Introductory lecture for course

Institutions, Behaviour and

Welfare

Dr. Maarten Vendrik

20-04-2011
Aim of course
 Introduction into New Institutional Economics (NIE)

 Rather recent development in microeconomics since 1960s

 Nobel prize of 2009 for new-institutional economists: Oliver

Williamson and Elinor Ostrom

 Institutions always important subject in economics, but new in

NIE as compared to ‘old’ institutional economics:
 emphasis on firm theoretical foundation and analytical models
 systematic and structured like neoclassical economics (NCE)

 However, less rigorous and formal than NCE and themes

essentially different
Contents

 New Institutional Economics as compared to

neoclassical economics

 Example: financial crisis

 Some basic concepts and relations

 Examples of Internet and pirates

 Mandatory literature and organization of learning

1. New Institutional Economics
versus neoclassical economics
 Central message of New Institutional Economics (NIE):
institutions have an important impact on economic performance

 Recognized by classical economists like Adam Smith and even

by founding father of neoclassical economics Marshall

 However, standard neoclassical (micro) economics abstracts

from institutions:
Different institutional arrangements merely alternative means to
reach Pareto-efficient outcomes
Conditions for Pareto-efficiency apply equally to capitalististic,
socialistic, or any other kind of economic system 
microeconomics institutionally neutral
Simplifications in neoclassical
economics
 Simplification  clear insight into basic mechanisms and
efficiency of allocation of economic resources

 However, (implicit) assumptions of

 perfect information and foresight
 zero transaction costs
unrealistic ánd consequential

 E.g. asymmetric info (intermediate microeconomics course) 

complications  only second-best allocation possible

 Already recognized by “old” institutional economists,

but also against abstract formal reasoning 
rather descriptive
Basic themes of NIE
 Since 1960s: NIE: emphasis on solid theoretical
foundation and analytical reasoning and modeling

 Basic themes of NIE:

 Effects and development of institutions (Sessions 2, 8)
 Impact of transaction costs (Session 3)
 Effects and emergence of property rights (Sessions 4, 5)
 Effects and rationales of various forms of contracts
(Sessions 6, 7)
 Effects and development of various forms of organization
(Sessions 9-11)
2. Example: financial crisis
 Started in market for mortgages for houses in USA

 Problems:
 Mortgages given to people with too low incomes
 Mortgages high relative to value of house

 How could this happen?

 Booming economy  underestimation of risks when economy would fall back 
imperfect foresight (theme of NIE)

 Borrowers less knowledgeable about risks than lenders  asymmetric

information (NIE)

 Lenders could sell risks by bundling mortgages with other mortgages in financial
products and selling these products to banks 
further bundling and selling to other banks and investors worldwide 
real value of products unclear  imperfect information (NIE)
Too much risk taking by banks
 Booming economy  too much confidence in value of financial products and
their reliability 
too much trust (NIE)  too low transaction costs (NIE) 
too smooth transactions (NIE)

 Why did banks take so much risks in buying financial products with
unclear value?
 Asymmetric performance pay schedules (NIE) for bank employees:
high bonus for good performance, but government support in case of failure (too
big too fail)

 Insufficient laws and regulatory rules that constrain too risky lending and
insufficiently enforced by sanctions from courts and supervisors =
formal institutions (NIE)

 Deficient ethical norms and professional codes (e.g. honouring and protecting
long-run interests of clients) and insufficiently enforced by sanctions of loss of
reputation or feelings of guilt = informal institutions (NIE)
Chain reactions and lack of trust
 In 2008 collapse of mortgage market in USA
 fall in value of related financial products 
spread to whole banking sector 
solvency problems of banks 
big banks rescued by governments 
huge budget deficits of governments 
creditworthiness problems of Iceland, Greece, Ireland, Portugal,
Spain 
rescued by other Euro countries because of banks involved  ?

 General problem: too little trust (among banks, investors,

consumers; NIE)  too high transaction costs (NIE) 
too sticky transactions (NIE)
See book of Akerlof and Shimer, Animal Spirits, 2009!
3. Institutions: definition
 What are institutions?

 NIE: institutions = rules of the “game” =

sets of formal and informal rules that govern economic and social
interactions of people in society,
including enforcement arrangements

 Formal institutions: e.g., laws, formal organizational rules

Informal institutions: e.g., customs, social norms, habits, informal
organizational rules

 Institutions ≠ concrete organizations like firm or university, but

= rules of the game without the players 
institutions + people using them = organization
Functions of institutions
 Institutions:
 steer individual behaviour in a particular direction 
 provide structure to everyday activity
 reduce uncertainty in human relations
 simplify decision making
 promote cooperation among human agents

 Formal and informal institutions both important and reinforce

each other’s effect

 Hence, Obama promotes informal norms in addition to formal

regulation!
4. Transaction costs
 Costs of running the system (Arrow) like costs of:
 search for information
 bargaining
 making contracts
 monitoring and enforcing contracts

 Before financial crisis: transaction costs too low

In crisis: transaction costs too high

 NCE: no frictions in economic transactions 

transaction costs = 0 
 No institutions needed to reduce transaction costs
 No firms of more than one person to economize on market transaction costs
Transaction costs in crisis
 Implication: economy before crisis close to neo-classical ideal?

