Introduction to the New
Institutional Economics
Christopher D. Gerrard
National TOT Workshop
Harare, Zimbabwe
October 28 to November 1, 1996
Objectives of the Presentation

To provide an introduction to and an
overview of the “new institutional
economics”
 To explain why the new institutional
economics can help policy makers,
managers, analysts, and consultants address
agricultural policy and institutional reform
issues
Background Readings
Christopher Clague, “The New Institutional Economics
and Economic Development” (forthcoming)
 Thrainn Eggertsson, “The Economics of Institutions in
Transition Economies” in Salvatore Schiavo-Campo
(ed.), Institutional Change and the Public Sector in
Transitional Economies (World Bank Discussion Paper
#241, 1994).
 Mustapha K. Nabli and Jeffrey B. Nugent, “The New
Institutional Economics and Its Applicability to
Development”, World Development, 1989.
 Hans P. Binswanger, Klaus Deininger, and Gershon
Feder, “Power, Distortions, Revolt, and Reform in
Agricultural Land Relations” (forthcoming)

The New Institutional Economics
is
“Economics”
 “Institutional”
 “New”

The NIE is “Economics”

Assume that individuals, households, and
collectivities (such as firms and other organizations) make rational choices subject to scarcity
 Formulate models (such as perfect competition) to
analyze real-world situations (such as agricultural
markets)
 Predict outcomes and evaluate these outcomes by
means of some normative criteria such as Paretoefficiency and equity
The NIE is “Institutional”



Standard neoclassical economics emphasize three basic
constraints:
– Consumer preferences
– Initial resource endowments of land, labor, and capital
– Technology
The NIE builds upon and broadens this approach to include
various kinds of institutional constraints in the analysis
In order to explain observable phenomena that the standard
framework cannot explain, except by assuming individuals are
acting irrationally
The NIE is “New”
To distinguish it from the “old” institutional
economists such as Thorsten Veblen, John R.
Commons, Wesley Mitchell, and Clarence Ayres
 The old institutional economics was economics
with institutions but without theory; standard
neoclassical economics is economic with theory
without institutions; and the NIE is attempting to
provide economics with both theory and
institutions

Summary
The new institutional economics, or NIE, is a
branch of economics that specifically incorporates
various institutional constraints into formal
economic analysis in order to explain, on the basis
of rational choice, observable real-world
phenomena that standard neoclassical economics
(absent institutional constraints) is unable to
explain, except by assuming irrational behavior on
the part of individual economic agents.
E.g. Land Relations -- Levels of Analysis
Exogenous Variables
Endogenous Variables
Level A: Neoclassical Counterfactual







Consumer preferences
Resource endowments
Technology
No transactions costs
Symmetrically distributed
information
Voluntary transactions on a
level playing field
Risk and uncertainty

With these assumptions alone, it is
impossible to explain, on the basis
of rational choice, virtually any of
the interesting or peculiar things
about land relations and land
markets in the agricultural sector.
Level B: Marxist Economics

Imperfect or entirely absent
capital markets

Differentiation of individuals into
different economic classes
Land Relations (cont.)
Exogenous Variables
Endogenous Variables
Level C

Transactions costs
 Asymmetric information, adverse
selection, and moral hazard
 Agency theory





Credit-rationing
Sharecropping and inter-linked credit
General superiority of family farms
Widespread use of tenancy by largescale land-holders
Incentive problems in collective farms
Level D




Covariate risks
Immobility of land
Population density
Processing characteristics of
specific agricultural commodities





Failure of intertemporal markets for crop
insurance and credit
Accumulation of large land holdings
Failure of lands sales markets to improve
efficiency
Intertemporal variations in property rights
Survival of plantation crops based on wage
labor
Land Relations (cont.)
Exogenous Variables
Endogenous Variables
Level E

Collective action
 Involuntary contracts
 Coercive power of the state
 Preferential playing-fields





Coalition building
Rent-seeking
Distortion s in commodity and factor markets
Bondage, slavery, tribute, and corvee systems
Emergence and persistence of dualistic farms
size structures
Level F

Whatever changes the set of
instruments for rent-seeking or
surplus extraction





The grand themes of historians, classical
economists, and Marxist historical analysis
Establishment and breakdown of political
coalitions
Demise of feudalism
Abolition of slavery
Land reform
What are “Institutions”
Institutions are “socially devised rules that are
recognized and frequently followed by members
of a community, and which impose constraints on
the actions of individual members of the
community”.
 While institutions may be liberating -- in the sense
that the community may be better off than in the
absence of rules -- the rules still impose
constraints at the individual level

Macro-level
institutions
Affect
incentives throughout
the economy
 Examples

–
–
–
–
–
–
–
–
Constitution of the country
Rule of law
Legislative law, common law, and customary law
Criminal law and civil law
Well-defined property rights: Group and individual
Contract law: Enforceable contracts
Justice and police systems
Corporation law: Governing the formation of for-profit and nonprofit corporations, associations, societies, and co-operatives.
– Competition law (monopolies commission)
– Labor law.

