for trust-worthy
partners, obtaining information, drafting and enforcing
contracts?

How can sellers diminish - in their own interests – the
screening costs of buyers?

How can the government cut down on transaction costs
and decrease the riskiness of market exchange?
Institutional Economics on Property
Rights

Private ownership and property rights are the
most effective institutions for providing
incentives to create, maintain, and improve
assets.
 If property rights are not secure, there will be
no incentive to invest in or improve assets.

Property rights institutions can protect from various
forms of expropriation by both public and private
entities, e.g. government expropriation
Lack of these rights reduces incentives to maintain
assets, to innovate and take risks, and to create new
wealth.

 Therefore,
property rights institutions are
important for economic well-being and growth.

Economic efficiency of property rights can be
positively or negatively impacted by their
characteristics
 Universality - all resources privately owned,
all property rights completely specified
 Exclusivity - owner receives all benefits and
incurs all costs
 Enforceability/Low exclusion costs - all rights
secure from involuntary seizure
 Exclusion costs are incurred when owners have
to employ resources to exclude others from
owning or using the property
Private autonomy means that the property rights
owners are free from private and public limitations
on how property is to be used

Private autonomy can be curtailed by both private
actions (e.g. by excluding certain suppliers from
selling in a market, i.e. by a supplier cartel) and
goverment actions

 Transferability - all property rights transferable
from one owner to another in voluntary
exchanges, for example through sale or donation.
 Infransferable property rights cannot be traded
and used by others, and hence often canot be
used to the fullest potential, i.e. by those who can
use them best.
 Divisibility. Divisibility. of property rights means
that property rights can be „unbundled“: mere
ownership rights can be separated form rights over
specific uses of an asset

Free access to a scarce natural resource ultimately
destroys the resource through over-exploitation.



many people have the right to use a single shared
resource
no one has a sufficient interest to bear the costs of
maintaining and increasing its value
without proper incentives, no one is motivated to
use the „proper“ amount of a scarce resource..

“Big” environmental problems (pollution, soil
erosion, overfishing, overgrazing etc.) often arise
when resources are under non-private property rights
or their ownership is spread among a great number of
persons

In such cases, introduction, clear definition and/or
concentration of ownership rights can lead to
increased efficiency
Suggestions of essays topics

Which property rights arrangements (in specific
industry) are usually more inefficient and why?

Which property rights assignments and/or
characteristics (in specific industry) „improve“
economic incentives in terms of property use
and preservation?
Insitutional Economics
on Contracts
 A contract
is an agreement, namely the concurrence
of two declarations of the will to exchange (sell,
loan, hire-out) property rights
 “Contracting”
institutions (e.g., legal formalism,
judicial efficiency, bankruptcy law) determine the
terms and ease (transaction costs) of contracting
between persons

An important characteristic of a contract, from the
transaction costs perspective, is its completeness,
informational asymmetry and self-inforcement
capacity
 A complete
contract is a contract that specifies the
consequences of every possible „state of the world“.
 In
most cases, it is impossible or too costly for the
parties to an agreement to make their contract
complete (not all eventualities can be foreseen) .
 Open-ended
or relational contracts , e.g. labour
contracts, franchise contracts, are agreements to
undertake a certain performance over an
indeterminate period.
 Relational
contracts specify only the general terms
and objectives of a relationship and mechanisms for
decision making and dispute resolution.
 The
law provides rules which fill in the gaps in the
actual agreement of the parties.
 These
rules lay down procedures as to how
unforeseen and unstipulated circumstances will be
handled, so that transaction costs are limited

Information asymmetry concerns transactions
where one party has more or better information than
the other.
 This
creates an imbalance of power in transactions
which can sometimes cause the transactions to go
awry.

Examples of situations where the seller usually has
better information than the buyer are numerous:
they include used-car salespeople, real estate agents,
mortgage brokers, life insurance transactions etc.
 Examples
of situations where the buyer usually has
better information than the seller include hiring
personnel, buying health insurance etc.

financial economists apply information asymmetry
in studies of differentially informed financial
market participants (insiders, stock analysts,
investors, etc).

in asymmetric information markets , the average
value of a commoditiy may tend to go down, even
for those of perfectly good quality.

the reason is, that because sellers can defraud the
buyer, many people may be not willing to risk
getting ripped off will avoid certain types of
purchases, or will not spend as much for a given
item.

Institutional economic theory of contracts describes
how business actors develop/use particular
contractual arrangements to deal with information
asymmetries
 Most
commonly, information asymmetries are
studied in the context of principal –agent problems,
adverse selection and moral hazard situations
 Principal-agent
problem or agency dilemma deals
with difficulties that arise under conditions of
principal´s (e.g. owner´s) inability (due to
incomplete and asymmetric information) to observe
the action of a hired agent (e.g. manager).
 Principal-agent
problem or agency dilemma deals
with difficulties that arise under conditions of
principal´s (e.g. owner´s) inability (due to
incomplete and asymmetric information) to observe
the action of a hired agent (e.g. manager).

By law, stockholders or shareholders own the
corporation, but their ownership rights are quite
limited

They can vote to: change the corporate charter,
elect the directors and remove them by majority
vote, and vote on substantial changes, such as
mergers.