 Not really, as market failures like

 Asymmetric info in mortgage market
 Imperfect info and foresight wrt risks and values of financial products
 Moral hazard in banking sector

  Welfare losses, especially in the long run in crisis

also counted as transaction costs in NIE! 
Market failures before crisis contributed to huge transaction
costs in crisis!
5. Property rights
 NCE: it does not matter who owns what.

 However, in the real world it does matter a lot!

 Example:
 Care and effort you spend on your apartment or house
strongly depends on whether you own or rent it!
 This has strong effect on value of apartment/ house!
6. Example: effects of Internet
and e-commerce
 Themes of transaction costs and property rights
especially salient in modern developments of Internet
and e-commerce 
promises huge saving on transaction costs in markets
 nearer to NCE ideal of perfect markets?

 However, also more time spent on search 

net effect decrease or increase in transaction costs?

 Free dissemination of info by the Internet 

protection and rewarding of intellectual property
rights more difficult  higher transaction costs!
7. Contracts
 Property rights transferred in contracts

 Example: labour contract 

right of employer to gain benefits from labour of employee
in exchange for right of employee to receive wage from
employer

 Problems in making and enforcing contracts:

 conflicting interests
 information imperfect and costly and limited capacity to process
information (= bounded rationality) 
 contracts incomplete and asymmetric information 
 room for opportunistic behaviour  moral hazard and adverse
selection 
 transaction costs of monitoring and welfare losses (agency
costs)
Contracts, organizations and
development of countries
 Problems can be overcome by trust, cooperation and shared social
norms between contract partners (informal institutions)

 Contracts form building stones of markets and other forms of

organizations like firms and the state

 Contracts shape incentives within such organizations

 Organizations form institutional systems.

 Ways in which institutional systems are organized crucial

determinants of success or failure in economic development of
countries 
explanation why some countries are still underdeveloped
(Session 11)
8. Example: pirate economics
 In developed countries most institutions followed by most citizens

 Exceptions: gangsters and pirates

 However, within these groups strong institutions, informal, but also

formal, e.g.
 Maffia (Godfather movies)
 Pirates: see chapter for tomorrow

 Pirates:
 Becoming a pirate rational decision as better treated by captain and more
democracy

 Democratic decisions on where to steal treasure and unanimous decisions on

pirate constitutions = contracts 
institutions supported by crew  self-enforcing  less need for sanctions
Institutions of pirates
 Bloodshed = transaction costs minimized by threat of no mercy
in case of resistance, symbolized by skull-and-crossbones or red
flag and supported by reputation of strict observance

 Quartermaster in charge of distribution of food and loot =

institution to limit power of captain

 Cooperation with national governments to attack ships of

enemy countries

 Cooperation between pirates, e.g.

 In golden age of piracy (1630-1730) fleets of pirate ships
 Election of pirate king in international gathering of pirates, following
large pirate constitution (Pirates of the Caribbean movie)
http://www.youtube.com/watch?v=0y98M
MmexMo&feature=BFa&list=PL1F187DA52
E3ED6CE&index=14
9. Mandatory literature I
 Problem: no good textbook on NIE on intermediate level

 1st year book:

Groenewegen, Spithoven en Van de Berg (2010), Institutional Economics:
An introduction
Too superficial for you

 Book on graduate level:

Furubotn & Richter (2005), Institutions and Economic Theory: The
Contributions of the New Institutional Economics, 2nd ed.: too detailed 

 Mandatory literature not nice textbook with bullet points, lists of key
concepts and summaries at end of chapters, as in previous blocks, but:
Mandatory literature II
 Introductory chapter from Groenewegen, Spithoven en Van de
Berg

 Sections from Furubotn & Richter

 Articles from scientific journals and chapters from other books

 Copies of section of F&R and some chapters from copyshop (CS

in blockbook)

 Articles and other chapters from Eleum, Course Material,

Learning Resources (LR in blockbook)
Mandatory literature III
 Sections from F&R give good overviews of basic concepts and basic
theories

 Clearly written, but rather detailed and sophisticated  try to distil main
points and thread from them

 Most articles easier to read, some of them demanding

Also here: focus on main points and thread
You have to learn this anyhow in your academic study!

 If you don’t understand an argument, post question on that on Eleum

 6 lectures are meant to

 clarify basic concepts and structure of subject area and to explain unclear
relations
 indicate what are main concepts, ideas and theories that you should understand
and learn for exam
Organization of learning
1. Short introduction to mandatory literature of each session in blockbook
with some indication of main and difficult points

2. When reading mandatory literature assess yourself what are main points.

3. In tutorial session presentation surveys main points and tutor takes care
that discussion sufficiently covers important and difficult points.

4. Survey lecture indicates main points to understand and learn for exam.

5. Look at old exam (Eleum, Course Material) for kind and level of exam
questions

6. Should give you enough guiding in studying for exam.

Additional material for
presentation
 Additional literature for presentation
 sometimes indicated in blockbook
 in Learning Resources on Eleum
 in books on study landscape

 However, nicer to find additional

cases/examples from Internet, newspapers,
magazines, previous courses or your own
experience.
Already start to collect this at beginning of
block!
Evaluation
 Final mark for course based on three components:

1. Presentation of mandatory material and additional

material and performance as session manager
(25%):
2/3 of grade for content and 1/3 for form
2/3 for mandatory part and 1/3 for additional part

2. Overall participation,incl. posting questions (25%):

+ (good/sufficient), 0 (dubious) or – (insufficient) for
each session

3. Written exam (50%), at least 5

 Thank you!