1. Edinburgh, 17th May 2008The Emergence of Institutions1 1 Santiago Sánchez-Pagés (University of Edinburgh) Stéphane Straub (University of Edinburgh)

2. Edinburgh, 17th May 2008The Emergence of Institutions2 Introduction Coordination failures (opportunism, distrust, misunderstandings) plague even the most basic economic interactions. In this paper we investigate the emergence of institutions that act as Coordination devices. We define an institution as a body with the power to enhance the efficiency of economic interactions.

3. Edinburgh, 17th May 2008 The Emergence of Institutions3 Examples -Developing economies at early stages. Witnesses in commercial exchange (Attali, 2003), Informal contract enforcement (Fafchamps, 2004). -Economies in transition to industrial stage. Japan after WWII, East Asian countries (Aoki et al., 1997), Transition countries (Johnson et al., 2002). -Specific markets US Cotton market (Bernstein, 2001) Diamond market (Bernstein, 1992).

4. The Emergence of Institutions4 Institutions and coordination failures Two lines of enquiry: 1.Analysis of specific institutions. -Coalitions of Genoese traders (Greif, 1997). -Merchant courts in fairs (Milgrom et al, 1990). 2.Coexistence of formal and informal institutions. -Reciprocity vs. Markets (Kranton, 1996; Dixit, 2004). -Tribes vs. National states (Ensminger, 1992). Edinburgh, 17th May 2008

5. The Emergence of Institutions5 5 Our contribution Little has been said on the emergence of institutions. We model the process through which they may arise. The emergence of the institution is the equilibrium of a game that agents play in the state of nature. That is, its emergence is self-enforcing.

6. Edinburgh, 17th May 2008The Emergence of Institutions6 6 Our contribution We characterize:  The factors that make possible or hinder the formation of institutions.  The level of efficiency at which they arise. We do not to model explicitly its internal functioning. Still, it is easy to think of enforcement mechanisms, for instance when applying our model to the emergence of the State. (more on this later)

7. Edinburgh, 17th May 2008The Emergence of Institutions7 The Model N+1 identical agents with initial endowment ω. Agents are randomly matched and play a prisoner’s dilemma game. Payoff are returns per unit of endowment invested.

8. Edinburgh, 17th May 2008The Emergence of Institutions8 The Model - We assume z > x > 0. - Two strategies: C cooperative, NC not cooperative. - (NC, NC) is the unique Nash eq. and is Pareto- inferior. Player C j NC C x,x -z, z Player i NCz, -z0,0

9. Edinburgh, 17th May 2008The Emergence of Institutions9 The Model In the state of nature, agents play the previous game without interference. Expected payoff is then αx. The parameter α denotes the status-quo level of coordination or trust. The institution is able to ensure that the (C,C) profile is played. But someone has to run it…

10. Edinburgh, 17th May 2008The Emergence of Institutions10 The Model One of the agents becomes the centre. She must relinquish the ability to trade. But is compensated in exchange. Agents must pay a fee a ≤ ω to interact under the centre’s umbrella. Trade certification, dispute prevention / resolution, reputation management…

11. Edinburgh, 17th May 2008The Emergence of Institutions11 Timing t=1 Participation decision. If none participates, the status-quo remains. t=2 The formality fee a is chosen. t=4 Agents are randomly matched and play game. t=3 Formality decisions

12. Edinburgh, 17th May 2008The Emergence of Institutions12 Formality decisions Having observed a, agents must decide whether to become formal or not. If they become formal, interacting with another formal agents yields per unit return where x a > 0, x aa 1/α. The efficiency of interactions depends on the fee paid to the institution.

13. Edinburgh, 17th May 2008The Emergence of Institutions13 Formality decisions Interacting with an informal agent yields regardless of your status. Expected payoffs when K ≥ 2 formal agents:

14. Edinburgh, 17th May 2008The Emergence of Institutions14 Formality decisions Proposition 1: For a given level of the fee a (i) Informality can be supported in equilibrium for all a ≥ 0 (ii) Full formality can be supported in equilibrium only if a ≤ a(N)

15. Edinburgh, 17th May 2008The Emergence of Institutions15 The procedure of institution formation Our procedure of institution formation starts with a lottery over the set of agents who freely participate in it. It determines who will become the central agent. Reasonable with identical agents.

16. Edinburgh, 17th May 2008The Emergence of Institutions16 The fully decentralized procedure In this procedure, the institution must emerge in the most decentralized way possible. First, the fee is freely chosen by the central agent: The institution is a revenue- maximizer. So it will “tend” to set the maximum fee compatible with formality, a(N).

