For fourth Year Students

Chapter 3: Demand for Institutions

3.1. The Role of Transaction Costs

The concept of transaction costs is the foundation of New Institutional Economics. Coase (1937)
in “The Nature of the Firm”: There is a cost to using the price system for coordinating supply
and demand: transaction costs. A firm will exist as long as it can perform a coordinating function
that is lower than the market or lower than another firm. Basic premise: Institutions matter for
economic performance. The purpose of NIE is to explain the determinants of institutions and
their evolution over time, and to evaluate their impact on economic performance, efficiency and
distribution. No commonly agreed upon definition.

What are Institutions? A set of formal and informal rules of conduct that facilitate coordination
or govern relationships between individuals. Why is it called “New”? To distinguish it from the
“old” institutionalist school (Veblen, Commons). NIE operates within the framework of neo-
classical economics, but it relaxes some of its assumptions and incorporates institutions as an
additional constraint. Economic activities are embedded in a framework of institutions, formal
& informal. NIE is a useful tool to address policy issues in developing countries because:
Frequent occurrence of market failure & incomplete or imperfect markets.

Many of the formal rules of behavior that are taken for granted in developed economies do not
exist in developing countries. Transaction cost economics: Defining transaction costs: Cost of
screening and selecting a buyer or seller, Cost of obtaining information on the good or service,
Cost of bargaining & negotiating a contract, Cost of monitoring & enforcing the contract. Coase
(1937): Market exchange is not costless. Firms emerge to economize on transaction costs.
Boundary of the firm determined by nature and extent of transaction costs. Williamson (1996,
2000): Combines the concepts of bounded rationality & opportunistic behavior to explain
contracts & ownership structure of firms. Continuum of organizational form (from vertical
integration to cash markets) that depends largely on the magnitude of transaction costs.

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North (1986, 1989, and 1994): Institutions that evolve to reduce transaction costs are key to the
performance of economies. Not all institutions that emerge are efficient. Role of government is
crucial in specifying property rights and enforcing contracts. North (1990): “The inability of
societies to develop effective, low-cost enforcement of contracts is the most important source of
both historical stagnation and contemporary underdevelopment in the third world.”

How transaction is cost economics relevant?. Globalization & industrialization of world

agriculture. Market liberalization & government devolution increasing reliance on vertical
linkages, long-term contracts, and coordinated relationships. Characteristics of rural agricultural-
economy in developing countries: Small farmers and traders face high transaction costs resulting
in thin markets. Market failure in the provision of credit, inputs, and services in remote areas.
Incomplete or imperfect land and labor markets.

The transaction costs literature will be important in explaining the choice of contracts between
different market participants. Analyzing the type of institutional innovation needed to integrate
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.

Example 1: Contract farming: Contract farming as a way to cut transaction costs and include
small farmers in high-value markets (Minot 1986, Delgado 1999). What are the conditions that
make contract farming sustainable and beneficial to small and poor farmers? What is the role of
the government in improving those conditions?

Example 2: Grades & standards: Increasing demand for safe, healthy, and high-quality food in
the industrialized countries are changing the nature of international grades & standards
(Kherallah, 2000). How can developing countries respond? Do grades and standards act as a
barrier to trade to small farmers or do they create an opportunity to enter high-value produce
markets?

Example 3: Transaction costs and traders behavior: How do traders respond to high transaction
costs in terms of screening for trust-worthy partners, obtaining information, and enforcing
contracts? (Gabre-Madhin, 1998). Is the institutional response of traders efficient? What is the

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role of the government to cut down on transaction costs and decrease the riskiness of market
exchange?

Weaknesses & limitations of transaction cost economics: Better at describing behavior &
providing diagnosis than at predicting outcomes or prescribing cures, measuring transaction costs
is difficult, poor modeling of risk & uncertainty, no unified framework or theory and still very
ignorant about institutions.

Social Capital: Isn’t “standard” economics enough? What is social capital? How does it
operate? A need to extend the models economists use and to incorporate findings from other
fields in fact already exist many examples.

Definition of Social Capital: “ 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). “Includes the social and
political environment that enables norms to develop and shapes social structure.

