Institutional and Behavioural Economics MSC Course Lecture Notes

CAEC 510 Institutional and
B h i
Behavioural
l Economics
E i
Prepared By
Fekadu Beyene (PhD)
Lectures, Collaborative M.Sc. Course in

A i lt l andd Applied
Agricultural A li d Economics
E i
1
Course Objectives
 The objectives of the course are to:
1. Familiarise students with agricultural and rural development challenges

in Africa;;
2. Ensure that students understand the various elements of the NIE

paradigm and theoretical framework as well as the application of the
theory to solve the problems constraining agricultural development in
Africa; and
3. Ensure that the students will at the end of the course be able to analyse the
constraints on agricultural and rural development through the application of
the NIE philosophy and thereby identifying the options/interventions for
accelerating the process of agricultural and rural development.
2
Expected learning outcomes
Students can analyze a specific problem using the New Institutional
Economics (NIE) framework
p
Students can explain the challenges
g to agricultural
g and rural development
p
policies in Africa through applying appropriate theories and principles of
the NIE
Students capacity to analyze and synthesize (using specific case of own

choice) would be reflected in the term paper to be written.
3
Ch t 1
Chapter 1: The
Th AAgricultural
i lt l D Development
l t
Challenge: stylised features
 Objective: By the end of this chapter, students will be

Objective:
able to explain the problems and challenges facing
agricultural development in Africa.
4
1.1 Basic challenges to the agricultural sector
One of the most underlying challenge in African agricultural sector is

achieving Sustainability.
Agriculture has to fulfill the following requirements to be sustainable:

 A) Economic sustainability - deliver real economic benefits to the rural sector
 B) Social sustainability - improve the economic well-

well-being of lower income
groups and other disadvantaged groups,
groups including women
 C) Fiscal sustainability – possibility to observe cost recovery
 D) Institutional sustainability - robust and capable institutions that can

eventually stand on their own (financial and other service institutions)
 E) Environmental sustainability – reduce to manageable levels agricultural 5
pollution of water sources and degradation of soils

1.2 Critical Challenges
 Knowing challenges enables one to think over how the Institutional Economics
helps us understand them better and search for alternatives (Dorward
(Dorward et al, 2009).

 A) Institutional
Absence of markets due to low purchasing power in the domestic market;
Weak and difficult contract enforcement resulting in high transaction costs;
Individual small
small--scale input purchases
Land tenure arrangements undermining possibility to borrow
Discrimination against women (access to land and financial services)
Failure of credit and insurance markets
6
11.2
2 Critical Challenges
Challenges…
 B)) Technical
H
Human hhealth
l h iin the
h event off weakk healthcare
h lh systems
Discontinuous switch between technologies and crops
Using significant shares of outputs for subsistence
Relative water scarcity and environmental degradation
Poor animal health service systems
7
11.2
2 Critical Challenges
Challenges…
 C) Political
Historical legacies (colonial exploitation, manipulation by the superpower)
Fragile and weak states, induced by development aid from developed

countries
Competition with food aid that crowds out farmers out of the market
Product safety standards set by WTO member countries to exploit

international market (Is this an opportunity or a threat?)
 8
1.2 Critical Challenges…
Figure: Index of cereal yields and total rural population, 30 sub-Saharan African countries 9
(Bromley, 2008:542)
1.2 Critical Challenges…
Figure: Indices of agricultural performance (Bromley, 2008:545) 10

1.3 Agricultural Development Policies
and Perspectives in Africa
 Agriculture generally seen as a basis of economic growth through
supporting the industrial sector, how
how??
 Initially, the private sector is believed to have no capacity and hence state
investment in agricultural development (state
(state--led)
led)
 Later, state role in providing public goods considered essential to

encourage private sector investment in agriculture (market
(market--led)
led) with
structural
t t l adjustment
dj t t prescription
i ti off liberalization
lib li ti andd privatization
i ti ti (mixed
( i d
outcomes; conditions for intensification (input,
(input, output and financial
markets)) not well developed)
markets
 Failure of both market and state-

state-led approaches to agricultural development
in Africa poses an important question and increases the concern to
understand
nderstand and examine
e amine the role of institutions
i tit ti (Instit tional Economics
(Institutional
tool) 11
1.3 Agricultural Development Policies and Perspectives in
Africa…
Vi
Views in
i explaining
l i i liberalization
lib li ti policy
li failure
f il
No Views Explanations
1 Partial implementation Failure to fully liberalize agricultural sector
2 Weak institutions Weak institutional support for market and private
sector development
3 Coordination failure Limited success in stimulating broad-based growth
4 State failure Weak institutions to facilitate exchange and protect
property rights (undermining investment)
5 High service delivery Limited access to inputs, finance and product
costs markets
6 Trade liberalization International constraints limiting returns to
investment (international trade liberalization
needed)
7 Poverty/soil fertility trap Subsidize fertilizer delivery until farm productivity
is lifted
12
Source: Dorward et al., 2009:16-18

Chapter 2: New Institutional Economics:
distinctive features and concepts
Obj ti : By
Objective:
Objective B th
the endd off this
thi chapter,
h t students
t d t should
h ld be
b able
bl to
t
compare the old and the new institutionalism and describe the
various branches of the New Institutional Economics
13
2.1 Basic Concepts
• Neoclassical Assumptions and Axioms
• Zero transaction costs and Perfect information
• Rational Choice
• Resource Scarcity and competition
• Institutions are given and do not matter in the economic analysis

(instrumental rationality)
• Methodological individualism
14
2.1 Basic Concepts…
Defining
g Institutions
 No commonly agreed upon definition
 Basic premise: Institutions matter for economic

performance
 Purpose is to explain the determinants of

institutions and their evolution over time,
time and to
evaluate their impact on economic performance,
efficiency and distribution
15
“Institutions are the rules of the game in a society; more formally,
they are the humanly devised constraints that shape human
interaction In consequence they structure incentives in
interaction.
exchange, whether political, social, or economic.” (North,
(North,
1990: );
A set of formal and informal rules of conduct that facilitate

coordination or govern relationships between individuals;
Historically, the role of formal institutions in facilitating

Historically,
exchange became common as transactions shifted from village
economy to regional economies where informal rules (based
on kinship ties) could not reduce uncertainty (North, 1990);
16
p
 Formal institutions are the constitutional

framework, which sets out the rules for
economic, social and political ‘players’
players
 Players are economic (firms), political

(Parliament) and social (churches) organizations
 I tit ti
Institutions are path-
path
th-dependent
d d t and
d country-
country
t -
specific
17
 Informal institutions are the norms of a society, which also set

out the
h rules
l for
f economic, i social
i l andd political
li i l ‘players’
‘ l ’
 Informal institutions allow pplayers

y to enforce economic
exchange, typically through reputation mechanisms, which
provide information about the behavior of players; identify
poor behavior; and exclude and punish players that ‘cheat’
according
di tot the
th rules
l off the
th game
 Open and Kinship systems of information and enforcement

promote development—
d l
development —12th century Europe
E andd 20th century
Vietnam
18
 How Do Informal Institutions Work?
 Players dependent on informal institutions may arise when

formal institutions do not ppromote growth
g ((not when they
y do
not exist)
 Informal
o a institutions
st tut o s may
ay resist
es st reform
e o to formal
o a institutions—
institutions
st tut o s—
e. g. The case of Soviet Union
 Economic institutions form part of,

of and are impacted by,
by the
larger social and political framework of society
19
 Common Features of institutions
 Institutions are a structural feature of the society or polity.

They are created with the only reason: decrease uncertainty
uncertainty..
 Stable over time (speed of change).
 They must pose constraints and affect individual behavior of

its members.
members
 Institutions change through time where the pace of change

varies from one to the other economy, why do you think so?
20
2.2 Emergence of Institutions Economics
 Adam Smith said that the p

productivity
y of an
economic system depends on specialization.
 Specialization will be useful only if there is an

exchange, and the lower the costs of exchange
(transaction costs) the more specialization there
will be and the higher economic productivity will
be.
 Level of transaction costs however depend on

institutions, its legal system, its political system,
its culture etc.
21
2.2 Emergence of Institutions Economics
 How players play the game determines the pace and direction of
economic development
 Institutions
s u o sw with rules
u es that
a eencourage
cou age good incentives
ce ves promote
po oe
economic interaction, exchange and activity, resulting in mutually
beneficial behaviour and economic development
 Institutions with rules that encourage perverse incentives lead to

economic stagnation and decline
22
2.3 Old and New Institutional Economics
Why Old Institutional economics and what is it?
 Emerged as the protest against methodological individualism

of the mainstream Neo-
Neo-classical Economics.
 Emphasized importance of institutions but lacked rigorous and

systematic
syste at c theoretical
t eo et ca foundations,
foundations
ou dat o s,
s, as well
we as empirical
e p ca
support.
 Concerned more with description of institutions

institutions.
23
2.3 Old and New Institutional Economics…
 Whyy is it called “New”?
 To distinguish it from the “old” institutionalist school (Veblen,

Commons)
 NIE operates
t within
ithi the
th framework
f k off neo-
neo-classical
l i l
economics, but it relaxes some of its assumptions and
incorporates institutions as an additional constraint.
24
 Key contributors to the Field!!!
 Coase R. (1937) “The Nature of

the Firm”
 C
Coase R (1960) “Th
R. “The theory
th off
social cost”.
 Williamson O. (1971) coins the

term “New Institutional
Economics”.
 N th D
North D. (1990) “I
“Institutions”.
tit ti ”
 Ostrom , E. (1990). “Governing

the commons”
Coase R. and North D.
 International Society for NIE 25
(ISNIE) established in 1997.