17. Edinburgh, 17th May 2008The Emergence of Institutions17 The fully decentralized procedure Second, the agent that runs the institution can renege ex-post. For the institution to arise then

18. Edinburgh, 17th May 2008The Emergence of Institutions18 The fully decentralized procedure Ex-ante participation constraint given the fee a because either all agents or none participate in the lottery. With a(N), the institution arises iff the (stronger) ex-ante constraint is met. It rewrites:

19. Edinburgh, 17th May 2008The Emergence of Institutions19 The fully decentralized procedure Proposition 2: If the ex-ante constraint holds, there exists a SPE of the fully decentralized procedure that implements formality under a(N).

20. Edinburgh, 17th May 2008The Emergence of Institutions20 Two sources of inefficiency Corollary 1: There exists a range of parameters for which a potentially welfare enhancing institution does not arise. This is more likely for economies of intermediate size and relatively high levels of status-quo trust. High trust undermines the position of the institution.

21. Edinburgh, 17th May 2008The Emergence of Institutions21 Two sources of inefficiency Corollary 2: The utilitarian first best fee can be implemented in a SPE of the fully decentralized procedure only for high enough or low enough levels of status-quo trust α. When status-quo trust is high, revenue and welfare maximisation are aligned. Otherwise, the institution arises at a sub- optimal level. The rent associated with being the centre is quite high.

22. Edinburgh, 17th May 2008The Emergence of Institutions22 Other procedures One can consider alternative procedures by relaxing these requirements. Imposing individual commitment alone has no effect. Collective commitment alleviates the second type of inefficiency. First best is achieved only when commitment is imposed in both dimensions.

23. Edinburgh, 17th May 2008The Emergence of Institutions23The Emergence of Institutions23 The emergence of the State These procedures can be applied to the classic concept of the State as an entity aimed at solving coordination problems. Our model predicts when such state will emerge and its level of efficiency of its operations. And endogenizes the rise of a ruler from a population of identical individuals.

24. Edinburgh, 17th May 2008The Emergence of Institutions24The Emergence of Institutions24 The emergence of the State A là Hobbes: via a Leviathan, a canonical State with the monopoly of violence who ensures coordination through coercion. In this context, the ruler/state could enforce cooperation in two ways:

25. Edinburgh, 17th May 2008The Emergence of Institutions25The Emergence of Institutions25 The emergence of the State A là Hume: via a political entrepreneur, able to persuade others to take a particular action or change their beliefs about its consequences.

26. Edinburgh, 17th May 2008The Emergence of Institutions26 Ideally, commitment should not rely on some exogenous enforcement mechanism. We consider two ways to endogenize commitment: 1.Threshold strategies. 2.Threat of secession. Endogenous commitment

27. Edinburgh, 17th May 2008The Emergence of Institutions27 Secession The threat of secession can alleviate the second type of inefficiency. We assume that when withdrawing, groups employ the same procedure of institution formation as the whole society. Secession can be avoided if N is low enough. And if in addition the level of status-quo trust is low enough, the threat of secession enhances welfare.

28. Edinburgh, 17th May 2008The Emergence of Institutions28The Emergence of Institutions28 The alternative to institutions Implicit mechanisms in repeated games: Folk Theorem applies. Can this type of results be obtained in games with random matching and when players have limited information about others’ (past) behaviour? Yes, under certain assumptions. Information is crucial.

29. Edinburgh, 17th May 2008The Emergence of Institutions29The Emergence of Institutions29 Relation-based vs. rule-based enforcement Relation-based: Exchange between pairs of members of one homogeneous group ; enforcement is multilateral (norms, communication). Rule-based: Groups exist, but trade may be between strangers; enforcement is bilateral. We have focused on the rule-based case (relevant in larger groups) and tried to explain why/how some agents specialize in being institution /judge, etc.

30. Edinburgh, 17th May 2008The Emergence of Institutions30 Conclusions We have presented a model where an institution emerges as the equilibrium of a game played in the state of nature. The institution may not emerge despite being welfare enhancing This happens for intermediate population sizes and high levels of status quo trust. But even if it emerges it can do it at a suboptimal level.

31. Edinburgh, 17th May 2008The Emergence of Institutions31 Conclusions Only full commitment at the individual and social level can avoid this. Secession has two effects: 1.To efficiently tame the central agent. 2.Inefficient proliferation of institutions. In future research we intend to explore the effect of endowment heterogeneity.