Introductory lecture for course
Institutions, Behaviour and
Welfare
Dr. Maarten Vendrik
20-04-2011
Aim of course
Introduction into New Institutional Economics (NIE)
Rather recent development in microeconomics since 1960s
Nobel prize of 2009 for new-institutional economists: Oliver
Williamson and Elinor Ostrom
Institutions always important subject in economics, but new in
NIE as compared to ‘old’ institutional economics:
emphasis on firm theoretical foundation and analytical models
systematic and structured like neoclassical economics (NCE)
However, less rigorous and formal than NCE and themes
essentially different
Contents
New Institutional Economics as compared to
neoclassical economics
Example: financial crisis
Some basic concepts and relations
Examples of Internet and pirates
Mandatory literature and organization of learning
1. New Institutional Economics
versus neoclassical economics
Central message of New Institutional Economics (NIE):
institutions have an important impact on economic performance
Recognized by classical economists like Adam Smith and even
by founding father of neoclassical economics Marshall
However, standard neoclassical (micro) economics abstracts
from institutions:
Different institutional arrangements merely alternative means to
reach Pareto-efficient outcomes
Conditions for Pareto-efficiency apply equally to capitalististic,
socialistic, or any other kind of economic system
microeconomics institutionally neutral
Simplifications in neoclassical
economics
Simplification clear insight into basic mechanisms and
efficiency of allocation of economic resources
However, (implicit) assumptions of
perfect information and foresight
zero transaction costs
unrealistic ánd consequential
E.g. asymmetric info (intermediate microeconomics course)
complications only second-best allocation possible
Already recognized by “old” institutional economists,
but also against abstract formal reasoning
rather descriptive
Basic themes of NIE
Since 1960s: NIE: emphasis on solid theoretical
foundation and analytical reasoning and modeling
Basic themes of NIE:
Effects and development of institutions (Sessions 2, 8)
Impact of transaction costs (Session 3)
Effects and emergence of property rights (Sessions 4, 5)
Effects and rationales of various forms of contracts
(Sessions 6, 7)
Effects and development of various forms of organization
(Sessions 9-11)
2. Example: financial crisis
Started in market for mortgages for houses in USA
Problems:
Mortgages given to people with too low incomes
Mortgages high relative to value of house
How could this happen?
Booming economy underestimation of risks when economy would fall back
imperfect foresight (theme of NIE)
Borrowers less knowledgeable about risks than lenders asymmetric
information (NIE)
Lenders could sell risks by bundling mortgages with other mortgages in financial
products and selling these products to banks
further bundling and selling to other banks and investors worldwide
real value of products unclear imperfect information (NIE)
Too much risk taking by banks
Booming economy too much confidence in value of financial products and
their reliability
too much trust (NIE) too low transaction costs (NIE)
too smooth transactions (NIE)
Why did banks take so much risks in buying financial products with
unclear value?
Asymmetric performance pay schedules (NIE) for bank employees:
high bonus for good performance, but government support in case of failure (too
big too fail)
Insufficient laws and regulatory rules that constrain too risky lending and
insufficiently enforced by sanctions from courts and supervisors =
formal institutions (NIE)
Deficient ethical norms and professional codes (e.g. honouring and protecting
long-run interests of clients) and insufficiently enforced by sanctions of loss of
reputation or feelings of guilt = informal institutions (NIE)
Chain reactions and lack of trust
In 2008 collapse of mortgage market in USA
fall in value of related financial products
spread to whole banking sector
solvency problems of banks
big banks rescued by governments
huge budget deficits of governments
creditworthiness problems of Iceland, Greece, Ireland, Portugal,
Spain
rescued by other Euro countries because of banks involved ?
General problem: too little trust (among banks, investors,
consumers; NIE) too high transaction costs (NIE)
too sticky transactions (NIE)
See book of Akerlof and Shimer, Animal Spirits, 2009!
3. Institutions: definition
What are institutions?
NIE: institutions = rules of the “game” =
sets of formal and informal rules that govern economic and social
interactions of people in society,
including enforcement arrangements
Formal institutions: e.g., laws, formal organizational rules
Informal institutions: e.g., customs, social norms, habits, informal
organizational rules
Institutions ≠ concrete organizations like firm or university, but
= rules of the game without the players
institutions + people using them = organization
Functions of institutions
Institutions:
steer individual behaviour in a particular direction
provide structure to everyday activity
reduce uncertainty in human relations
simplify decision making
promote cooperation among human agents
Formal and informal institutions both important and reinforce
each other’s effect
Hence, Obama promotes informal norms in addition to formal
regulation!
4. Transaction costs
Costs of running the system (Arrow) like costs of:
search for information
bargaining
making contracts
monitoring and enforcing contracts
Before financial crisis: transaction costs too low
In crisis: transaction costs too high
NCE: no frictions in economic transactions
transaction costs = 0
No institutions needed to reduce transaction costs
No firms of more than one person to economize on market transaction costs
Transaction costs in crisis
Implication: economy before crisis close to neo-classical ideal?
Not really, as market failures like
Asymmetric info in mortgage market
Imperfect info and foresight wrt risks and values of financial products
Moral hazard in banking sector
Welfare losses, especially in the long run in crisis
also counted as transaction costs in NIE!
