Handbook of New Institutional Economics

New institutional economics (NIE) studies institutions and how institutions interact with organizational arrangements. Institutions are the written and unwritten rules, norms and constraints that humans devise to reduce uncertainty and control their environment. These include (i) written rules and agreements that govern contractual relations and corporate governance, (ii) constitutions, laws and rules that govern politics, government, finance, and society more broadly, and (iii) unwritten codes of conduct, norms of behavior, and beliefs. Organizational arrangements are the different modes of governance that agents implement to support production and exchange. These include (i) markets, firms, and the various combinations of forms that economic actors develop to facilitate transactions and (ii) contractual agreements that provide a framework for organizing activities, as well as (iii) the behavioral traits that underlie the arrangements chosen. In studying institutions and their interaction with specific arrangements, new institutionalists have become increasingly concerned with mental models and other aspects of cognition that determine how humans interpret reality, which in turn shape the institutional environment they build (North 1990, p. 3–6; Williamson 2000).

The discipline of economics is made up of a static body of theory that explores the efficiency of resource allocation at an instant of time and under the restrictive assumptions of frictionless markets. Recent research has explored the nature of the frictions by incorporating institutions, transaction costs, and political economy into economic analysis thereby providing the theory with a bridge to the real world of real economies. But the first constraint of static analysis severely hinders our ability to analyze and improve the performance of economies in a world of continuous change. And, in fact, the employment of static theory as a source of policy recommendation in a setting of dynamic change is a prescription for the policies producing unanticipated and undesirable results. In this essay I intend to provide an approach to the study of the process of economic change. There is still much that we do not understand about the process but this essay provides an analytical framework that does, I believe, highlight the problems that must be confronted in order to understand and improve economic performance. I first describe the intentional nature of human interaction in aworld of pervasive uncertainty (2) before going on to describe the process of economic change (3). I conclude with drawing some implications from this approach to the process of change which highlight the lacunae in our understanding of this process (4).

In my long life I have known some great economists, but I have never counted myself among their number nor walked in their company. I have made no innovations in high theory. My contribution to economics has been to urge the inclusion in our analysis of features of the economic system so obvious that, like the postman in G. K. Chesterton’s Father Brown tale, “The Invisible Man,” they have tended to be overlooked. Nonetheless, once included in the analysis, they will, as I believe, bring about a complete change in the structure of economic theory, at least in what is called price theory or microeconomics. What I have done is to show the importance for the working of the economic system of what may be termed the institutional structure of production. In this lecture I shall explain why, in my view, these features of the economic system were ignored and why their recognition will lead to a change in the way we analyze the working of the economic system and in the way we think about economic policy, changes which are already beginning to occur. I will also speak about the empirical work that needs to be done if this transformation in our approach is to increase our understanding. In speaking about this transformation, I do not wish to suggest that it is the result of my work alone. OliverWilliamson, Harold Demsetz, and Steven Cheung, among others, have made outstanding contributions to the subject, and without their work and that of many others, I doubt whether the significance of my writings would have been recognized. While it has been a great advantage of the creation of the Prize in Economic Sciences in Memory of Alfred Nobel that, by drawing attention to the significance of particular fields of economics, it encourages further research in them, the highlighting of the work of a few scholars, or, in my case, one scholar, tends to obscure the importance of the contributions of other able scholars whose researches have been crucial to the development of the field.

Transaction cost economics is an effort to better understand complex economic organization by selectively joining law, economics, and organization theory. As against neoclassical economics, which is predominantly concerned with price and output, relies extensively on marginal analysis, and describes the firm as a production function (which is a technological construction), transaction cost economics (TCE) is concerned with the allocation of economic activity across alternative modes of organization (markets, firms, bureaus, etc.), employs discrete structural analysis, and describes the firm as a governance structure (which is an organizational construction). Real differences notwithstanding, orthodoxy and TCE are in many ways complements—one being more wellsuited to aggregation in the context of simple market exchange, the other being more well-suited to the microanalytics of complex contracting and nonmarket organization.

I begin by contrasting the lens of contract (out of which TCE works) with the lens of choice (orthodoxy). Vertical integration, which is the paradigm problem for TCE, is then examined. The operationalization of TCE is discussed in Section 3. Variations on a theme are sketched in Section 4. Public policy is discussed in Section 5. Concluding remarks follow.

