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Theme 1 - Introduction IBC & Institutional Contextual PerspectivesArticle 1.1 (1) - North (1991) - Institutions
Institutions = the humanly devised constraints that structure political, economic and social interaction.
They consist of both informal constraints and formal rules. Institutions have been devised by human
beings to create order and reduce uncertainty of exchange.
The purpose of this article is to elaborate on the role of institutions in the performance of economies
and illustrate the analysis from economic history.
Gradually, trade expands beyond the village, to bazaar-like economies, and eventually to the rest of
the world. This shows the importance of resources in order to define and enforce trade agreements. In
small villages, trade exists in a social network of informal constraints that facilitates local exchange,
and the transaction costs are low. As trade expands beyond a village, the possibilities for conflicts
grow. The size of the markets grows and transaction costs increase sharply because the dense social
network is replaced. Hence, more resources must be devoted to measurement and enforcement. The
development of long-distance trade requires a sharp break in the characteristics of an economic
structure. Geographic specialization begins to emerge as major characteristics and some
occupational specialization are occurring as well.
The growth of long-distance trade poses two distinct transaction cost problems:
1. The problem of the agency; where a sedentary merchant would send a relative with the cargo
to negotiate.
2. Contract negotiation and enforce in parts of the world where there is no easily available way
to achieve agreement and enforcement contracts.
In every system of exchange, economic actors have an incentive to invest their time, resources, and
energy in knowledge and skills that will improve their material status. However, in some primitive
institutional settings, the kind of knowledge and skills that will pay off will not result in institutional
evolution towards more productive economies. There are 3 types of primitive exchange:
1. Tribal society
Exchange in a tribal society relies on a dense social network and are governed by the
balance of power. The group is always endangered and tries to secure its own position.
Deviance and innovation are viewed as threats to group survival.
2. The regional economy with bazaar trading
1) High measurement costs
2) The continuous effort at clientization (development of repeat-exchange relationships
with partners)
3) Intensive bargaining at every margin
What is missing are the fundamental underpinnings of institutions that would make voluntary
organisations viable and profitable.
3. Long-distance caravan trade
The informal constraints that made trade possible in a world where protection was essential
and no organized state existed. While tribal chieftains found it profitable to protect merchant
caravans they had neither the military muscle nor the political structure to extend, develop,
and enforce more permanent property rights.
The long-distance trade eventually led to the rise of the Western world. Innovations that lowered
transaction costs consisted of organizational changes, instruments and specific techniques and
enforcement characteristics that lowered the costs of engaging in the exchange over long-distances.
1. Innovations that increased the mobility of capital were the techniques and methods evolved to
evade usury laws.
, 2. Innovations that lowered transaction costs, and mainly the bill of exchange and particularly
the development of techniques and instruments that allowed for its negotiability as well for the
development of discounting methods.
3. Innovations that spread risks
These specific innovations and particular institutional instruments evolved from the interplay between
two fundamental economic forces; the economies of scale associated with a growing volume of trade,
and the development of improved mechanisms to enforce contracts at lower costs.
The institutional context of Western Europe differs from the other illustrations as there is competition
among the fragmented European political units accentuated by changing military technology which
forced rules to seek more revenue in order to survive. However, there are 3 other reasons:
1. Political competition in early Europe was more acute than in other parts of the world
2. The relationship between the basic institutional framework, the consequent organizational
structure and institutional change
3. The path-dependent nature of economic change is a consequence of the increasing return
characteristic of an institutional framework
Path dependency: organizations owe their existence to the opportunities provided by the formal and
informal institutional framework. Differing opportunity sets lead to different historical paths.