Market failures before crisis contributed to huge transaction
costs in crisis!
5. Property rights
NCE: it does not matter who owns what.
However, in the real world it does matter a lot!
Example:
Care and effort you spend on your apartment or house
strongly depends on whether you own or rent it!
This has strong effect on value of apartment/ house!
6. Example: effects of Internet
and e-commerce
Themes of transaction costs and property rights
especially salient in modern developments of Internet
and e-commerce
promises huge saving on transaction costs in markets
nearer to NCE ideal of perfect markets?
However, also more time spent on search
net effect decrease or increase in transaction costs?
Free dissemination of info by the Internet
protection and rewarding of intellectual property
rights more difficult higher transaction costs!
7. Contracts
Property rights transferred in contracts
Example: labour contract
right of employer to gain benefits from labour of employee
in exchange for right of employee to receive wage from
employer
Problems in making and enforcing contracts:
conflicting interests
information imperfect and costly and limited capacity to process
information (= bounded rationality)
contracts incomplete and asymmetric information
room for opportunistic behaviour moral hazard and adverse
selection
transaction costs of monitoring and welfare losses (agency
costs)
Contracts, organizations and
development of countries
Problems can be overcome by trust, cooperation and shared social
norms between contract partners (informal institutions)
Contracts form building stones of markets and other forms of
organizations like firms and the state
Contracts shape incentives within such organizations
Organizations form institutional systems.
Ways in which institutional systems are organized crucial
determinants of success or failure in economic development of
countries
explanation why some countries are still underdeveloped
(Session 11)
8. Example: pirate economics
In developed countries most institutions followed by most citizens
Exceptions: gangsters and pirates
However, within these groups strong institutions, informal, but also
formal, e.g.
Maffia (Godfather movies)
Pirates: see chapter for tomorrow
Pirates:
Becoming a pirate rational decision as better treated by captain and more
democracy
Democratic decisions on where to steal treasure and unanimous decisions on
pirate constitutions = contracts
institutions supported by crew self-enforcing less need for sanctions
Institutions of pirates
Bloodshed = transaction costs minimized by threat of no mercy
in case of resistance, symbolized by skull-and-crossbones or red
flag and supported by reputation of strict observance
Quartermaster in charge of distribution of food and loot =
institution to limit power of captain
Cooperation with national governments to attack ships of
enemy countries
Cooperation between pirates, e.g.
In golden age of piracy (1630-1730) fleets of pirate ships
Election of pirate king in international gathering of pirates, following
large pirate constitution (Pirates of the Caribbean movie)
http://www.youtube.com/watch?v=0y98M
MmexMo&feature=BFa&list=PL1F187DA52
E3ED6CE&index=14
9. Mandatory literature I
Problem: no good textbook on NIE on intermediate level
1st year book:
Groenewegen, Spithoven en Van de Berg (2010), Institutional Economics:
An introduction
Too superficial for you
Book on graduate level:
Furubotn & Richter (2005), Institutions and Economic Theory: The
Contributions of the New Institutional Economics, 2nd ed.: too detailed
Mandatory literature not nice textbook with bullet points, lists of key
concepts and summaries at end of chapters, as in previous blocks, but:
Mandatory literature II
Introductory chapter from Groenewegen, Spithoven en Van de
Berg
Sections from Furubotn & Richter
Articles from scientific journals and chapters from other books
Copies of section of F&R and some chapters from copyshop (CS
in blockbook)
Articles and other chapters from Eleum, Course Material,
Learning Resources (LR in blockbook)
Mandatory literature III
Sections from F&R give good overviews of basic concepts and basic
theories
Clearly written, but rather detailed and sophisticated try to distil main
points and thread from them
Most articles easier to read, some of them demanding
Also here: focus on main points and thread
You have to learn this anyhow in your academic study!
If you don’t understand an argument, post question on that on Eleum
6 lectures are meant to
clarify basic concepts and structure of subject area and to explain unclear
relations
indicate what are main concepts, ideas and theories that you should understand
and learn for exam
Organization of learning
1. Short introduction to mandatory literature of each session in blockbook
with some indication of main and difficult points
2. When reading mandatory literature assess yourself what are main points.
3. In tutorial session presentation surveys main points and tutor takes care
that discussion sufficiently covers important and difficult points.
4. Survey lecture indicates main points to understand and learn for exam.
5. Look at old exam (Eleum, Course Material) for kind and level of exam
questions
6. Should give you enough guiding in studying for exam.
Additional material for
presentation
Additional literature for presentation
sometimes indicated in blockbook
in Learning Resources on Eleum
in books on study landscape
However, nicer to find additional
cases/examples from Internet, newspapers,
magazines, previous courses or your own
experience.
Already start to collect this at beginning of
block!
Evaluation
Final mark for course based on three components:
1. Presentation of mandatory material and additional
material and performance as session manager
(25%):
2/3 of grade for content and 1/3 for form
2/3 for mandatory part and 1/3 for additional part
2. Overall participation,incl. posting questions (25%):
+ (good/sufficient), 0 (dubious) or – (insufficient) for
each session
3. Written exam (50%), at least 5
Thank you!