In the Schumpeterian conception, democracy consists of regular and non-violent competition for control of government between alternative teams of elites (Schumpeter 1942). The question that much scholarship in electoral studies addresses, and on which this essay will focus, is: how does changing the rules of the electoral game change the strategies of parties and candidates, hence the outcome of elections?

The last twenty-five years have witnessed dramatic growth in the number of political regimes that meet basic standards of procedural democracy, such as freedom of association and expression, competitive elections that determine who holds political power, and systematic constraints on the exercise of authority (Robert Dahl 1971; Samuel Huntington 1991). What has been called the “third wave of democracy” is driven by the confluence of various trends—the establishment of democracy in countries with no prior democratic experience, its reestablishment in countries that had experienced periods of authoritarian rule, and the expansion in the number of independent states following the demise of European and Soviet communism. A common consequence of these transitions is to focus attention on the constitutional rules that guide competition for and the exercise of political authority under democracy. One of the fundamental aspects of constitutional design is the choice between parliamentary government, presidential government, or a hybrid format that combines some aspects of these two.

At the center of all democratic governments are legislatures. In all legislatures, members compete for access to a variety of valuable resources, such as floor time and committee or cabinet positions. The internal distribution of these resources fundamentally shapes the legislative process, and by extension, determines which individuals or coalitions can influence legislative outcomes. In this paper, I argue that, within a given legislature, the distribution of legislative influence tends to mirror the external checks and balances in the polity as a whole. In other words, as Lijphart (1984) has argued, just as polities with little separation of purpose (i.e., with limited diversity of interests and factions) tend to have more unitary governmental institutions than do polities with greater separation of purpose (which tend toward institutions that create separation of powers), so too will internal legislative institutions reflect the separations of purpose and power within a polity. This law of organization is referred to as the

mirroring principle

.

The literatures on the performance of federal systems divide around three central questions. The first concerns the economic performance of federalism; the second, the political performance; and the third, the sources of stability for federal arrangements.

Economists typically focus on the first question, with an emphasis on the normative aspects, such as: How ought federalism to be designed? In answering this question, the economic theory of federalism provides a theory about the optimal organization of the state, addressing issues, such as what powers should be assigned to what levels of government; why should not the central government do everything? This literature has strong positive implications, for it also explains the economic implications of alternative divisions of powers among the various levels of government.

The problem of enforcing agreements in exchange is at the heart of economic life and has been a central topic for economic theory in the past several decades. As economists have focused more closely on what goes on inside the ‘black box’ of the firm, especially under conditions of uncertainty and asymmetric information, the role of contractual commitment in economic organization has come to the fore. Much of the theory of incentives that has emerged since the 1970s depends crucially on assumptions about the enforceability of contractual mechanisms designed to align the interests of principal and agent and achieve efficient production and exchange (Laffont and Martimort 2002).

The quotation from Milton Friedman heading this chapter summarizes the evolution of beliefs of many economists (including myself) following the collapse of the Soviet Union and its satellites. Initially, it was widely believed that creation of markets and the freeing of the economy would be enough to lead to economic growth and prosperity. The lesson of this episode in human history is that removal of restraints and creation of property rights is not sufficient. Rather, an economy needs a legal system in order to thrive and grow, and creation of such a legal system is a difficult task. Indeed, it is not obvious that it is always possible to succeed in this process.

The proper functioning of a market economy requires that freedom of contract be protected effectively. This can be achieved in different ways. A major design decision concerns the rulemaking discretion that the legislator delegates to the courts. When taking this decision, the legislator should take into account the specialization advantages and transaction costs that come with more or less specialized rulemaking. Factors influencing this trade-off explain the different solutions adopted in the two main legal traditions of the West. Common law evolved keeping more rulemaking powers in the judiciary, and thus was characterized by unspecialized rulemaking. The civil law tradition, however, was transformed during the 19

th

century, reserving greater rulemaking power for the legislative branch and thus reducing the discretion that judges had enjoyed during the Ancient Regime.

