Introductory Lecture on New Institutional Economics MV 2011

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Introductory lecture for course Institutions, Behaviour and WelfareDr. 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


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 nd 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 (NIE) asymmetric information

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


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


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) 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, Spithove