Developments within economic theory

Public choice, collective choice, political economy Arrow, 1959 – impossibility theorem, no perfect political system Buchanan & Tullock, 1962 – analyzing government processes (social choice, decision-making rules, pressure groups and special interests) Olson, 1965 – logic of collective thinking, no state or big organization can operate based on voluntary contributions or altruistic efforts –Public perspectives on economic policy (no benevolent dictator but real political process)

Industrial organization’s institutional economics Coase, firms, contracts; transaction costs (TC) Williamson, details of TC: incomplete contracts (residual rights), opportunism Grossman and Hart, 1986 – integration vs contract relationships –Vertical integration vs. contractual relationships (role for different types of institutions) –Boundaries of a firm

Theoretical informational economics Akerlof, Asymmetric information distort markets –adverse selection –signaling –moral hazards –as a result generated variety of non-price mechanisms to solve economic problems

Time consistency Kydland-Prescott, 1977 (discretion vs. rules in macroeconomic policy) Calvo, 1978 Promises are not always self-implementing –need for state to enforce private promises –problem of getting the state itself to enforce its promises (North called it the central problem of development) –Trade-off between strong and weak states

Coase and property rights Coase, 1960 – Coase theorem: if transaction costs are zero, assignments of property rights are inconsequential for economic efficiency If TCs are big, property rights are important for economic efficiency

Complexity theory (80’s), nonlinear systems Arthur, 1989 Technology, increasing returns systems, and path dependence David, 1985 QWERTY typewriting system –introducing a new technical standard > the more people use it, the more beneficial for an individual to use it (increasing returns) > once you use it, you do not want t change your habit (lock-in) –it illustrates the importance of path dependence (D. North) > sometimes to explain some economic facts or structure of political and economic institutions you need to study history.

Empirical observations of economics Differences in per capita incomes far larger than can be explained by differences in resource endowments (Hall and Jones 1999) Economic historians stress that “rise of the western world” was due to specific features of historical processes in England and Western Europe in 17th century. i.e. “Glorious revolution” and the rise of England (North and Weingast, 1989; Weingast, 1997) Development processes –failure of African development –Latin American experience Transition experience –larger initial declines in incomes –very slow recovery in former Soviet Union (lack of institutions, different culture and institutions)

New institutional economics Oliver Williamson – role of organizational hierarchies in reducing transaction costs Douglas North (Nobel Prize in 1993) North (1990): –complexity of institutional structures –institutional change is incremental and path- dependent –details of design are very important –difficulties of institutional constructions – path dependence, conflict of formal and informal rules

North (1990): “Institutions are humanly devised constraints that structure political, economic, and social interaction. They consist of both informal constraints (sanctions, taboos, customs, traditions, and codes of conduct) and formal rules (constitutions, laws, property rights)”

Need for institutions Cooperation of economic agents is possible when interactions are repeated, information is complete, and number of players is small. However, individual transactions usually occur as a one shot game, information is lacking, and there is large number of players Institutions that permit low cost transacting and producing in a world of specialization and division of labor require solving the problems of human cooperation

Gains from trade Gradual evolution from local autarky to specialization and division of labor Small-scale village trade: –dense social network of informal constraints Long distance trade: –classical problem of agency –contract negotiation and enforcement in alien parts of the world Urbanization of the society: –effective, impersonal contract enforcement –capital markets entails security of property rights. Establishing a credible commitment requires either of two: strong ruler who will exercise power at his discretion weak ruler who has no power to seize property of entrepreneur Modern time: –international specialization and division of labor –need for international institutions and organizations to safeguard property rights across national boundaries

When institutions do not evolve Economic actors have an incentive to invest time and resources in knowledge and skills under any institutional arrangement At the same time, not all institutional arrangements will evolve towards more productive economies Examples of primitive types of exchange: –tribal society –regional economy with bazaar trading: (1) high measurement costs, (2) continuous effort in clientilization, and (3) intensive bargaining at every margin –long-distance caravan trade

Success story: Early Modern Europe, 11 th -16 th centuries Innovations that lowered transaction costs: –increase in capital mobility –lowered information costs –spread the risks

Conclusions Institutions are needed to facilitate transactions Development of institutions is incremental and path dependent Institutions are not necessarily efficient, can be formal and informal Some societies are locked-in with bad institutional structure and do not evolve