Micro-level institutions
Affect incentives in individual situations in a part
of the economy
 Examples:
– Formal organizations (such as corporations, labor
unions, trade association, and interest groups) and the
rules by which such organizations operate
– Markets of all kinds, and the rules by which these
markets operate
– Contracts, both explicit and implicit, such as
employment contracts, tenancy contracts, loan contracts,
insurance contracts, and agency contracts
Characteristics of institutions

Predictable, essentially stable, and applicable in
repeated situations
 Either formally written down and enforced
(among others) by government officials, or
unwritten and informally sanctioned
 With some degree -- but not necessarily an
absolute degree -- of rule obedience
Origins and Strands

The NIE is the culminating intersection of a
number of different lines of investigation,
disparate in origin, and differing in form.
 Nonetheless, there are five major strands:
– Transactions costs, markets, and hierarchies
– Economics of costly and asymmetric information
– Economics of property rights
– Collective action
– The emergence of cooperation and norms
Transactions costs,
markets, and hierarchies



Ronald Coase I: Why do certain economic transactions
take place internally within firms, while others take place
externally in markets?
Oliver Williamson: Firms are transactions-costs
minimizing arrangements, which evolve over time with
changes in the nature and sources of transactions costs as
well as with changes in the means for minimizing such
transactions costs.
In particular, “bounded rationality” and “opportunistic
behavior” lead firms to internalize certain economic
transactions.
Economics of costly and
asymmetric information



This literature started with two problems in the insurance
industry -- adverse selection and moral hazard.
Now applied to a large class of problems where there
exists asymmetric information between the two (or more)
parties to a contract.
Encompasses principal-agent models, sharecropping,
optimal contracts, incentive-compatibility, the economics
of screening, and the economics of lemons.


Economics
of property rights
This literature views property rights as institutional mechanisms for
internalizing externalities.
Douglass North:
– As economies become more complex, it becomes more and more
important to define and enforce property rights in order to reduce
transactions costs.
– Since collective action to define and enforce property rights is a very
costly process, there exists a vital role of the state in the process of
defining and enforcing property rights.

Ronald Coase II: If there are no transactions costs and no asymmetric
information, bargaining and negotiation will lead to efficient outcomes,
independent of the initial assignment of property rights.
– Economics with transactions costs would be like the physical world
without friction.
– The initial assignment of property rights affects only the distribution of
income.

Collective
action
Concerned with the conditions under which groups of people with a
common interest perceive and act to achieve that common interest
– How groups overcome non-excludabilty and the free-rider problem
– The free-rider problem occurs when self-interested individuals choose not
to participate in the provision of collective goods or to reveal false
preferences about the value of the collective goods to them


Concerned not only to physical collective goods but also abstract
collective goods -- such as public policies
For successful collective action, it helps to have:
–
–
–
–
–
–
Relatively small, homogenous groups with common objectives
Political entrepreneurs
Selective incentives
Leadership, organizational, and communication skills
Appropriate balance between voice and exit
Tolerance on the part of other groups
The emergence of cooperation
and norms



Concerned with how cooperation and norms emerge in order to
overcome collective action problems: It helps to have institutional
arrangements that will induce cooperative behavior in situations of
potential conflict.
While similar to the collective action literature, this literature is more
experimental and prescriptive: How to design or to craft institutions
that will induce cooperative behavior.
Has been applied to the provision of common pool goods such as
forests, fisheries, grazing lands, and water:
– Because of collective action problem and information costs, neither the
market nor hierarchy are efficient or effective allocation mechanisms for
common pool goods.
– While cooperation and persuasion are the best ways of managing common
pool goods, it helps to have social customs and conventions that work to
induce cooperative solutions.
Why the New Institutional
Economics?