The purpose of NIE:
1 Explain (opposed to describe) the determinants of institutions and analyze

1.
institutional change;
2 Evaluate impact of institutions on economic efficiency and distribution

2. distribution.
3. A useful tool to address policy issues in developing countries such as

f
frequent occurrence off market
k ffailure
il & incomplete
i l or imperfect
i f markets
k
26
 Challenges in institutional analysis
• Confusion with definition

• Institutions are invisible
• Multiple inputs from different disciplines are needed
• Given multiple disciplines and concepts a coherent
institutional framework is needed
• .Multiple
Multiple level of analysis
27
2.4 Branches of New Institutional Economics
Public Choice & Political Economy

(Buchanan, Tullock, Olson, Bates) Social Capital
(Putnam, Coleman)
NIE
Transaction Costs Economics
Property
p y rights
g
(C
(Coase, North,
N th Williamson)
Willi ) (Alchian, Demsetz)
Theory of Collective Action

(Ostrom, Olson, Hardin)
Law and Economics

(Posner)
28
Group work: classroom discussions
1. Identifyy a set of rules in yyour organization

g that yyou are familiar
with.
2. Discuss how these rules are implemented and any challenge

associated with them.
3. Suggest, if any, whether the rules should change or continue to

operate.
29
Chapter 3: Institutions and Development: A
Hi i l andd Macro
Historical M Perspective
P i
Objective: By the end of this chapter, student will be able to

Objective:
explain how institutions explain economic performance and
di ti i h the
distinguish th various
i theories
th i off institutional
i tit ti l change.
h
30
3.1 Institutions and Economic Development
Some key issues
The link between institutions and development is understood through

evaluating their effects on economic performance (North, 1990).
Differences among countries in their pace of economic development is

largely attributed to their path of institutional change (path dependence)
Institutions as underlying determinants of long-

long-run performance of
economies
North (1990) rejects the instrumental rationality view of neo

neo--classical
economists who assume economic actors possessing complete information
to decide and he argues that there is procedural rationality where actors are
imperfectly informed in which there exist significant transaction costs 31
3.1 Institutions and Economic Development…
The incentive to cheat or free-
free-ride as behavioral characteristics of humans
makes it impossible to devise institutions solving complex exchange
problems
Institutional motivations with better outcomes (rather than efficient) can be

realized through
g the ppolity
y enforcing
g pproperty
p y rights
g ((vote trading)g) that
compensates the losers
Developing countries remained poor as institutional constraints do not

encourage productive activity; there is a need to redirect incentives to
productivity –increasing paths (North, 1990, 1994)
32
3.1 Theories of Institutional Change
Competing
p g theories ((basic qquestions):
)
a) What are the reasons for institutional change?
b) Who are the key actors involved in the processes of

i tit ti l change?
institutional h ?
c) Is institutional change induced or imposed?
33
3.2 Theories of Institutional Change…
 3.2.1 Theory of Induced Institutional Innovation
 The driving forces for institutional change is the technical progress and
change in relative factor prices (Hayami
(Hayami and Ruttan 1985)
 Institutional change is the product of the interaction between demand and

supply, basically influenced by the neoclassical equilibrium model. Market
f
forces create a ddemandd ffor iinstitutional
i i l change.
h
 3.2.2 Transaction costs theory
 Existing institutions are inefficient in terms of reducing transaction costs.

Hence, new institutions that could reduce transaction costs are required.
34
 3.2. 3 Distributive bargaining theory
 The driving forces for institutional change is distributional conflict over

resources of significant economic importance (Libecap, 1989: Knight 1992,
1997).
 In this theory, institutions are the by-products of social conflict
 Institutional change is a response to conflict to correct for distributional

imbalances
 Take an example of property rights change
35
 3.2.3 Distributive bargaining theory…
 To apply bargaining theory, one needs to allow for the possibility that some
social actors are more powerful than others and investigates the effect of
th
those diff
differences (Knight
(K i ht 1992:127).
1992 127)
 The success of an actor in bargaining is directly related to the ability of an

actor to produce strategic commitments (or threats),
threats) i.e.
i e compliance or non-
non-
compliance to the rules of the game.
 The theory can be applied where there is conflict over resource uses
between groups or individuals.
36
The p
payoff
y structure for the bargaining
g gggame
AP
Strategies C G
P
C ∆P, ∆AP X, X + εp
G X+ εp, X ∆P, ∆AP
if P,AP < x, there will be two equilibrium outcomes.

If P chooses strategy G and AP chooses C, then P gains more
than AP. This difference (P > 0) is known as ‘distributional
37
advantage’ and each group tries to achieve .
3.2.4. Political-
Political-Economy Theory
a) Interest Groups
 There is a political exchange between interest groups (Olson 1982)
 “Politicians hear nothing from many, but a lot from few”;
 Dedicated group of voters influence processes of institutional change in

return for their political support
 Emergence of rent-
rent-seekers in the process, having access to public fund in a
very unnoticeable
i bl way to the h public
bli (e.g.
( money spent on lobbying
l bb i to
manipulate rules of the game)
38
3.2.4. Political-
Political-Economy Theory
b) Public choice theory
 James Buchanan came up with public choice theory
 the principal-
principal-agent relationship between the voters and politicians (Tullock
(Tullock
1987).
 Thus, institutional change arises from the influence of the principals

(
(constituents)
i ) on their
h i agents who
h are expectedd to maintain
i i their
h i promises
i
or commitments (political market)
39
 3.2.5 Evolutionary theory
 Building upon an evolutionary perspective, the concept of ‘convention’

was developed based on the works of Sugden (1989), Harsanyi and Selten
(1988) and Hayek (1979).
 It refers to unintended consequences of human interaction, driven by

‘group’ other than ‘individual’ interests.
 A useful point in this theoretical argument is that though conventions can in

a stronger sense be converted to rules, they are not the result of any
collective choice and do not originate from abstract rational analysis
(Sugden
S d 1989:97).
1989 97)
 It includes rules that have never been consciously designed but are in the
interest of everyone to keep (North 1990).
1990)
 Rules evolve in unintended way rather being designed on calculative basis40

contrary to the rational choice.
Chapter 4: Techno
Techno--economic characteristics and
agricultural
g systems
y in ppoor countries
 Objective: By the end of this chapter, students will be able to

examine the underlying structural and institutional factors
constraining the performance of agricultural systems in poor
countries and the role of coordination in overcoming them.
41
4.1 Characteristics of Agricultural Systems
 Some characteristics:
 a) Emergence of the private sector and wider involvement of the state
(Kydd 2009)
 b) Insecure and often unclear land tenure systems undermining productivity

- a debate whether movingg towards private
p property
p p y increases securityy
 c) poorly coordinated input and output markets and exploitative (unfair)

 relationship between market intermediaries and suppliers
 d) absence of institutional arrangements that could encourage greater

i
involvement
l t off the
th private
i t sector
t in
i agricultural
i lt l researchh andd extension
t i
services
 Question: In your view, which of these constraints limit agricultural

Question:
development? (Discuss in group and report on your opinion?) 42
4.2. Horizontal and vertical coordination
 Research on economic organization emphasizes two levels of analysis:
 1. Horizontal coordination – where inter-

inter-firm coordination sharing similar
characteristics ((as pproducers,, or suppliers
pp or service providers)
p )
 2. Vertical coordination – where the existence of one firm relies upon the
existence of the other in the agricultural production and marketing systems
 Hence, the nature of institutions required to facilitate coordination in both

cases might vary.
vary
 Unified functions and interdependency of between the agricultural

production
d i sector andd the h complementary
l input
i production
d i andd food
f d
processing sectors needed 43
4.2. Horizontal and vertical coordination …
Consumers
associations
Wholesalers
Vertical
Agricultural
producers
d
Input
suppliers
li
44
Horizontal
G t iinter-firm
Get t fi coordination
di ti right
i ht
TCE
45
Figure: Evolution of food system inter-firm coordination research (Cook et al., 2008:292)
Table: Types of coordination in a liberalized market
system
Impersonal Relational
Rules and regulations N/a

State (formal institutions)
Formal collective Major players take

Private organization (e.g., industry decisions
actors
t association)
i ti ) with
ith d
decision-
i i i f
informally
ll amongstt
making powers themselves
“Relational coordination––characterized by informal agreements

enforced by consensus or private sanction––may be the most effective
p
option for manyy cash crop
p systems
y in Africa” (p.523).
(p )
46
Source: Poulton et al., 2003:522
Chapter 5: NIE Analysis of Markets and
Market Structure

Objective:: By the end of this chapter, students will be able to analyze

Objective
various type of markets affecting agricultural development and
examine the critical role of institutions (market and non
non--market) in
improving their performance.