,Article 1.2 (2) - Williamson (2000) - New Institutional Economics
New Institutional Economics (NIE) = an economic perspective that attempts to extend economics by
focusing on the social and legal norms and rules (institutions) that underlie economic activity and with
analysis beyond earlier institutional economics and neoclassical economics. The NIE states two
propositions:
1. Institutions do matter
2. The determinants of institutions are susceptible to analysis by the tools of economic theory
The NIE has grown in stature and influence. It has progressed not by advancing an overarching
theory but by uncovering and explicating the microanalytic features and by pilling block upon block
until the cumulative value-added cannot be denied. It will be useful for the purposes of perspective to
consider the four levels of social analysis.
→ The solid arrows signify that higher level imposes constraints on the level immediately below.
→ The dashed arrow signify feedback to the level immediately above
The NIE has four levels:
1. Embeddedness level = informal level (cultural): help define the nature of the firm
- Social theory approach
- Informal rules of the game
- The level where the norms, customers, mores, traditions are located
- Institutions at this level have a lasting grip on the way society conducts itself and therefore
these institutions at this level change very slowly
- Change happens over centuries or millennia
2. Institutional environment = formal level: help define and is defined by the nature of the market
organization
- Positive Political Theory or Economic of Property Rights Approach: concerned with working
out the economic and political complications of level two features. The goal is to better
understand how things work.
- Property Rights Reasoning system: system to define property rights and arbitrate disputes is
necessary. However, it is going beyond the rules of the game to include contracts because
this leads to level 3.
- Formal rules of the game
- Design instruments: executive, legislative, judicial, and bureaucratic functions of government
, - Important features: definition and enforcement of property rights and contract laws
- Change happens over decades or centuries
3. Governance level = Play of the game: connected to authoritative coordination and control
systems
- Location of institutions of governance
- Focus of analysis: governance of contractual relations
- Change happens over years or decades
- Transaction Cost Economics approach: transaction is the basic unit of analysis, but the
governance is an effort to craft order. Thereby to mitigate conflicts and realise mutual gains.
This entails 4 moves:
1) To name and explicate the principal dimensions with respect to different transactions
2) Name and explicate the principal attributes for describing governance structures
3) Effect a discriminating match, according to which transactions are aligned with
governance structures
4) Ascertain whether the predicted alignments are corroborated by the data
4. Resource allocation and employment level = Corporate level
- Neoclassical Economics and Agency Theory
- The firm is typically described as a production function
- Adjustment to prices and output occurs continuously
- Change happens continuously
The four levels influence each other; informal institutions influence the formal rules of society, which in
turn influence how the rules of the game are made. which in turn govern the demand and supply of
firms. However, it is empirically difficult to measure the multiple levels. The NIE is primarily concerned
with levels 2 and 3.
Williamson addresses good key ideas associated with the NIE:
● Human actors
Social scientists should be prepared to name the key attributes of human actors. Both the
condition of cognition and self-interestedness need to be addressed. Also, given cognitive
limits, the complex contracts are unavoidably incomplete. Therefore, contracts have to be
supported by credible commitments. Contractual parties that look ahead and recognize
potential hazards will work out contractual ramifications. These parties will enjoy advantages
over parties that do not look ahead or simply take their chances.
● Feasibility
All possible forms of organization are flawed. In order to overcome this problem, the
asymmetric state of affairs needs to be corrected. The extant mode of organisations for which
no superior feasible alternative can be described and implemented with expected net gains is
resumed to be efficient. Public policy needs to display a superior feasible alternative.
● Firms and bureaus
It is important to address and acknowledge the theory of the firm. All firms have an internal
structure and this has risen for some reason. There is a need to identify and explicate the
properties of alternative modes of governance whihc differ in discrete structural ways. The
choice of a governance structure moves from market to hierarchy through a sequence of
moves as shown in the image below (s = safeguards, h = hazards)
→ Starting point is autonomous contracting, which is the ideal transaction in both law and
economics. The discrete transaction paradigm comes under strain as contractual hazards
appear. Such hazards comprise contractual integrity and give rise to impasses,
maladaptations and distortions. Moving forward to more complex governance structures
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