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 outcomesConditions 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 andinsufficiently 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 rulesInformal 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 crisisalso 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=0y98MMmexMo&feature=BFa&list=PL1F187DA52E3ED6CE&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 demandingAlso here: focus on main points and threadYou 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 learning1. 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 form2/3 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!