47
5.1 Market
5. a et failure
a u e and
a d missing
ss g markets
a ets
 Markets fail when institutions fail to influence firms to

internalize negative externalities
 Externalities are harmful or beneficial effects resulting from a

set of activities related to production or consumption (Can
you give some examples?)
 The concept largely applied in environmental economics
48
5.1 Market failure and missing markets…
 What is market?
 Market as “an organization”,

g , is understood as: 1)) social arrangement
g to facilitate
repeated exchange among parties, 2) social network consisting a set of actors with
customer relationships, a legitimate order (or governance structure) controlling
transactions between market actors ((Furubotn
Furubotn and Richter, 2005);
 Market competition does not only lead to resource allocation (as in neoclassical
view)) but also becomes a source new knowledge,
g , learning
g and creativity
y for
economic agents; hence market evolves given the institutional constraints
(Mantzavinos,
Mantzavinos, 2001)
 Considering technologies and coordination important components while explaining

markets from an evolutionary perspective
 Thus, market is not something out there but should be formed and produced by the
49
market actors;
5.1 Market failure and missing markets
 What is market failure?
 Markets
k ffail il when
h mechanisms
h i through
h h which
hi h
they will be created and coordinated generally
f il with
fail i h respect to six
i transaction
i activities
i ii
(search, inspection (pre-
(pre-contractual),
contractual),
contracting,
i execution,
i control,
l enforcement
f
(post--contractual))
(post contractual))
50
 Measures to overcome market failure in pre-
pre-contractual relations ((Furubotn
Furubotn and
Richter, 2005);
 1. search for information about product quality – advertising ( Stigliz’s

economics of information)
 2. create a means to reduce quality measurement cost – product warrantees, share-

share-
contracts as in royalty contracts, vertical integration so that firms share
measurement costs
 3. implicit agreements as in relational contracts – long

long--term agreements enforced
as “tit
tit-for
tit- for-- tat strategies”
strategies (informal)
 4. strategic alliances and partnerships – currently applied and mostly formal which
i a bilateral
is bil l vertical
i l or horizontal
h i l agreement, involving
i l i pooling
li off assets andd
capabilities (e.g
(e.g objective of COMESA, Aviation Industry, ) 51
 Measures to overcome market failure in post-
post-contractual relations:
 1. inducing self-
self-enforcing contracts to assure quality supply
 2. ex
ex--ante measures to protect against ex-
ex-ante opportunism (such as the one
occurring in franchising – renting out brand names where the franchise may supply
poor quality product (risk
(risk)) to damage the reputation of the franchiser)
 3. vertical and horizontal integration where long

long--lived transaction
transaction--specific
investments (one exists because of the other)
 4.. pprivate
va e third-
thirdd-pa
partyy determination
de e a o ofo performance,
performance
pe o a ce,
ce, such
suc as aarbitration
b a o in “rights
g s
disputes”
 5 network organizations - positioning actors within the network to safeguard against

5.
ex--post opportunism
ex
52
 We learn that ppredation byy the state and individuals through

g
opportunism can undermine the efficiency of markets
 A precondition for a market is the presence of legal

mechanism to enforce property rights, after which individuals
get engaged
e gaged in mutually
utua y beneficial
be e c a exchanges
e c a ges (Rubin,
( ub , 2005)
005)
53
5.2 Market coordination
A t specificity,
Asset ifi it uncertainty
uncertainty,
t i t , frequency,
f precision
i i off
quality or timing requirements
Vertical integration Compete in wider

(firm/hierarchy) markets
Participate in
Relational contract markets
((vertical integration
g
Pure competition
P titi Horizontal Horizontal
(spot markets) coordination integration
(hierarchy)
Precision of quality or timing requirements, enforcement

Source: Poulton and Lyne, difficulties, lumpy assets, excludability 54
2009:151)
5.2 Labor Markets
 There is a close link between labor market institutions and economic growth
as:
1. Institutions (contracts) providing job security create incentives in enhancing

labor productivity;
2. Legal protection (legislations and regulations) for the safety of employees

playing a crucial role in reducing out-
out-migration (brain-
(brain-drain) especially in
developing countries;
3. Reforms favoring g the formation of labor unions supports

pp the pprotection of
rights of the employees;
4. Policies favoring strict labor market regulations, employment protection and

minimum wages are less important than those supporting active (flexible)
55
labor market policies to move people from welfare to work (Nickel and
Layard, 1999)
5.3. Land Markets
 How do we understand land market?
market? Markets serve as a means to have access
to land (showing a unique nature of transaction compared to agricultural
product market);
 The nature of property rights (security

(security and specificity)
specificity) remaining a necessary
condition for land markets to emerge and operate efficiently;
 Access to land when land is untitled and where there are conflicting claims
takes long
g time and often involves a politically
p y charged
g process
p (e.g.
( g in pastoral
p
systems of land use);
 Question for thought:

thought: Land grabbing by large
large--scale foreign investors in
developing countries seen as a challenge to secured access to land (Von
(Von Braun
and Meinzen
Meinzen--Dick, 2009);
2009); but as governments of developing countries lack the
capacity
p y to expandp agricultural
g investment,, do we consider this pprocess as a
threat or as an opportunity for the rural poor?
56
5.3. Land Markets…
 Land markets in Africa (Colin and Woodhouse, 2010)
1
1. Redistribution of land to more efficient users
2. Customary systems of land tenure moving into private property to permit

market mechanisms work
3. Widespread incidence of a variety of rental and sharecropping

arrangements (Senegal,
(Senegal Ghana,
Ghana Sudan, Lesotho)
Sudan Ethiopia and Lesotho)
4. Majority of sale and rental transactions are ‘informal’, without protection

in the statutory legal system.
system
5. Socially and politically embedded land markets (e.g. indigenous vs

settlers; foreigners vs local)
6. However, there are obstacles to the functioning of land markets; 57

5.3 Land Markets…
Requirements to
Remove Obstacles
● National land reform

initiatives addressing
multilayered and
interrelated obstacles
facing private investors
seeking access to land
● The governance
system ensuring
transparency and
accountability in the
titling, registration and
transfer of property
rights (the court
system)
Figure: Procedures for accessing land as an obstacle operating

and expanding businesses (Source: World Bank, 2005) 58
5.4 Rural Financial Markets
Types of financial markets
Insurance
markets
k t
Financial
Fi i l
markets
59
5.4 Rural Financial Markets…
 Financial market is the term broader than money market and includes
different aspects;
 Performance of agricultural systems is influenced by the efficiency of the

rural financial markets;
 In the NIE analysis of financial markets, emphasis is given to the way such
markets are coordinated and function as well as the obstacles to them;
 In African agriculture, a huge transaction costs and weak collateral systems

undermined the emergence
g and performance
p of rural financial markets ;
 How do institutions facilitate their performance (e. g. reducing transaction

costs, enforcing contract markets in contract faming)?;

60

5.4 Rural Financial Markets…
 Formal versus informal
 a)) Informal
I f l financial
fi i l sector
t - too
t little,
littl too
t expensive
i (high
(hi h iinterest
t t rate)
t )
often without strict rules and procedures
 Non-market institutions such as social capital or informal saving and credit

