New Institutional Economics [NIE]
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© Avner Offer, University of Oxford, 2010
• Emergence and change of institutions is the most
important problem for historians:
• e.g. family, schools, law courts, guilds, governments,
firms, armies, science, professions, etc. What are they
for?
• NIE currently provides big payoff to historians:
– Relatively new, so hasn’t been applied a great deal.
Enormous potential.
– Analytically orthodox, assumes rationality, but quite
accessible.
– Compares well with competing methods.
– Problems very salient. Institutions are ubiquitous
and mysterious.
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From harmony to opportunism
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• If markets are best, why aren’t we all traders?
• Markets are unreliable, due to opportunism and
ignorance. We don’t know, and we don’t trust.
• The basic insight: Exchange not costless. Transactions
are difficult. Institutions evolve to reduce their costs.
• Institutions provide a substitute for ‘perfect’ markets.
• Markets are also social institutions, to the extent that
they fall short of ‘perfection’.
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Intuition: railways and farmers
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• Railway emits sparks, which burn the crops.
What to do?
• If crops worthless without the railway, farmers
will pay for spark boxes, or buy out the railway.
• If railway worthless without the crops, owners
will buy out or compensate the farmers.
• That is the market solution.
• But may not happen - why?
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Coase Theorem
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Ronald Coase, `The Problem of Social Cost', Journal of Law
and Economics, vol. 3, 1960.
Coase Theorem: no matter how rights to various resources are
distributed initially, the resources will always end up in their
highest valued use, given zero transaction costs.
Rights will be purchased by those who can use them best.
An ‘invisible hand’ theorem.
But, reality is positive transaction costs:
– Costs of establishing and defending property rights.
– Access to credit
– Costs of trading.
– Arise due to ignorance and opportunism.
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Coase theorem: two takes
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2.
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Property Rights economics: Zero transaction costs. Invisible Hand theorem.
Privatisation more efficient than state control. [Chicago, right-wing]
Transaction cost economics: Positive transaction costs. Can defeat benefits of
privatisation. [Berkeley, vaguely left-wing]
Which version is the authentic one?
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[Property rights defined as long as it is cost-effective to do so - until marginal benefit
equals marginal cost]
Property Rights approach:
The fisheries: A common property resource. Lake Victoria.
» Boundaries too costly to police, so fisheries get depleted
E.g. Nationalisation: who benefits? Workers, managers, consumers, taxpayers,
median voter?
» Incomplete specification encourages opportunism, inefficiency, ‘rent
seeking’.
» Distributional struggle can dissipate rent. Or can redistribute it.
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Transaction costs = ‘contracting’
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• Problems of making effective agreements [contracting]:
– Which product to buy, which workers to hire, how much to pay,
terms of delivery, monitoring effort, ensuring quality. Endless
detail.
– Search, measurement, bargaining, co-ordination, monitoring,
enforcement, compliance.
– Regulated by agreement [contracts]. But all contracts
incomplete: impossible to anticipate every contingency. The
longer the time-scale, the more incomplete the contract.
– E.g. ‘Battle of the forms’ [Macaulay, 1963]:
buyer and seller forms identical on front, but ‘small print’ on the
backs is mutually contradictory.
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Contracting conundrums: asymmetric information
• How does owner of a resource (Principal) control the
user of the resource (Agent)? [what is ownership?]
• E.g. master & servant, employer & worker, client and lawyer,
patient & doctor, student & teacher. [principal-agent theory]
– The problem is asymmetric information: Agent knows
more than Principal.
» Agent's effort not directly observable.
» Outcome influenced by the environment, which is
unobservable by Principal.
» Agent tempted to cheat. [opportunism, ‘strategic
behaviour’]
• Solution: Principal seeks an ‘optimum contract’ [selfenforcing] that minimizes incentive to cheat. E.g. piecework.7
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Agricultural land tenure:
historical sequence of contracts
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• Why has agriculture been run mostly by family farms,
not by landowners or joint-stock companies?
• Agency problem:
Landowner (Principal) has property rights in land, needs
worker (Agent) to apply labour and skills in order to
extract food.
• Land tenure as an institution for solving agency
problem. Historical sequence of solutions
[tenures]= [contracts]
• slavery-> serfdom->common-property>wagelabour>share-cropping-> fixed rent->owner-occupation.
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Why should worker co-operate?