A burgeoning literature finds that financial development exerts a first-order impact on long-run economic growth. Levine and Zervos (1998) showthat banking and stock market development are good predictors of economic growth. At the microeconomic level, Demirguc-Kunt and Maksimovic (1998) and Rajan and Zingales (1998) find that financial institutions are crucial for firm and industrial expansion. While disagreements remain, the bulk of existing evidence points to a strong finance-growth nexus.

Modern economic theory has long neglected, even ignored, the analysis of the different modes of organization that characterize a market economy. Notwithstanding the efforts of Alfred Marshall, one of its founding fathers, in identifying the properties of “business organizations” (1920, Book IV, chap. 10 sq.), standard microeconomics relied for decades on the concept of firms as production functions, an umbrella to the technologically determined combination of inputs.

Understanding the factors that determine which types of transactions are mediated through markets and which within hierarchical organizations called firms has been an important subject of theoretical and empirical work in microeconomics generally and central to work in New Institutional Economics (NIE) in particular for at least the last 25 years. This essay reviews research that examines the choice between governance of vertical relationships involving suppliers of intermediate goods and services (“upstream”) and the purchasers of those goods and services (“downstream”) through some form of market-based contractual arrangement versus governance within an organization through vertical integration. My primary emphasis is on the transaction cost economics (TCE) framework for understanding the choice of governance arrangements, though I will briefly discuss several other theories of vertical integration as well.

There are many settings in which one economic actor (the principal) delegates authority to an agent to act on her behalf. The primary reason for doing so is that the agent has an advantage in terms of expertise or information. This informational advantage, or information asymmetry, poses a problem for the principal—how can the principal be sure that the agent has in fact acted in her best interests? Can a contract be written defining incentives in such a way that the principal can be assured that the agent is taking just the action that she would take, had she the information available to the agent?

I outline here the institutions of decision-making in the large public firm in the wealthy West, emphasizing those that try to thwart decision-making from going awry.

By corporate governance, I mean the relationships at the top of the firm—the board of directors, the senior managers, and the stockholders. By institutions I mean those repeated mechanisms that allocate authority among the three and that affect, modulate and control the decisions made at the top of the firm.

New markets do not emerge, nor do they appear. They are

made

by the activities of firms. New markets are created when firms correctly sense (by accident or by design) a latent need and communicate their solution to that need: markets spring into being when economic actors shift resources to that firm’s solution. The most visible way to create a new market is to offer a product/service that is novel, thereby addressing needs that were not met (and perhaps not even sensed). Much of this chapter focuses on firms’ efforts to develop and commercialize new offerings, and on how buyers respond, thereby creating new markets. However, new markets are also created when firms cultivate an underserved clientele with established products. Much of marketing is about how to bring new customers into a developed industry (as opposed to rearranging market shares among existing customers). This chapter will also highlight these market-creation activities.

The “transaction cost” theory of the firm introduced by Coase (1937) has become a standard framework for the study of institutional arrangements. The Coasian framework helps explain not only the existence of the firm, but also its size and scope. Why, in Coase’s (1937, pp. 393–94) words, “does the entrepreneur not organize one less transaction or one more?” Some firms are highly integrated: IBM, for example, produces many of its components and software and maintains its own sales force for mainframe computers. Others are much more specialized: Dell Computer outsources virtually all its hardware and software components, selling directly to end users through its catalog and website, while the shoe company Reebok owns no manufacturing plants, relying on outside suppliers to make its products. U.S. manufacturing and service companies are increasingly contracting with specialized information technology firms for their computing and data warehousing needs, spending $7.2 billion on outsourced computer operations in 1990. Standard and Poor’s estimates total worldwide outsourcing for 2003 at $170 billion.

It is somewhat surprising that academic economists are interested in agricultural contracts given their otherwise urban affiliations. No doubt this interest arises because farming has historically been the fundamental economic enterprise of mankind. Its omnipresent place in our culture makes it a familiar context to couch otherwise abstract theoretical models. Thus we find casual reference to landowners and tenant farmers in economic theory (e.g., Sappington 1991) and, indeed, the modern theory of contracts developed in this context. There is also a seemingly disproportionate amount of attention paid to agricultural contracts in literatures dealing with economic institutions. Again, this partly stems from agriculture having always been with us. Adam Smith could hardly have written about restaurant franchise contracts, but he, John Stuart Mill, and other classical economists concerned themselves with the contracting and organization of farming.