Non-
groups (or associations) as opposed to Banks becoming source of finance
 B) The formal sector – supply less than demand; which measures are
needed?
• Increase in production and productivity of agricultural enterprises to
reduce risk of non
non--repayment
• Sustainability of credit schemes to build farmers’ confidence
• Macroeconomic measures to expand p and strengthen
g the rural credit
systems
61
5.4 Rural
5. u a Financial
a c a Markets…
a ets…
 Two key characteristics of rural financial Markets in LDCs (Conning

and Udry
Udry,, 2007)
 1. Fragmented
g or absent markets,, where in some cases only
y ggroup-
group
p-based
 mutual savings and insurance arrangements such as rotating savings and
credit associations exist
 2. Government interventions to provide impartial and accessible legal

mechanisms for the arbitration and enforcement of contracts
62
5.5 Agricultural Markets
 General problem:
problem: Poorly functioning markets, weak domestic consumer
demand, high transaction costs and lack of export possibilities as major
constraints;
 Required actions of the state:

state:
 1) engaged in global agricultural trade negotiations and align domestic policies
 with global features (such as WTO (Alavi
(Alavi,, 2007)
 2)) designing
g g institutions to pprevent the deleterious impact
p of developed-
developed
p -country y
 policies on developing-
developing-country food security;
 3) Creating appropriate price incentives, encourage market development, and
 optimize investment in institutions and infrastructure
 4) Encourage development of farmers organizations, cooperatives and unions
Note: Institutional analysis enables one to understand the complicated procedures

associated with this in order to enhance agricultural markets. 63
5.5 Agricultural Markets…
 M
Measures tto iimprove access (case
( studies):
t di )
 1. collective action in smallholder marketing - smaller marketing groups
have higher internal cohesion because it is easier to monitor other members
(Markelova
M k l and d Meinzen
M i
Meinzen--Dick,
Di k 2009;
2009 Shiferaw
Shif ett al.,
l 2008)
 2. building on the role of social capital - in reducing transaction costs in

search for trading partners (Gabremadhin
(Gabremadhin,, 2001)
 3. achieving
g a balance between competition
p and coordination ((actingg in
common or in a complementary way) as greater levels of competition does
not necessarily generate better system performance (Poulton
(Poulton et al., 2003)
 4. promoting the role of trust in contract enforcement between smallholder

farmers and other agents (processers) in the agricultural commodity market
chains ((Masuku
Masuku,, 2009))
64

5.5 Agricultural Markets…
Agricultural markets to
meet multiple
objectives:
1. Engage
g g in contract
farming
2. Improving food
safety
3 Extending trade
3.
relations
Question: what can

you observe from the
picture?
65
Figure: Market, trade and institutions (Source: IFPRI, 2007)
5.6 Conditions for Agricultural Transformation
stage Government action Status of agriculture

required to enable
Phase 1: Roads,
R d irrigation
i i i systems, Extensive,
Extensive
establishing research, extension, land reform Low productivity
the basics
Profitable intensive
Phase 2: kick- Reliable local, seasonal technology; wider uptake
starting markets finance, input and output inhibited by lack of
markets finance input and output
finance,
markets
Phase 3: Effective farm input

withdrawal Effective private demands; surplus production
sector markets
Large volume of finance, input

66
Fig.: Processes and conditions for agricultural demand, produce supply; non-
transformation (Source: Dorward et al., 2003: 82) agricultural linkages
Chapter 6: The State and Property Rights
Objective:: By the end of this chapter,

Objective chapter students will be able:
To understand the complexities in defining and enforcing property rights

and explain the underlying factors causing property rights change ;
To vital role of the state and its political institutions in securing property
rights
67
6.1 Concept of Property Rights
manyy ppeople
p regard
g pproperty
p y as a tangible
g ‘physical
p y object’.
j Institutional
economists use a different conceptual language.
Property is considered as a “benefit (or income) stream” in that the owner

controls this benefit stream (Bromley 1991).
1991)
A right may be a ‘set of actions and behaviors that possessor of a property

may not be prevented from undertaking, or a duty on all others to refrain
from preventing those actions or behaviors’.
Therefore, rights are not relationships between the right holder and an
object but rather are relations between the right holder and other people
object,
with respect to the object (Bromley 1991:15).
68
6.1 Concept of Property Rights…
Alternative definitions
1. property right is defined as “the capacity to call upon

the collective to stand behind one’s claim to benefit
stream” from an asset of economic importance
(Bromley 1991:15).
2. “ property rights over assets consists of the rights, or

the powers, to consume, obtain income from, and
alienate these assets” Barzel (1989:2).
69
6.1 Concept of Property Rights…
3. “bundles of rights” including access and withdrawal,

exclusion,
l i management andd alienation
li i rights
i h (Schlager
(S hl andd
Ostrom 1992: 249-
249-251)
4. Furubotn and Richter (2005) review and classify property

“absolute” and “relative
rights as “absolute” “relative”,
”, the former involving
assignment of exclusive individual property rights to
physical
h i l objects,
bj t whereas
h “relative”
“ l ti ” property t rights
i ht include
i l d
all rights related to contractual obligations and agreements
R l i PRs:
Relative PR Exchange.
E h Contractual
C l obligations
bli i -
particularly when time is an important part of the
“transaction” -> monitoring and enforcement of the contract
70
6.2 Property rights regimes
1) Private property:
property:
- is any property that is not public property. Private property may

be under the control of a single individual or by a group of
individuals collectively.
- a set of ordered institutional arrangements in which the state

protects the rights of certain individuals to access, control and
manipulate resource benefit steams. Others have a right to
expect that only socially-
socially-acceptable uses will occur,
occur and a duty
to refrain from preventing those uses.
- What are the advantages of private property? Some agree on

its role in the efficient allocation of resources and investment in
resource improvements
- Why have claims to private land use emerged in pastoral and

agropastoral areas? (e.g.
(e g In the case of priavte ranches among
the Maasai)
Maasai)
71
6.2 Property rights regimes…
2) Common Property:
Property: distinction of “common
“common--pool” and “common
property”.
 a common
common--pool resource (CPR) is a particular type of good
consisting of a natural or human
human--made resource system, the size
or characteristics of which makes it costly, but not impossible, to
exclude potential beneficiaries from obtaining benefits from its
use.
 Common Property is the private property of a group of co-

co-owners.
 "common property regime" refers to a particular social

arrangement regulating the preservation, maintenance, and
consumption of a common-
common-pool resource.
 common-pool resources are not necessarily governed by common

common-
property regimes, they may be owned by national, regional or
local governments as public goods,
goods, by communal groups as
Common property resources,
resources, or by private individuals or
corporations as private goods.
goods.
72
 Property rights in productive resources – land itself, trees,
pasture, many water sources, fish,
fi h etc. often
f characterized
h i d by
b
non--private property rights structures
non
 Substantial part of income generation, especially in SSA
 Poor,
oo , aandd reliance
e a ce on
o non-
non
o -pprivate
vate resources
esou ces as safety
sa ety net
et
 Almost all “big” environmental problems are a function of

resources under non
non--private,
private non
non--market property rights
(desertification, forest management, soil erosion, pollution,
over--fishing, overgrazing)
over
73
2) Common property…
 Examples of common
common--pool resources include irrigation
systems, fishing grounds, pastures
pastures,, and forests
 common-pool resources are generally subject to the

common-
congestion,, overuse, pollution
problems of congestion pollution,, and potential
destruction unless harvesting or use limits are devised and
enforced which could lead to the deterioraton of
enforced,
livelihoods..
livelihoods
 in a common p property
p y regime,
g , a common
common--ppool resource has
the appearance of a private good from the outside and that
of a common good from the point of view of an insider. The
resource units withdrawn from the system are typically
owned individually
y byy the appropriators.
pp p A common
property good is rivaled in consumption.
74
3) State Property:
- Resources are nationalized and citizens may have use

rights, while the state has all forms of rights to the
resources
esou ces in question.
ques o
- a state property regime is a set of institutional

arrangements in which the state retains direct control of
the benefits derived from a resource by determining access
and use rules for individuals (Bromely, 1989, 1991).
- In many y socialist countries,, individuals are entitled to use

resources but not to transfer rights to the resources without
the interference of the state.
75
However, such state property regimes fail due to:
 rigidity of the state agencies in their application of rules;
 state agencies usually ignore,

ignore or even attempt to
undermine, indigenous political structures and institutions;
 state agencies
g often lack the p
power,, authority
y and/or
/ will to
implement rules prescribed at regional or national levels;
and,
 state employees who are responsible for the enforcement of

resources use rules are often remunerated, legally or
illegally, through the collection of fines. (e.g. corruption and
bribes)
76
4)) open
p access:
 When resources are owned by no one or are used
by all without any restriction
restriction, they exihibit open
access resources
 Such lack of property regime leads to resource

destruction and increases behavioral uncertainty
 Often termed as “tragedy of open access” or

formerly coined as “the tragedy of the commons”
(G. Hardin 1968)
77
Bundles of rights
g
 Note: we do not find very much distinction in

Note:
property rights as such,
such rather a bundle of rights
approach is important.
 The bundle of rights is a common way to

explain the complexities and interdependence of
g
rights to resources amongg actors having
g different
positions
78
Bundles of rights associated with positions
Full owner Proprietor Authorized Authorized Authorized

claimant user entrant
Access X X X X X
Withdrawal X X X X
Management X X X
Exclusion X X
Alienation X
Source: Ostrom and Sclager, 1996:133

