Institutions The Coase Theorem – The Link to Institutions The Coase Theorem – The Link to Institutions Institutions and Economic Performance Institutions and Economic Performance The Static Case The Static Case The Dynamic Case The Dynamic Case The Polity as Creator of Institutions The Polity as Creator of Institutions

The Coase Theorem – The Link to Institutions Economic Efficiency Economic Efficiency Neoclassical economic theory usually works with following implicit assumption: the process of exchange is costless = transaction costs are zero Neoclassical economic theory usually works with following implicit assumption: the process of exchange is costless = transaction costs are zero In this case the best things are: In this case the best things are: Perfect Competition Perfect Competition Laissez-faire Laissez-faire

The Coase Theorem – The Link to Institutions Transaction Costs Transaction Costs Negotiation Costs Negotiation Costs Measurement Costs Measurement Costs Costs of Enforcing Exchanges Costs of Enforcing Exchanges Decreasing transaction costs increases market efficiency Decreasing transaction costs increases market efficiency

The Coase Theorem – The Link to Institutions Asymmetric Information increases measurement costs Asymmetric Information increases measurement costs Reputation, Repeated Dealings and Competition decrease Costs of Enforcing Exchanges Reputation, Repeated Dealings and Competition decrease Costs of Enforcing Exchanges

The Coase Theorem – The Link to Institutions Coase Theorem Coase Theorem With zero transaction costs, the efficient outcome always prevails regardless of property rights assignments With zero transaction costs, the efficient outcome always prevails regardless of property rights assignments If transaction costs are positive, property rights assignments have a big impact on economic outcomes If transaction costs are positive, property rights assignments have a big impact on economic outcomes

The Coase Theorem – The Link to Institutions Question for discussion: Question for discussion: Suppose someone enters a room full of people and begins to smoke a cigarette, generating a negative externality. Smoking is allowed in this room. What sort of agreement must be reached in order to eliminate the externality? What are the transaction costs that make it difficult to reach such an agreement? Suppose someone enters a room full of people and begins to smoke a cigarette, generating a negative externality. Smoking is allowed in this room. What sort of agreement must be reached in order to eliminate the externality? What are the transaction costs that make it difficult to reach such an agreement?

Institutions and Economic Performance - The Static Case

A nation’s institutional framework, the complex network of rules, customs and enforcement systems, determines transaction costs A nation’s institutional framework, the complex network of rules, customs and enforcement systems, determines transaction costs A well functioning economy requires a well functioning government A well functioning economy requires a well functioning government Formal rules impact on measurement and enforcement costs Formal rules impact on measurement and enforcement costs

Institutions and Economic Performance - The Static Case Informal rules – four fundamental cultural factors Informal rules – four fundamental cultural factors Society’s radius of trust Society’s radius of trust The rigor of the ethical system The rigor of the ethical system The way in which authority is exercised The way in which authority is exercised Society’s attitudes regarding work, innovation, saving and profit Society’s attitudes regarding work, innovation, saving and profit

Institutions and Economic Performance - The Dynamic Case

Three key elements of the development and integration of new technology Three key elements of the development and integration of new technology 1. A nation must foster human creativity Freedom and incentives to think about and experiment with new ideas Freedom and incentives to think about and experiment with new ideas Society must be open to change and willing to deal with the disruptions in the status quo that the new technology brings Society must be open to change and willing to deal with the disruptions in the status quo that the new technology brings

Institutions and Economic Performance - The Dynamic Case 2. A well functioning capital market 3. Competitive environment that forces firms to continually improve their products or risk being forced out of business Joseph Schumpeter in the early 1940s – The process of creative destruction Joseph Schumpeter in the early 1940s – The process of creative destruction A successful economy must be adaptively efficient A successful economy must be adaptively efficient Perfect competition is not necessarily optimal for creative destruction Perfect competition is not necessarily optimal for creative destruction Complementarity of macro and micro inventions Complementarity of macro and micro inventions Institutions themselves cannot be stagnant Institutions themselves cannot be stagnant

Institutions and Economic Performance - The Dynamic Case The persistence of poor economic performance: path-dependency – Why? The persistence of poor economic performance: path-dependency – Why? Informal institutions evolve very slowly over time Informal institutions evolve very slowly over time

Institutions and Economic Performance - The Dynamic Case Questions for discussion: Questions for discussion: Think of some example how an inferior technology has won out over a superior technology. Explain why this has happened. Think of some example how an inferior technology has won out over a superior technology. Explain why this has happened. Can you rank countries according to the level of institutions? Can you rank countries according to the level of institutions?

The Polity as Creator of Institutions Government strong enough to protect property rights and enforce contracts is also strong enough to confiscate the wealth of its citizens Government strong enough to protect property rights and enforce contracts is also strong enough to confiscate the wealth of its citizens Contract Theory x Predatory Theory Contract Theory x Predatory Theory The Role of Time Horizon – A Time Inconsistency (Dynamic Inconsistency) Problem The Role of Time Horizon – A Time Inconsistency (Dynamic Inconsistency) Problem

The Polity as Creator of Institutions