Agrarian Institutions Analysis Session 13 Dr. Michael Sykuta University of Missouri-Columbia Department of Agricultural Economics Director, Contracting and Organizations Research Institute 135 Mumford Hall, Columbia, MO USA Phone: , Fax:

Review of Basic Concepts  What is New Institutional Economics?  Simply relaxes certain neoclassical assumptions:  Transaction costs are positive  Information is not perfect  Decision makers are “boundedly rational”  “Institutions Matter”  It is necessary to understand the “rules of the game” by which individuals trade in order to understand how they choose to trade.

Review of Basic Concepts  What are transaction costs?  The costs of engaging in an exchange transaction:  Search costs  Negotiation costs  Contracting costs  Monitoring costs  Enforcement costs  Note, most all have to do with information costs of some sort.

Review of Basic Concepts  What is a transaction?  A (voluntary) reallocation of property rights.  Remember: transactions are not about exchanging goods and services per se, but about exchanging property rights to the valuable attributes embodied in those items.  You need to identify the attributes that are the source of value!

Review of Basic Concepts  What are “property rights”?  The right to:  Use the asset (usus)  Appropriate returns/benefits from the asset (usus fructus)  Change its form, substance, location (abusus)  A single “asset” may have multiple dimensions of property rights  Property rights may be partitioned and exchanged in part, or in whole.

Review of Basic Concepts  Private property rights  Include ability to exclude others from using asset  May be attenuated by institutional constraints  For property rights to have value:  Must be well-defined  Must be enforced

Review of Basic Concepts  Adam Smith: Specialization of labor is an essential element for individual and social wealth creation.  Specialization necessitates exchange.  Exchange requires clearly defined and enforceable property rights.  Exchange also requires sufficiently low costs of exchange (transaction costs).

Review of Basic Concepts  “Law of Demand” tells us: When price of exchange falls, the amount of exchange “consumed” increases.  Therefore, we want to identify ways to reduce transaction costs to increase ability to specialize and to increase welfare.

Review of Basic Concepts  What are Institutions?  The formal and informal rules of behavior that govern interpersonal relationships  “Formal” or explicit institutions are laws, regulations, etc.  “Informal” rules are those social norms, traditions, and cultural rules

Review of Basic Concepts  Institutions  Define property rights  Define rules of exchange  Define incentives and constraints for individual decision makers  Conclusion: Institutions affect transaction costs.

Review of Basic Concepts  Institutional and organizational analysis is necessarily comparative:  We must compare feasible alternatives to determine the optimal solution.  We first assume that observed differences in organization/governance reflect differences in institutional environments.

The Problem of Social Cost Ronald Coase, 1960  Three Primary Contributions  Reconsidering the nature of “externalities”  Stigler’s “Coase Theorem”  Coase’s “Coase Theorem”

The Problem of Social Cost Ronald Coase, 1960  Reconsidering the nature of “externalities”  The concept of reciprocal harm: An externality cannot be created by one party alone…it takes two for a harm to exist.  If it takes two to create a harm, policies that assign liability to only one party may be economically inefficient.

The Problem of Social Cost Ronald Coase, 1960  Four possible solutions to “externality” problems:  Market transactions  Integration (incorporate within the firm)  Government intervention  Do nothing.  Which creates the highest NET benefit?

The Problem of Social Cost Ronald Coase, 1960  Stigler’s “Coase Theorem”  When transaction costs are zero, the initial property right allocation is irrelevant, Or phrased another way  When transaction costs are zero, an efficient allocation will result regardless of the initial allocation.

The Problem of Social Cost Ronald Coase, 1960  Coase’s “Coase Theorem”  Because transaction costs are not zero, the initial allocation of property rights does matter;  Some welfare enhancing transactions may not occur because the cost is too high;  We need to pay attention to property right allocations and to lower transaction costs.