79
6.3 Forces of change in property rights
1) Equity versus efficiency
 There is tradeoff in achieving economic efficiency and

attaining equity (distribution); one is satisfied at the
expense of the other, i.e. efficiency cannot be
materialized when distributional inequality is at stake
(Wang 2001; Eggertsson 1990).
 The distribution view recognizes that the forces of change

in property rights are the inherent dissatisfactions by
certain groups or individuals from the existing property
rights structure. The existing distribution of property
rights may benefit some but harms others.
 In such contexts, change is determined by the capacity of

actors to ‘contract’ for property rights change or
persistence of existing ones ((Libecap
Libecap 1989).
80
6.3 Forces of change in property rights…
 The economic efficiency view - property rights change
results from opening of new markets, change in relative
prices of factors of production,
production demographic shift and
technological innovation.
 Change in these factors in an economy creates a pressure

for change in property rights (Demsetz
(Demsetz 1967; Boserup
1965; North 1981; Bromley 1991; Ensminger 1997).
 They argue that efficiency of land use increases when

property rights change from a purely open access (no
property rights) to common and then to private due to
population growth and resource scarcity leading to more
commercialization.
commercialization
 Though transaction costs of enforcing rights are increasing

at each stage, the return from improved efficiency largely
outweighs the costs (Bromley 1991)
81
2) The ‘ cost-
cost-benefit’ versus ‘scarcity
‘scarcity--incursion’ analysis
a) Cost-
Cost-benefit argument –
 property rights emerge when the benefits obtained from controlling access
to resources exceed the transaction costs of defending the resource from
others, i.e. the ‘social cost-
cost-benefit’ comparisons or ‘internalization of
externalities’ from introducing new property rights.
 gains from internalization of externalities must exceed the costs to cause

alteration of property rights regime. Those economic forces fetching new
opportunities (e.g. emergence of markets or newly introduced technology)
should ensure cost-
cost-effective way of internalizing external effects ((Demsetz
Demsetz
1967) (e.g. controlling of hunting areas as a result of the rise of fur
industry)
82
b) the scarcity
scarcity--incursion analysis - a counterargument challenging Demsetz’s
view and that of his proponents (Field 1989). This is particularly the case in
terms of predicting the direction of change in property rights when the
value of a resource rises.
An increase in resource value would rather lead to less exclusive property

rights since the more valuable resource will attract greater incursion (Field
1989).
According to Field,
Field a higher resource
reso rce value
al e will
ill cause
ca se pressure
press re from
outsiders intending to use the resource. This will cause the exclusion cost to
rise much more than the benefits obtained from excluding others.
83
84
 An increase in the number of these commons ((from a singleg large

g commons to
completely divided parcels for individuals N) will lead to a decline in the marginal
governance cost (Tm) because of reduced cost in organizing collective action.
 However, such an increase in the number of commons will lead to a rise in the
marginal cost of exclusion (boundary management, Em), where an increasing
exclusion costs saves transaction costs.
 A point where marginal governance costs and marginal exclusion costs intersect
(M*), one may find an optimal number of parcels for the commons and size of users.
85
 An increase in resource value (EmR) and an introduction of new

technology of exclusion (EmT) will again affect the optimality,
where both having the opposite effect, but again maintaining
the optimal point.
 Field’s model does not completely deny the influence of

population and economic growth as determining factors for
private property to emerge.
emerge
86
6.4 State, Property rights and legal pluralism
state (or statutory) law as made by legislatures and enforced by
the government;
religious law, including both law based on written doctrines and

accepted religious practice;
customary law, which may be formal written custom or living

interpretations of custom;
project (or donor) law, including regulations associated with

particular projects or programs, such as an irrigation project;
organizational law
law, such as rules made by user groups; and a
range of local norms, which may incorporate elements of other
laws.
Thus, legal pluralism can be a possible source of conflict and

uncertainty 87
6.5 State and political institutions
 Where do we focus (the role of the state or the primacy of market)?
 Two perspectives in explaining the role of the state:
 a)) Neoclassical view
 State (rulers) in the development and enforcement of constitution which

further specifies the structure of property rights (North, 1981);
 Property rights specification by the state permits it to maximize monopoly

rents in which case principal
principal--agent model arises (as in tax collecting
process by the state agents);
 R l maximizing
Rulers i i i their
th i revenue tot meett personall objectives
bj ti subject
bj t to
t the
th
degree of competition with their rivals (Levi, 1988). 88
6.5 State and political institutions…
 b) neoinstitutionalist view
 Principal
P
Principal-
i i l-agentt relationship
l ti hi between
b t voters
t andd politicians
liti i andd political
liti l
exchange between interest groups;
 Institutional arrangements having impact on the ability of agents (law

makers, government agents, bureaucrats) to make political commitments
credible;
 Ex-post opportunism of the state is constrained by political institutions ,

Ex-
one of which could be a limited terms of office; nationally inherited ethical
habit may undermine opportunism
 State playing a role in safeguarding and enforcing international agreements

(e.g. hostages for exchanges, tit-
tit-for
for--tat for cooperation) ((Furubotn
Furubotn and
Richter, 2005) 89
b) neoinstitutionalist view…
P liti l iinstitutions
Political tit ti off the
th state
t t playing
l i a role
l in
i correcting
ti for
f marketk t failures
f il
associated with production externalities and facilitating provision of public
good (Bates, 1995);
These institutions providing credible commitments in safeguarding

investments (refraining from policies of predation)
predation) even in the absence of
market
k t mechanisms
h i (S ki ett al,.
(Soskice l 1992);
1992)
They help in overcoming misallocation of resources over time, corruption and

rent--seeking (Bates, 1995);
rent
Question : Describe the characteristics of state political institutions in your

respective country or region.
90
Explaining Institutional Performance
New Institutional Economics Political economy analysis
Differences in institutional Differences in institutional

performance across countries performance across countries
Attributed to differences in Identification of different political

institutional structure across settlements (i.e. balance of
countries power between classes and
groups affected by institutions)
Theories of transaction costs Theories relating political

associated with particular settlements to net social benefits
institutions off particular institutions
91
Figure: NIE versus Political Economy (Khan, 1995:78)
92
Chapter 7: Collective Action
Objective:: By the end of this chapter, students will be able:

Objective
To apply the theory of collective action in solving various problems associated

with agriculture and natural resource management;
To differentiate the various frameworks applied in institutional analysis ; and
To describe how game theory is used in various contexts in the process of

analyzing institutions.
93
7.1 Basic Concepts
 Conceptualizing collective action has come after the work of pioneer

contributors to the field such as Mancur Olson (1965)
 Problems of collective action in the provision of public goods (problem of

exclusion of free-
free-riders))
 R. Hardin (1982) criticizes Olson as he considers economic incentives as

the main drivers by ignoring non
non--economic reasons.
reasons
 Common to both authors is that collective action is organized when the

efforts of two or more individuals are needed to accomplish specific
outcome (Sandler 1992)
94
 Collective action is organized when greater benefits are expected through
joining a group rather than acting individually. The incentive to organize it
is dictated by limited capacity of an individual to provide a good from
which he or she generates private benefit (Meinzen
(Meinzen--Dick et al. 2004).
 collective action is defined as “an action taken by a group (either directly

or on its behalf through an organization) in pursuit of members’ perceived
shared interests”
interests” (Marshall 1998).
 It can also be defined as “a

“a coordinated behavior of groups toward a
common interest or p purpose
purpose”
p ” ((Vermillion 1999
1999:: 184).
184)).
95
7.2. The Theory of Collective Action
 The most important challenge in collective action is how to find
individuals acting collectively in an environment where they face
a dilemma
dil about
b t one another’s
th ’ action
ti (Hardin
(H di 1982).
1982)
 As a result
result, studies on collective action tend to examine factors
motivating individuals to coordinate their activities to improve
their collective well-
well-being (Sandler 1992:19).
 Trust, reciprocity and reputation are the three core individual level
variables determining individual cooperative behavior in
collective action (Ostrom
(Ostrom 1998)
96
7.2. The Theory
y of Collective Action…
 Individuals ggain reputation

p for beingg trustworthyy ((or keeping
p g
promises) and showing higher levels of cooperation.
 Trust shows the expectations that individuals have about

others’ behavior. Some degree of trust about others’ action in
accordance with the established norm is a precondition for
individuals to cooperate.
cooperate
 When others also cooperate, the reciprocal relationship is

attained and this tends to continue as predictions from the
theory of repeated games inform us (Sobel
(Sobel 2002).
97
7.2. The Theory of Collective Action…
Reputation of
participants Pj…Pn
for using reciprocity
i pastt collective
in ll ti
action situations
Trust of Pi that Pj
…Pn are Levels of Net
reciprocators cooperation benefits
Likelihood Pi is
using reciprocity
The Core relationships at the individual level affecting levels of 98
cooperation in a social dilemma (Source: Ostrom, 2005, p.23.)