By law, shareholders cannot decide on:

day by day business policy,
the dividends they receive,
investments or acquisitions, nor
who will be the manager or
what his/her salary will be.
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
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
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The board of directors has the power to set dividends,
to hire, fire, and set compensation of the senior
executives, to decide to enter new lines of business, to
reject merger offers or approve and submit them to
shareholders, etc.

but, directors must generally rely on the officers of
the firm for information. By controlling information
and by setting the agenda, the senior executives will
generally have effective control.
 The
principal-agent problem is found in most
employer/employee relationships, when the
employer cannot continually observe worker effort,
and owner/manager situations when stockholders
hire top executives of corporations etc.
 Various
contract arrangements may be used to
align the interests of the agent with those of the
principal
 E.g.,
performance-based contracts are employed
to create incentives for the agent to act in the
principal's interest, such as in the case of
managerial compensation.

If the seller („principal“) is not informed about
a certain characteristic of the buyer („agent“),
an adverse selection problem may arise
 An
example of adverse selection is when people
who are high risk (more likely to get sick) are more
likely to buy insurance.
 The
insurance company cannot effectively
discriminate against them, usually due to lack of
information about the particular individual's risk
but also sometimes by force of law or other
constraints
 However,
in certain cases, such as in the job-market,
the agent can „signal“ his type to the principal
which may help to resolve the problem.
 An
effort to find „the signal“ should not, however,
be discriminative.
 Moral
hazard occurs when a party insulated from
risk may behave differently than it would behave if
it were fully exposed to the risk.
 Moral
hazard is a special case of information
asymmetry. The party that is insulated from risk
generally has more information about its actions and
intentions than the party paying for the negative
consequences of the risk.
 Financial
bail-outs of lending institutions by
governments, central banks or other institutions can
encourage risky lending in the future
called „too big to fail“ lending institutions can
make risky loans that will pay if the investment
turns out well but will be bailed out by the taxpayer
if the investment turns out badly.
 So
 Moral
hazard can also occur with borrowers.
 Borrowers
may not act prudently (in the view of the
lender) when they invest or spend funds recklessly.
 For
example, credit card companies often limit the
amount borrowers can spend using their cards,
because without such limits those borrowers may
spend borrowed funds recklessly, leading to default.
 In
insurance markets, moral hazard occurs when
the behavior of the insured party changes in a way
that raises costs for the insurer, since the insured
party no longer bears the full costs of that behavior.

Two types of behavior can change.
 One
type is the risky behavior itself, resulting in
what is called ex ante moral hazard.
 In
this case, insured parties behave in a more risky
manner, resulting in more negative consequences
that the insurer must pay for.
 For
example, after purchasing automobile
insurance, some may tend to be less careful about
locking the automobile or choose to drive more,
thereby increasing the risk of theft or an accident for
the insurer.
 After
purchasing fire insurance, some may tend to
be less careful about preventing fires etc.
 A second
type of behavior that may change is the
reaction to the negative consequences of risk, once
they have occurred and once insurance is provided
to cover their costs.
 This
may be called ex post moral hazard. In this
case, insured parties do not behave in a more risky
manner that results in more negative consequences,
but they do ask an insurer to pay for more of the
negative consequences from risk.
 E.g.,
because individuals no longer bear the cost of
medical services, they have an added incentive to
ask for costly and more elaborate medical service—
which would otherwise not be necessary.
 In
these instances, individuals have an incentive
to over consume, simply because they no longer
bear the full cost of medical services.
 Sometimes
moral hazard is so intensive it makes
insurance policies impossible.
 Coinsurance,
co-payments, and deductibles reduce
the risk of moral hazard by increasing the spending
of consumers, which decreases their incentive to
consume.
 Thus,
the insured have a financial incentive to avoid
making a claim.
 A self-enforcing contract is one in which neither
party ever has an incentive not to fulfil the contract
Contract are „self-enforced“ if the expected value
of the future relationship is so large that neither party
wishes to break it.

The terms of the franchise contract do two things:
 They
explicitly describe the behavior that the
franchisor expects of the franchisee, making the
contract terminable if the franchisor finds that the
franchisee does not behave accordingly

They guarantee that franchisees earn some ongoing
stream of income within the relationship, an income
that they put at risk if they stray from the requested
behaviors

The franchisor’s behavior is controlled by his desire to
maintain reputation, which he would put at risk if he
behaved opportunistically vis-à-vis his franchisees

Higher cost of finding franchisees, once damaged
reputation, and ultimately of operating the chain as a
corporate entity – an option that the franchisor would
have chosen from the outset if it were more efficient
than franchising
Suggestions of essays topics

Examples of situations (specific industries),
where the seller usually has better information
than the buyer, and their solution

Because of information asymmetry, people not
be willing to risk getting ripped off may avoid
certain types of purchases. Is it even possible
for the market to decay to the point of
nonexistence?
Suggestions of essays topics

How can information asymmetry be diminished
thanks to the Internet, which allows to acquire
hitherto unavailable information?

Which jobs tend to be- due to information
asymmetry- overpaid? These jobs are falling to
the cathegory of "credence goods." A credence
good (or service) is an economics term for a
good in which the value is difficult or
impossible for the consumer to determine.