The primary purpose of contract lawis, mostwould concede, to facilitate private ordering. The parties are the best judges of their interests and the law should, as much as possible, stay out of the way. There are exceptions–there might turn out to be good reasons to discourage, or prohibit, certain classes of promises (for example, disclaimers or promises to commit illegal acts) or to be suspicious of the manner in which agreements have been reached (for example, the battle of the forms or duress). Still, the facilitation of voluntary exchange remains the primary goal of contract law. Voluntary exchange is not a zero-sum game; it allows parties to achieve gains from trade. The parties enter into their agreement because they each expect to be better off. They might, of course, turn out to be wrong. It might have seemed a good idea at the time, but conditions might have changed so that one party now regretted having entered into the agreement. Or, one party might simply have misperceived the possible outcome. Had it known more (or been a more intelligent processor of available information), it would not have entered into the deal. Regardless, the basic presumption that there are gains from trade is the economic foundation for a facilitative law of contract.

Regulation is part of the complex web of a nation’s public policy. To understand regulatory design, then, it is imperative to understand the general determinants of public policy. The purpose of this essay is to highlight the usefulness of a transactional approach to public policy determination in understanding the origins, nature and the evolution of the institutions of regulation. As it merits an essay in a volume on the New Institutional Economics, we approach public policy as a (complex and often intertemporal) transaction among policy makers. As such, the nature and features of public policies are impacted by the type of contracts facilitated by the institutions—i.e., the rules of the political game—of the country in question. Here, then, we analyze the institutional determinants of regulatory policy making by looking at regulation as the outcome of complex intertemporal exchanges among policy makers. As in normal economic transactions, efficient intertemporal exchanges require safeguarding institutions. In their absence, we will observe the development of non-cooperative and shortterm behavior, inflexible rules to avoid political opportunism, and in general low quality regulatory policies.

Open-access, common-pool resources, such as many fisheries, aquifers, oil pools, and the atmosphere, often require some type of regulation of private access and use to avoid wasteful exploitation. In the absence of constraints on users, such as those provided by informal community norms, more formal property rights, or other types of state regulation, individuals competitively exploit the resource rapidly and wastefully. Short-term horizons dominate, with little investment or trade to channel the resource across time or across users to higher-valued applications. This excessive extraction, which amounts to private plunder, continues so long as it is in the interests of the individual parties, even if society would be better off with less intensive and extensive use. Without some limits on individual behavior to better reflect broader, social benefits and costs, only private net benefit calculations govern resource use decisions.

Property rights determine the incentives for resource use. Property rights consist of the set of formal and informal rights to use and transfer resources. Property rights range from open access to a fully specified set of private rights. By open access we mean that anyone can use the asset regardless of how their use affects the use of others. A full set of private rights consists of the following: 1) the right to use the asset in any manner that the user wishes, generally with the

caveat

that such use does not interfere with someone else’s property right; 2) the right to exclude others from the use of the same asset; 3) the right to derive income from the asset; 4) the right to sell the asset; and 5) the right to bequeath the asset to someone of your choice. In between open access and private property rights are a host of commons arrangements. Commons arrangements differ from open access in several respects. Under a commons arrangement only a select group is allowed access to the asset and the use rights of individuals using the asset may be circumscribed. For example, a societal group, e.g., a village, tribe or homeowner’s association, may allow its members to place cattle in a common pasture but limit the number of cattle that any member may put on the commons.

Newregulation can elicit a great variety of responses from individuals, firms, interest groups, and bureaucracies. This chapter examines a range of common legal and illegal behaviors that arise as responses to new regulations. It also compares the approaches that newinstitutional economics and neoclassical economics use to study these responses. The motivation for introducing new regulation is generally to influence behavior: to promote or restrict competition, to redistribute income, to increase or reduce barriers to entry, to increase or reduce spillovers, and so on. However, regulation often influences behavior in ways that differ from the initially stated rationale. This chapter focuses on the consequences of regulation, on this wide range of responses, rather than on the rationale offered for introducing the regulation.