7.2 The Theory of Collective Action…
Information from Subtractive or
the past actions shared resources
Linkage structure
The Core
Reputation Relationships
Number
N b off
participants
Trust Levels of Net
cooperation benefits
Face to
F t face
f
communication
reciprocity
Heterogeneity of
participants
Freedom to enter Shape of the production

and exit function
99
A framework linking the structural variables to the core relationships (Ostrom

7.3. Fairness, trust, reciprocity and cooperation
 F i
Fairness, trust andd reciprocity
i i - important
i t t factors
f t affecting
ff ti cooperative
ti
behavior in collective action;
 Reciprocity :
A norm that ggenerallyy reflects an attribute that an individual is inclined to

react positively to the positive actions of others and vice versa (Fehr and
Gächter 2000; Bolton and Ockenfels 2000; 2000; Fehr and Schmidt, 2004);
It is governed by moral rules; a benefit granted to one party only upon an

implicit condition that it will be returned some other time in the future;
100
7.3. Fairness, trust, reciprocity and cooperation…
Self-enforcing agreements could emerge and mutual reinforcement of

Self-
behavior will take place in a repeated interaction setting;
First movers trusted second movers to reciprocate even in condition where

there is no possibility of punishment (experimental games) (Berg et al.
1995; Hoffman
Hoffman, McCabe and Smith 1998);
Positive and negative reciprocity – based on the responses of the first

mover (involving
(i l i retaliatory
t li t actions);
ti )
101
7.3. Fairness,
a ess, ttrust,
ust, reciprocity
ec p oc ty and
a d cooperation…
coope at o …
An example from a case study
Figure: Strategic form of cooperative game (Beyene, 2010:561)
102
7.3. Fairness,
a ess, ttrust,
ust, reciprocity
ec p oc ty and
a d cooperation…
coope at o …
 Altruism: - a characteristic in which an agent continues to cooperate while

Altruism:
the opponent fails to reciprocate; a behavior which slightly differs from that
of conditional cooperators
 Inequity aversion:
aversion: - An individual with an aversion to income inequality
would sacrifice own income to increase or decrease others’ income so as to
achieve a more equal allocation (Fehr and Schmidt, 1999; Ahn et al.,
2003).
 Self-interested
Self- interested:: an individual is p
poorly
y motivated by
y private
p benefits to be
consistent irrespective of that of others.
103
7.3. Fairness, trust, reciprocity and cooperation…
b) Linear
altruism
a) self-interested
Source: Ahn et al. (2003: 299)

104
c) Inequity-aversion
7.4 Determinants of Collective Action
Some of the factors that determine participation in collective action include:
11. Heterogeneity (economic,

(economic socio-
socio-cultural)
2. mutual vulnerability of group members,
3. rule enforcement capacity,
4. established
bli h d selective
l i incentives
i i (punishments,
( ih rewards)
d)
5. Effectiveness of leadership
6. the nature of property rights
7. Attributes of resources (size, predictability)
Case studies report controversial results causing difficulties to develop

standard theory.
theory.
Question: What other factors do you think affect cooperative
behavior in collective action?
105
7.5 The role of social capital
p in collective action
 a) Basic ideas
 What is social capital? How does it operate? How is it currently measured?
 “Social capital refers to features of social organization [in particular,

horizontal associations] such as networks, norms and social trust that
facilitate coordination and cooperation for mutual benefit.” Putnam (1995).
 “a variety of different entities, with two elements in common: they all

consist of some aspect of social structure, and they facilitate certain actions
of actors … within the structure” Coleman (1988).
 Coleman makes distinction between types of social capital as “bonding

social capital” (within a group) and “bridging social capital” (Coleman
)
1988).
106
7.5The role of social capital in collective action…
 “includes the social and political environment that enables norms to develop and
shapes social structure
structure. .. Or a more formalized institutional relationships and
structures, such as government, the political regime, the rule of law, the court
system and civil and political liberties” Grootaert (1998)
 “Social capital is defined as the norms and social relations embedded in the social
structures of societies that enable people to coordinate action to achieve desired
goals.” The World Bank (2000).
 Based on accounts of previous works (Coleman 1988; Ostrom 1990, 92 and

Putnam 1993), Ostrom (1999) defines it as: ‘shared knowledge, understandings,
norms rules and expectations about patterns of interaction that groups of
norms,
individuals bring into a recurrent activity’ (p.176).
107
7.5 The role of social capital in collective action…
b) Forms and Levels of Analysis
Forms Levels of analysis
 Norms
 Networks  Individual/Household
 Trust  Local/Community
 National
 Essential in Coordination and  International
cooperation
Questions: a) Discuss briefly the role of social capital in agricultural trade and
technology transfer?
b) How do you characterize social capital as public or private good?

108
7.5. The role of social capital in collective action…
How is social capital hypothesized?
• lowers transactions costs of exchange
• Reduces cost of enforcing rules in the provision and appropriation
• strengthens informal insurance by facilitating adaptation in risky

environment mainly in traditional societies (e.g. social connections
assist
i t livestock
li t k spreadd over a larger
l geographical
hi l area as risk
ik
management activities Collier and Gunning 1999)
• improves local authority performance by drawing them into

networks
109
7.5 The role of social capital in collective action
Empirical analysis: How is Contacts and other

social capital quantified? network measures
(Absence of)
Violence Trust
measures
Social
capital
Degree of civic
engagement Strength
g of
and/or family networks
Group
responsibility membership
(and
characteristics)
110
But measurement is difficult and is often indirect using some proxies!
7.6 Co
Collective
ect ve action
act o in natural
atu a resource
esou ce management
a age e t
 As a stream of the New Institutional Economics, collective action is applied

in:
 A) agrobiodiversity management
 B) soil and water conservation
 C) watershed management /management of irrigation systems
 D) marketing of agricultural products (cooperatives,

(cooperatives improving access to
services)
 E) improving
i i the
th supply
l off public
bli goods
d ((provision
i i and
d maintenance
i t off
infrastructures) 111
7.6 Collective action in natural resource management…
g
Depending on the characteristics of the goods (resource attributes) , the nature

of property rights structure and the attributes of resource users, the
degree of success in collective action could vary.
Design principles for a long-

long-enduring CPR institutions
1. Clearly defined boundaries
2.
2 Congruence between appropriation and provision rules
3. Collective-
Collective-choice arrangements allowing for the participation of most of
the appropriators in the decision making process
4.
4 Effective monitoring by monitors who are part of or accountable to the
appropriators
112
7.6 Collective action in natural resource management
5 Graduated sanctions for appropriators who do not respect

5.
community rules
6 Conflict
6. Conflict--resolution mechanisms which are cheap and easy
7. Minimal recognition of rights to organize (e.g., by the
government)
8. In case of larger CPRs, Organisation in the form of multiple
layers of nested enterprises
113
7.7. Reform, Resource Governance and Public
y
Policy
The concept of governance
What is governance? It is understood as:
1) the process of deciding what the collective will do and how it will do
in such a way that institutions are created through the process of
governance to provide order to the relations among members of the
collective (Bromley 1989)
1989).
2) the exercise of legitimate authority in transacting affairs, broadly

understood to refer to the maintenance of social order through
endogenously evolved sets of rules or authority structures, or some
combination of locally evolved and externally imposed rules sets
(Mearns 1996:300)"
114
7.7. Reform, Resource Governance and Public Policy…
 Government - the "exercise of influence and control, through law and

coercion, over a political community, constituted into a state within a
defined territory (Mearns
(Mearns,, 1996)"
 Government need information for governance, how to get it is often

problematic
 Information gap on resource conditions undermines the effectiveness of

policies in shaping resource governance
 Therefore, governments should establish governance structures (refer to

institutional arrangements through which rules are created and enforced,
the structures performing the sanctioning of compliance with rules)
 Hence, the sources of information for governments are the ultimate rule
enforcers and those abide by rules
115
7.7. Reform, Resource Governance and Public Policy…
 Resource user-
user-groups are always in competition, conflict and overuse of
natural resources where institutions play regulatory and redistributing
functions
 Institutional change such as decentralization is recommended as a solution

to effective resource governance, why?
 But absence of effective decentralization,

decentralization poor accountability to public
interest, ineffective representation, elite capture and opportunism remaining
critical inherent challenges
 Natural resource management is affected by users’

users attributes,
attributes resource
attributes and the institutional environment
 Different case studies provide different (sometimes