African countries are facing a crisis of sustainability.
– Macroeconomic sustainability
– Fiscal sustainability
– Institutional sustainability
– Ecological sustainability


While much macroeconomic adjustment has taken place, which has
reduced the level of indirect taxation on the agricultural sector, the
agricultural supply response has been disappointing.
New public policies alone have not been sufficient:
– Liberalization and privatization
– Decentralization and participation

To be effective, these policies require new legal and institutional
frameworks to support them -- that is, a “second generation” of
adjustment issues.
E.g. Agricultural marketing

Price determination vs. price discovery
– Price determination refers to the way in which the economic forces of
supply and demand influence prices under various market structures
– Price discovery refers to the process by which buyers and sellers arrive at
specific prices and other terms of exchange

While economists typically discuss price determination
without reference to institutions, it is not possible to
discuss price discovery without reference to institutions:
– Price discovery occurs in an institutional context.
– Price discovery is a costly process,
– Which is often characterized by asymmetric information,
– And by collective action problems.
– Price discovery involves three dimensions: Time, place, and form.
Examples
Characteristics
Price discovery institutions in agriculture
Individual
Negotiations
Group
Bargaining
Decentralized
negotiations
between
buyers and
sellers
Groups,
associations,
or cooperatives that
negotiate
on behalf of
farmers,
processors, or
wholesalers
Individual
maize
marketing
in Kenya
Kenyan
sugar
Most food
items in
most
countries
Kenya
Cooperative
Creameries
Contract
barley and
tobacco
Spot
Auctions
Commodity
Futures
Formula
Pricing
Competitive
bidding in
centralized
markets
based on
physical
inspection
of commodities
Organized
exchanges for
storable
commodities
based on
standardized
contracts with
respect to
grade, time,
and location
Prices based
on benchmark
prices either
in central
markets, or
according to,
say, butterfat
or protein
content
Prices
established
and
controlled
by governments,
usually for
political
reasons
Coffee and
tea auctions
in Kenya
Grain
marketing
in South
Africa
Fertilizer
pricing in
Kenya before
1991
Maize
marketing
in Kenya
before December 1993
Pugu
livestock
market in
Dar es Salaam
Milk pricing
in the U.K.
and the
Netherlands
Administered
Prices
European
Common
Agricultural
Policy
Policy and Institutional Reform


Requires a vision: A picture of where you want to be
Requires special efforts in a whole range of areas:
– E.g. The lifting of price controls and the liberalization of trade
does not automatically bring forth the required economic and
social institutions.
– The demand for efficient institutions does not necessarily create its
own supply on a timely basis.

Requires a theory of policy and institutional reform:
– Policy makers, managers, and analysts could use some theoretical
guidance.
What is the vision?






Rural growth is widely shared, with private and competitive
agriculture and agribusiness as the main engines of growth
Family farms and nonfarm enterprises provide ample remunerative
employment opportunities to men and women
Rural people manage the soils, water, forests, grasslands, and fisheries
in a sustainable manner
Rural people are linked to well-functioning markets for products,
inputs, and finance
Rural people have access to medical care, clean water and sanitation,
educational opportunities, and sufficient nutritious foods
Essential legal frameworks, public investments, productive and social
services are provided and financed in a pluralistic, decentralized, and
participatory manner
Family farms
provide
income, ample
employment
Rural growth is
widely-shared
Decision-making
is decentralized,
participatory
The Vision?
No urban bias
in health
education,
safe water
Markets
Resources are
managed
sustainably
function well
Where are special efforts required?
I

Rural strategy and policy formulation
– Macroeconomic and sector-wide pricing policies
– Food security and nutrition policy
– Markets and agribusiness
– Land policy and land reform

Local and community development
– Rural finance
– Rural infrastructure

Intensification of agricultural systems
– Agricultural research
– Extension and rural information systems
Where are special efforts required?
II

Management of natural resources and forestry
– Managing soil productivity
– Mainstreaming biodiversity
– Environmentally sound pest management
– Livestock, rangelands, and pasture management
– Fisheries and aquaculture
– Forestry and agroforestry

Water allocation, irrigation, and drainage
What theoretical guidance is
available?

Small, open economy macroeconomics
 Market and price analysis
 The new institutional economics
 Environmental and natural resource
economics
Commodity B
Frontiers of the Economic
System
Production frontier: Maximim output with
no transactions.
Transactions frontier: Maximum output,
subject to transactions costs. State has
provided an ideal institutional framework.
Firms use incentive contracts, monitoring
and other methods to minimizecosts.
Social frontier: Maximum output,
subject to transactions cost and
collective action problems.
Commodity A