Incentives and risks
• Principal’s problem – how to incentivize worker:
– Plantation: (slavery or wage-labour). Monitor effort.,
Costly monitoring and enforcement. Weak incentive.
– Common Property: mutual monitoring of resource use.
Norms as substitute for boundaries.
– Share-cropping. Only monitor outcome, not effort.
Stronger incentive, risk-sharing, profit-sharing.
– Fixed rent. Owner income fixed, risk on worker.
– Owner-occupation. Agent buys out principal. Solution of
contract problem. ‘Internalising the contract’. No
monitoring or enforcement. Except within the farm.
– Who should be the owner? ‘Residual claimant’ has the
strongest incentive.
• Why do tenures change over time? Align incentive with
factor prices and risk preference.
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What are companies for?
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• Different types of contract:
– In markets, buying and selling (invisible hand)
– Within firms, command and obey (visible hand)
– Coase, `The Nature of the Firm', Economica vol. 4, (1937).
– Make or Buy? The boundaries of the firm:
‘A firm has a role to play if transactions can be organized
within the firm at less cost than if the same transactions were
carried out through the market.’ [Coase, 1937]
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Markets or Hierarchies?
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[Oliver Williamson]
• Markets: interaction between the firms.
– Coordination through prices and contracts.
• Hierarchies: interaction within firms.
– Coordination by command and co-operation.
• Government: the largest ‘firm’ of all.
– Co-ordination by coercion. Enforcement of
contracts.
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Oliver Williamson
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• Markets and Hierarchies (1975); Economic
Institutions of Capitalism (1985). Assumptions:
– Bounded rationality, ie incomplete information.
– Hence, incomplete contracts.
– Norms: Trust nobody. Assume ‘pervasive opportunism
with guile’.
– Monitoring makes trading costly.
– Asset specificity. [lock in]
– Exposes actors to opportunism. [hold-up]
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Asset specificity: giving hostages
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• ‘highly specific assets give rise to a condition of
bilateral dependency’ [Williamson, 1999]
• Asset is specific to the contract. ‘Lock-in’
– Building a house on a long lease.
– Fisher Body vs. General Motors: mutual hold-up.
Increased demand. Contract not self-enforcing.
• Investment incentive vs. holdup potential.
• Solutions:
– ‘most-favoured nation’ contract.
– Second-sourcing: [computer chips]
– Firm Integration. Transfer control to ‘residual
claimant’.
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agency solutions
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• Integration. Command instead of contract. But constrained by
monitoring capacity. Human capital hold-up
– Britain [Family firms: size limited by managerial capacity]
[delegation to workers: ‘flexible production’]
– USA. [Divisional structure] [tight supervision:‘mass production’]
• Monitoring soldiers: private, section, squad, platoon, company,
regiment, brigade, division, corps, army, front, general staff, chief-ofstaff, Prime Minister, Queen, God. Unit small enough to monitor.
• Reciprocity, repetition, regard: building up trust:
‘one doesn’t run to lawyers if he wants to stay in business because
one must behave decently’ [purchasing agent, quote in Macaulay,
1963]; Enforcing contracts regarded as failure.
• ‘Efficiency wages’: wage premium as an effort incentive.
• Governing by consent – cheapest [only?] method.
• Democracy default when agents acquire bargaining power [human
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capital]?
Opportunism: e.g. health insurance
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• Opportunism before contract. Only the sick will take
out insurance [but also ‘cherry picking’: only the
healthy will be allowed to insure] Adverse selection.
• Opportunism after contract: insured will start
smoking after risk is covered. [Or insurer might not
pay] Moral hazard.
• Institutional Solution: e.g. universal compulsory
health insurance. Pools all risks. Solves adverse
selection. Moral hazard remains?
• But: is insurer credible? Will it deliver?
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Our own agency problems
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• Student both principal and agent.
• Student needs to ensure she is taught well.
– But doesn’t want to study! And parents only benefit
indirectly!
• Teacher needs to ensure student learns well
– But doesn’t want to work hard. Wants students to read her
own books.
• Solution: examinations: incentivize both!
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Measurement problem. [quality problem]
Double marking:
Monitors both students and teachers.
But costly!
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Education: why not-for-profit?
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• Agency problems.
– Quality problem. Institutional solutions – inspections,
examinations. Professional ethics: peer approbation
– Consumers myopic, will underinvest in private education.