Developed countries are the exception, not the rule. Billions of dollars of aid and countless hours of advice notwithstanding, most countries have not been able to foster sustained growth and social progress. Increasingly research has shown that weak, missing or perverse institutions are the roots of underdevelopment. Other explanations for development, such as investment, technological innovation, or years of schooling are not correlated with higher rates of economic growth (Easterly 2002). Instead, cross-country regressions persistently demonstrate large and statistically significant correlations between institutional variables and growth, and in horse races between variables, an index of institutional quality “trumps” geography or trade as an explanation for growth (Rodrik, et al. 2002).

Economists have long been concerned with the explanation of differences across countries in levels of national income, population, and per capita incomes, as well as in their rates of growth. Because many of the processes of economic development operate over long periods of time, those studying the sources of these differences have quite naturally turned to the historical record for relevant evidence. Their concern with economic history thus comes not only from a desire to achieve a better understanding of the past, but also from a belief that such knowledge can serve as a guide for policymakers striving to improve the economic and social conditions of currently less developed nations. Many scholars have set about making contributions to knowledge through detailed investigations of the processes of growth in individual countries. Others have sought to discern what factors were crucial through comparative studies, focusing on issues such as why nations differed with regard to the timing of the onset of growth or how and why their records of achieved rates of growth varied over a long period of time.

In 1989, the Soviet bloc in Eastern Europe disintegrated. In mid-1991, the old Yugoslavia began its painful, protracted breakup. Later that year, an abortive communist coup led quickly to the FSU (former Soviet Union). Twenty-eight countries were free to choose their own economic and political institutions. Public and elite opinion was set on a large move away from the old socialist system, towards some form of market capitalism. In most countries, there was an accompanying shift toward greater political freedom and democracy. All countries undergoing this transition have now experienced more than eleven years of post-communist change.

Douglass North (1990) describes institutions as the rules of the game that set limits on human behavior, now a universally-accepted definition. North and others especially underline the crucial role of informal social norms. They predict that, like all rules of the game, social norms should affect the economic prosperity enjoyed by individuals and countries—that they should have a crucial impact, for example, on economic and political development. In fact, substantial evidence demonstrates that social norms prescribing cooperative or trustworthy behavior have a significant impact on whether societies can overcome obstacles to contracting and collective action that would otherwise hinder their development. Much of this evidence comes from outside the new institutional economics, emerging instead from scholarly research in the field of “social capital.” A review of this evidence, and its implications for our understanding of the role of social norms and institutions, is therefore the focus of this chapter.

Markets rest upon institutions. The development of market-based exchange relies on the support of two institutional pillars that are, in turn, shaped by the development of markets. Research in the field of new institutional economics has largely focused upon one such institutional pillar—‘contract-enforcement institutions’—that determine the range of transactions in which individuals can commit to keep their contractual obligations. Yet, markets also require institutions that constrain those with coercive power from abusing others’ property rights. These ‘coercion-constraining’ institutions influence whether individuals will bring their goods to the market in the first place.

This chapter’s discussion of market-supporting institutions is geared toward the issues we know the least about. First, the dynamics of market-supporting institutions and the implied dynamics of markets; second, the inter-relationships between the dynamics of market-supporting and political institutions where the latter comprise the rules for collective decision-making, political rights, and the legitimate use of coercive power. It argues, in particular, that neither the assertion that liberal political institutions lead to markets nor that markets lead to liberal governance are supported by theory or history. Markets and political institutions co-evolve through a dynamic inter-play between contract-enforcement and coercion-constraining institutions.

When economic sociology appeared on the academic scene in the mid-1980s its interactions with New Institutional Economics were soon plentiful as well as productive. Especially the ideas of OliverWilliamson and Douglass North were often discussed and found useful. That this was a fruitful interaction is exemplified not least by the fact that Williamson’s notion of “hybrid” was developed in response to comments on his distinction between markets and hierarchies by some sociologists. The concept of “transaction cost” soon became part of the sociological language, and sociologists suddenly seemed more receptive to ideas of economists than they had been for a very long time.

A major problem in understanding institutions relates to the complexity and diversity of contemporary life and the resulting specialization that has occurred within the social sciences. The central aim of the social sciences is to explain human behavior. But what kind of human behavior? Within which kinds of institutional settings?