(sometimes contradictory)
contradictory) results on
how each of these set of factors (variables) influence resource management
outcomes
116
Figure: Resource and users’ attributes affecting
resource management
g outcomes ((Source:
117
7.8 Frameworks for Institutional Analysis
y
a)) Purpose
p of Institutional Analysis
y
 To sufficiently capture the institutional context so that we can

more accurately predict how other policies are likely to impact
on different groups and communities
 To capture the institutional context, and how any particular

policy may in turn affect the functioning of the institutions
 To determine factors that directly affect institutions, and so as to

develop insights that help derive policy recommendations to
directly change the institutions
118
7.8 Frameworks for Institutional Analysis…
 Institutional analysis requires a framework for analysis of how institutions

change, affect behavior and coordinate human action (for testing hypothesis
and falsify propositions)
 Two frameworks: Institutional analysis and development framework (IAD)

and Institutions of Sustainability (IOS), where the former is very popular
and has been widely applied and tested in various circumstances
 First, we start with IAD, having three basic parts (initial

(initial context, action
arena and outcomes,
outcomes, each being further decomposed to guide the analysis)
 Choice of a component is determined by the nature of an empirical study
119
b) Four levels of institutional analysis
Williamson’ss framework: 4 level of social analysis

Williamson
 Level 1: Embeddedness. Informal institutions, customs, traditions, norms and

religion; (social
(social theory)
theory)
 Level 2: Institutional environment. Formal rules of the game: property,

bureaucracy. (economics
(economics of property rights theory)
theory)
 Level 3: Governance:
Governance: play of the game - contract. ((transaction
transaction cost economics
theory))
theory
 Level 4:
4: Resource allocation and employment (prices and quantities; incentive
alignment). (neoclassical
(neoclassical economics/agency theory)
theory)
 N t : The
Note:
Note Th NIE focuses
f on levels
l l 2 andd 3;3 level
l l 1 by
b sociologists
i l i t andd level
l l 4 is
i
 emphasized by neoclassical economists. 120
Level Frequency purpose
(years)
Embeddedness:
L1 informal institutions, Often non-calculative;
102 to 103
customs traditions
customs, traditions, spontaneous
norms
Institutional Gett th
G the institutional
i tit ti l
L2 environment: formal 10 to 102
rules of the game
environment right, 1st
order economizing
Governance: play of Get the governance

L3 the game, 1 to 10 structures right, 2nd
order economizing g
Resource allocation Get the marginal

L4 and employment
Continuous conditions right, 3rd
order economizing
121
Figure: Four levels of institutional analysis (Source: Williamson, 2000:597)
c) A Framework for Institutional Analysis (IAD)
Physical/
Ph i l/
material
conditions
Action arena
Patterns of
- Actors Evaluative
interaction
Community - Action situations criteria
attributes
Outcomes
Rules-in-use
122
Source: Ostrom, Gardner and Walker (1994: 37)
In the IAD Framework, the initial context affects the action situations in the
action arena;
In the action arena, actors would interact (fight, negotiate, influence one
another, collaborate) where this is influenced by their action resources;
Through certain patterns of interactions actions would lead to outcomes;

Actors have different evaluative criteria for outcomes;
Unfavorable outcomes lead to change in the rules

rules--in
in--use while favorable ones
would reinforce the actions in the action arena to generate the outcomes;
Hence, the framework is iterative in nature;
Analysis could focus on some parts of the framework as one may not capture
123
all elements of the framework in one particular study;
Policy and
governance
Environment
Physical
infrastructure Socioeconomic
Action
Institutions and their domain
attributes
enforcement and
coordination
Activities and their Actors and their
attributes attributes
Outcomes
124
Source: Dorward and Omamo, 2009:79

 Dorward and Omamo (2009) refine IAD and focus on initial context (the
environment – policy, physical infrastructure and socioeconomic)
socioeconomic) and the
action arena (action domain
domain--actors, institutions, activities, and outcomes
outcomes))
and then how the environment influences the action domain;
 The environment as a set of exogenous variables affects actors behavior

through institutions;
 Interactions among institutions actors and activities involve action leading

to outcomes;
 The outcomes of the actions may change or reinforce the environment,

institutions activities and actors;
 Question:: what distinction do you see between this and IAD framework? 125
Question
Empirical example: A framework used for a case study in Somali
Region of Ethiopia
126
Source: Beyene, F. (2008:100)

Institutions of Sustainability Framework
127
7.9 Thee complexity
co p e ty of
o multilevel
u t eve institutional
st tut o a analysis
a a ys s
Complexity in the nested nature of rules
Operational rules, collective-

collective-choice rules, constitutional
onstitutional--choice rules and even
meta--constitutional rules
meta
Meta-constitutional rules rarely analyzed and the link among the levels
Meta-
increases complexity of the analysis
Sometimes, we consider (or assume) the next higher level as given and focus at
one level in the analysis of determinants or effects of institutional change
NIE uses methods familiar in the mainstream economics
The challenge
g in usingg mathematical models is the requirements
q theyy need in
terms of assumptions
128
7.10 Game Theory in Institutional Analysis …
 What is game theory and why?
 Interaction of individuals involving

g how they
y make decisions and how
these decisions lead to an outcome is studied using game theory;
 As Morrow (1994) explains, game theory is based on utility theory that

deals with how preferences of an actor over certain outcomes are measured.
measured
It is also guided by rational choice theory;
 By “rational
“rational”,
”, it means a condition in which one will choose “the best
means to gain a predetermined set of ends” (Morrow, 1994:17);
 In employing game theory as analytical tool, we move from forming thick

accounts to thin form of reasoning to build explanation on why a certain
equilibrium outcome is preferred over any other (Bates et al. 1998:14);
 Game theory is applied in analysing contractual relations, trade, in political

relations, political economy analysis
129
A Nash-
Nash-Equilibrium is a pair of strategies that are best replies to each
other on the equilibrium path where institutions are likely to emerge,
A game has at least two players with a set of strategies and expected
outcomes (also called payoffs),
payoffs) where different strategies lead to
different payoffs and each player tries to maximize the benefits by
changing her strategies
A game can be represented in a strategic form or in an extended form

where the latter shows the sequence of moves unlike the former
130
a) Extended form of a game
(1 1)
(1,1)
2 u
U
1 d

(1,1)
 D
 2 u
(0,-3)
d
(2 2)
(2,-2)
131
b)) Strategic
g form of a g
game
Player 2
Player 1 u d
U (1,1) (1,1)
D (0,-3) (2,-2)
132
Chapter 8: Transaction Costs in Smallholder
A i l
Agriculture
Objective:: By the end of this chapter, students will be able:

Objective
To explain problems in the governance of transactions and the role of

opportunism and information asymmetry in affecting efficiency of
transactions; and
To describe the importance of institutions (contracts) in reducing

transaction costs and the inherent problems in contractual relations.
133
8.1 The Coase Theorem
 What are transaction costs?
 Initial Assumption of Coase

Coase:: Production and exchange can be solely
carried out through the price mechanism.
mechanism
 In the process of determining price rate, there is a cost of discovering prices

(Cheung 1983)
 The idea that “Perfect markets direct all production in the absence of
transaction
i costs (zero)”
( )” is
i a fiction,
fi i leading
l di to the
h Coase
C Th
Theorem:
134
8.1 The Coase Theorem…
 “in the absence of transaction costs, the most efficient solution

to maximize aggregate income will be obtained irrespective of
the original distribution of resources or liability” (the
Theorem))
 however, if transaction costs are positive, then property rights

institutions do matter.
matter This occurs in a real world.
world
 Later on, he introduced the notion of positive transaction cost,

which is the cost of carrying out market transactions: costs of
organization (the contribution of Coase to NIE)
135
8.1 The Coase Theorem…
 Coase (1937)
• Market
e exchange
e c ge iss not
o costless
cos ess
• Firms emerge to economize on transaction costs
• Boundary of the firm determined by nature and extent of transaction

costs
 Question:: Imagine a private library located next to a hotel organizing a

Question
night--club,
night club where noise pollution can undermine the use of the library
affecting the business of the library owner. Would private bargaining
between the two resolve the externality
y pproblem without involvement of the
state? 136
8.2 Transaction cost economics
 According to this theory, institutional change takes place to reduce
transaction costs, including:
• Cost of screening and selecting a buyer or seller
• Cost of obtaining information on goods or services
• Cost of bargaining and negotiating a contract
• Cost of monitoring and enforcing the contract
137
8.2 Transaction cost economics…
 Willi
Williamson (1996,
(1996 2000):
2000)
• Combines the concepts of bounded rationality & opportunistic

behavior to explain contracts and ownership structure of firms
• Continuum of organizational form (from vertical integration to

cash markets) that depends largely on the magnitude of transaction
costs
138
 North (1986, 1989, 1994)
• Institutions that evolve to reduce transaction costs are key to the

performance of economies
• Not
N t all
ll iinstitutions
tit ti that
th t emerge are efficient
ffi i t
• Role of government is crucial in specifying property rights and
enforcing contracts
 North (1990)
“The inability of societies to develop effective, low-
low-cost enforcement of
contracts is the most important source of both historical stagnation and
contemporary underdevelopment in the third world.”
139
How is transaction cost economics relevant?
Globalization and Market liberalization