– Teacher’s problem: Locked into specific skills. Faces
opportunistic employer. Solution: Low pay, with Tenure &
Pension.
– Can be offered credibly by long-lived dedicated institution,
which needs to recruit continuously, and does not have
opportunistic motives.
– But maybe it does: under pressure from buyers (voters) to
reduce costs. Myopic pressure to defect!
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Why academic tenure?
• Problem of NIE explanation: functionalist or historical (i.e.
path dependent? Are outcomes optimal or simply inherited?
Why are British and American academic systems different?
• For tenure: Incentive to acquire specific asset: invest in D.Phil.
• Against tenure: Moral hazard. Neglect teaching, research.
• Solutions to monitoring problem. a functional reconstruction.
• Old British system. Economy of regard. Relational.
Reciprocal.
–Short probation. Low promotion. Tutorials: student-teacher
mutual monitoring, external exams. Research taken on trust.
High table. Common room.
•American system. Promotion expectation. Impersonal.
–Strict probation. Steep promotion. Monitoring of
publications. Student feedback on teaching. Brown bag lunch.
University club closes.
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Why the difference?
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• American higher ed.: Technical competence,
utility for business, research output. Impersonal.
• British higher ed.: Relational competence.
education of clergy, gentlemen, administrators.
• Question: Why is the British system changing?
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Answer:
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•Collapse of the British
Empire?
• i.e. international competition
• Is this a functional or historical
reconstruction?
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Another institution: marriage
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• How do you obtain true love?
• Engagement ring as commitment device.
[‘diamonds are forever’]
• Marriage as authentication device.
• Market competition for partners at outset.
• Followed by lock-in/holdup.
‘a condition of large numbers bidding at the outset
does not necessarily imply that a large numbers
bidding condition will obtain thereafter’
(Williamson)
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Marriage (contd.)
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• Asset specificity: Children lock in wives. Invest more. Moral
hazard from husbands. Defect more easily. They become
more demanding. [a theory of housework?]
• Incentives: family an efficient unit of production:
economizes on monitoring and enforcement, produces
unique goods. But changes in bargaining power over time.
• Maintained by: renegotiation, repetition, trust, reciprocity,
mutual dependence.
• In conditions of abundance, efficiency incentives weaker?
Avoid commitment altogether?
• But under poverty too—poorest marry less and divorce
more. [promises not credible?]
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Meta-histories: Institutional evolution
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• Private enforcement:
– International trade. Maghribi traders (11th C): agency relies on ethnicity, religion,
kinship. Cost of exclusion. [Greif]
– Champagne fairs (11-13thC) bonding, weights and measures, merchant codes, accounting
conventions. Co-ordination. [Milgrom, North, Weingast]
– Early-modern Guilds: guarantees of skill, quality. But monopoly rents. [Epstein; Ogilvie]
– Frontier settlement: Ranchers vs. farmers. Twilight zone of self-enforcement. [Alston,
Libecap; Ellickson]
• State enforcement:
– Law and Economics school: Function of the Common Law is to enforce property rights,
and economic efficiency. [not justice] [historical/normative reconstruction]
– The Glorious Revolution, 1688. Devolution of budget to Parliament secures property
rights, and enables economic growth. (North and Weingast).
- The Stationary Bandit. Dictator has interest in maximising welfare of everyone as
condition of his own survival. So single dictator (e.g. Stalin) more efficient than Junta.
[Mancur Olson] [subjects have bargaining power – as in democracy: hence incentive to
destroy the most powerful – e.g. engineers, generals, party members]
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The ‘transition’ in Russia and China
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• Russia: ‘Nirvana economics’: shock treatment,
introduction of markets, weak state, weak
property rights.
– Result: gangster capitalism.
• China: Strong state, weak property rights.
guanxi as substitute for property rights. Webs of
social obligation, of convention, of trust. ‘good
enough’.
– Result: world-beating economic growth.
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New Institutional recap.
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• Coase theorem:
– Zero transaction costs: Property Rights
» Law and economics. Privatisation.
– Positive transaction costs: NIE
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Markets vs. Hierarchies.
Incomplete contracts.
Asset Specificity [contractual lock-in and hold-up]
Rent-seeking.
• Agency Theory [principal-agent]
– Moral hazard, Adverse Selection, optimal contracts.
• Insights into the Open Fields? [Liberation of serfs,
village community, land reform, collectivisation,
privatisation in Eastern Europe?]
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