industrialization of and government
world agriculture devolution
Increasing reliance on vertical linkages, long-

term contracts, and coordinated relationships
140
Characteristics of rural agricultural-

agricultural- economy in developing countries:
• S ll farmers
Small f andd traders
t d facef high
hi h ttransaction
ti costs
t resulting
lti ini thin
thi
markets
• Market failure in the provision of credit, inputs, and services in remote

areas
• Incomplete or imperfect land and labor markets
141
 The transaction costs literature will be important in:
• Explaining the choice of contracts between different market

participants
• Analyzing
A l i the th type
t off institutional
i tit ti l innovation
i ti neededd d to
t integrate
i t t
small farmers and the poor in the new agricultural economy
• Understanding the role of the government and the private sector in

supporting the development of these institutions
142
8.3. Opportunism in contractual relations…
A ((unassisted market))
h=0
B (unrelieved hazard)
s=0
h>0 C (credible commitment)
s>0 Market safeguard
D (integration)
143
A simple contracting schema (Williamson, 2000: 602)
8.3 Opportunism in contractual relations…
 A contract is an agreement between a buyer and a supplier in which the terms of
exchange are defined by a triple: price, asset specificity and safeguards, where
quality, quantity and duration are specified (Williamson, 1996, p.377).
 Long terms contracts are complex and incomplete and their enforcement cost
could be higher, the source of incompleteness being ‘bounded rationality’,
where we find limited cognitive competence to store and process information.
information
 “Contractual incompleteness poses added problems when paired with the

condition
di i off opportunism—which
i hi h manifests
if iitself
lf as adverse
d selection,
l i morall
hazard, shirking and other forms of strategic behavior” (Williamson 2000,
p.601).
 The basis for opportunism is information asymmetry where self self--interested

individuals will not readily disclose information about their preferences
144
8.3 Opportunism in contractual relations…
 In which form of contract is opportunism a problem?

 Markets - short term contracts ((instantaneous)) where identity

y is irrelevant
since a transacting party can go its own way at negligible cost to the other.
 Hierarchy - Transactions that are placed under unified ownership (buyer

and supplier are in the same enterprise) and subject to administrative
controls (an authority relation, to include fiat) are managed by hierarchy.
The contract law of hierarchy is that of forbearance, according to which
internal organization is its own court of ultimate appeal.
 Hybrid - Long
Long--term contractual relations that preserve autonomy but
provide added transaction-
transaction-specific safeguards, compared with the market.
 Hybrid contracts and hierarchy emerge as asset specificity builds up and

identity matters.
145
8.4 Factors affecting effectiveness of contracts
 Asset specificity A specialized investment that cannot be redeployed to

alternative uses or by alternative users except at a loss of productive value.
A t specificity
Asset ifi it can take
t k severall forms,
f off which
hi h human,
h physical,
h i l site,
it
and dedicated assets are the most common. Specific assets give rise to
bilateral dependency, which complicates contractual relations.
 Safeguard The added security features, if any, that are introduced into a
contract in order to reduce hazards (due mainly to asset specificity) and to
create confidence. Safeguards can take the form of penalties, a reduction in
incentive intensity, and/ or more fully developed private
private--ordering apparatus
to deal with contingencies.
 Extent of Using Private ordering The self- self-created mechanisms to

accomplish
li h adaptive,
d ti sequential ti l ddecision
i i making
ki between
b t autonomous
t
parties to a contract, including informa-tion disclosure, dispute settlement,
and distributional mechanisms to deal with gaps, errors, omissions, and
inequities.
 Question:: What other features affect contractual relations?

Question 146
8.5. Determinants of transaction costs
 Five dimensions affecting transaction costs:
 1. specificity – transactions requiring specific investments create high TC

as contractors anticipate the problem of ‘hold-
‘hold-up’ once investment is made
(e.g. a contractual relation between output supplier and a processer
investing in processing equipment);
 2. uncertaintyy and complexity-

complexity
p y- uncertainty
y increases the costs of
establishing how participants should behave as transactional variables
(clients, technology and supply) change;
 3. frequency and duration – high frequency entails low average transaction

cost as marginal transaction costs are decreasing; the longer the duration,
the higher
g the transaction cost will be since longer
g terms involve a detailed
negotiation.
147
8.5. Determinants
ete a ts of
o transaction
t a sact o costs…
 4. measurement or search cost – the extent to which we measure

transactions determine the cost (e.g. a tractor owner cultivating land and a
lawyer negotiating a case where the latter involves higher degree of
opportunism)
 5. connectedness – interdependent transactions are more costly than

independent ones as the former involves greater efforts in coordination of
detailed relationships; however, perfectly connected activities could reduce
transaction costs (e.g. a building project for a warehouse)
 Question:: Do you expect possible interaction among these five

Question
 determinants of transaction costs?
costs?
148
8.6 Contract farming
 Contract farming - an agreement between a buyer and farmers establishing
conditions for the production and marketing of a farm product or products;
 A farmer agrees to provide established quantities of a specific product,

meeting the quality standards and delivery schedule set by the purchaser.
 I turn, the
In h buyer
b commits
i to purchase
h the
h product,
d often
f at a pre-
pre-
determined price.
price.
 Th buyer
The b could
ld also
l commit it to
t supportt production
d ti through
th h supplying
l i farm
f
inputs, land preparation, providing technical advice and arranging transport
of produce to the buyer’s premises.
 Contract farming as a way to cut transaction costs and include small

farmers in high
high--value markets
149
8.6 Contract farming…
 Some case studies (Simmons et al., 2005; other sources) indicate that:
Contracts could increase return to capital;
Farm size, education and participation in farm groups as determinants of

the
h effectiveness
ff i off contracts;
 Group work: After reading the case study by Simmons et al. (2005) try to
answer the following questions;
1. What are the conditions that make contract farming sustainable and
beneficial to small and poor farmers?
2. What is the role of the government in improving those conditions? 150

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CAEC 510 Institutional and

Lectures, Collaborative M.Sc. Course in

1. Familiarise students with agricultural and rural development challenges

2. Ensure that students understand the various elements of the NIE

Students capacity to analyze and synthesize (using specific case of own

 Objective: By the end of this chapter, students will be

One of the most underlying challenge in African agricultural sector is

Agriculture has to fulfill the following requirements to be sustainable:

 B) Social sustainability - improve the economic well-

 C) Fiscal sustainability – possibility to observe cost recovery

 D) Institutional sustainability - robust and capable institutions that can

 E) Environmental sustainability – reduce to manageable levels agricultural 5

pollution of water sources and degradation of soils

Absence of markets due to low purchasing power in the domestic market;

Weak and difficult contract enforcement resulting in high transaction costs;

Land tenure arrangements undermining possibility to borrow

Discrimination against women (access to land and financial services)

Failure of credit and insurance markets

Discontinuous switch between technologies and crops

Using significant shares of outputs for subsistence

Relative water scarcity and environmental degradation

Poor animal health service systems

Historical legacies (colonial exploitation, manipulation by the superpower)

Fragile and weak states, induced by development aid from developed

Product safety standards set by WTO member countries to exploit

Figure: Indices of agricultural performance (Bromley, 2008:545) 10

 Later, state role in providing public goods considered essential to

 Failure of both market and state-

Source: Dorward et al., 2009:16-18

• Zero transaction costs and Perfect information

• Resource Scarcity and competition

• Institutions are given and do not matter in the economic analysis

 No commonly agreed upon definition

 Basic premise: Institutions matter for economic

 Purpose is to explain the determinants of

A set of formal and informal rules of conduct that facilitate

Historically, the role of formal institutions in facilitating

 Formal institutions are the constitutional

 Players are economic (firms), political

 Informal institutions are the norms of a society, which also set

 Informal institutions allow pplayers

 Open and Kinship systems of information and enforcement

 Players dependent on informal institutions may arise when

 Economic institutions form part of,

 Institutions are a structural feature of the society or polity.

 Stable over time (speed of change).

 They must pose constraints and affect individual behavior of

 Institutions change through time where the pace of change

 Adam Smith said that the p

 Specialization will be useful only if there is an

 Level of transaction costs however depend on

 Institutions with rules that encourage perverse incentives lead to

 Emerged as the protest against methodological individualism

 Emphasized importance of institutions but lacked rigorous and

 Concerned more with description of institutions

 Whyy is it called “New”?

 To distinguish it from the “old” institutionalist school (Veblen,

 Coase R. (1937) “The Nature of

 Williamson O. (1971) coins the

 Ostrom , E. (1990). “Governing

(ISNIE) established in 1997.

The purpose of NIE:

1 Explain (opposed to describe) the determinants of institutions and analyze