Includes the more formalized institutional relationships and structures, such as government, the
political regime, the rule of law, the court system , 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). Norms, networks, trust, coordination, cooperation, individual/household,
local/community, national, international and private versus public good.

How is social capital hypothesized to work? It lowers transactions costs of exchange,

improved diffusion of information and innovations, strengthens informal insurance mechanisms,
increases the probability of trust-sensitive exchanges being made, improves local authority
performance by drawing them into networks. Social? Capital? Is it Social? Social in sense of
society. But this does not necessarily mean public good. Is it Capital? Analogy to other forms of
capital useful. Don’t push too hard on this, especially distinction between stocks and flows.

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How is social capital quantified (at “micro” level)? Contacts & other network measures, group
membership (and characteristics), degree of civic engagement and/or responsibility, strength of
family networks, trust measures, (absence of violence).

Social capital: problems to bear in mind: Exclusionary aspects, If it’s who you know, how did
you get to know them? May be particularly true for the poor, endogeneity, measurement is
difficult; it can have negative externality effects.

3.2. Interdependence between Transaction Costs and Institutions

The concept of transaction costs is the foundation of New Institutional Economics. The idea is
costs of transactions determine what goods and services are produced and the capacity of any
economy to take advantage of the division of labor and specialization-the two key concepts of
economic theory since Adam Smith. Thus, transaction costs profoundly influence not just
individual firms but the size and activities of the entire economy. But in addition to the concept
of transaction costs, two other concepts are also central to NIE: the concepts of property rights
and contracts. Presence of transaction cost is in fact the foundation of institution al economics.

The institutions and rules which govern how markets work (the “rules of the game”, in the
terminology of Douglass North) may also be adapted and refined so as to reduce transaction
costs. Transaction cost theory derives from the “New Institutional Economics” approach and
focuses on institutions of governance. Institutions of governance refer to modes of managing
transactions and include market, quasi-market, and hierarchical modes of contracting. It is based
on the premise that institutions are transaction cost-minimizing arrangements, which may change
and evolve with changes in the nature and sources of transaction costs (Coase, 1937; Williamson,
1985). The most obvious example of this is the introduction of standard weights and measures
and quality standards which make it easier for products to be directly compared. The creation of
“market-places” in which buyers and sellers of specific products assemble at known times and
places is another obvious institutional mechanism for reducing search costs.

There are also more complex informal rules and codes of conduct which govern how
negotiations may be closed and contracts enforced within particular types of markets or amongst
specific societies or groups of people. Specifically, where established codes of conduct serve to
create increased trust, transaction costs are seen to fall considerably and this may be a key
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explanatory factor for why markets grow faster within certain societies and locations. Efficient
institutions are the ones that diminish uncertainty in inter-human relations or, in the terms of neo-
institutional analysis, they diminish transaction costs.

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Chapter 4: Measurement of Transaction Costs

There are a number of fundamental issues relating to transaction cost measurement, which
underlie the subsequent discussions of typology, chronology, and measurement methodologies.
These can be grouped as: (1) integrating transaction costs in policy analysis; (2) defining
transaction costs; (3) the effect of time on transaction costs; and (4) the tradeoff between
precision and measurement cost.

1. Integrating Transaction Costs in Policy Analysis

Transaction costs need to be measured within a larger framework of the overall costs and
benefits of a proposed policy. Many transaction cost measurement studies have implicitly or
explicitly assumed that the benefits provided by different policies are similar so that a cost-
effectiveness framework is sufficient.

This may not always be the case. For some policies, there is a much broader range of benefits
than the other policies examined. It is rarely the case that the types and levels of benefits are the
same for all the options, so a full cost–benefit analysis is desirable. It is essential to make a
distinction between decreasing transaction costs and increasing efficiency for a number of
reasons.

A policy should not be rejected due to high transaction costs alone since there may be tradeoffs
between transaction costs and other types of costs. Some policies with low abatement/decline
costs may have higher transaction costs. Transaction costs also need to be viewed in the context
of what costs would be incurred in the absence of the policy being evaluated.

2. Defining Transaction Costs

Measurement of transaction costs forces examination of what is and is not a transaction cost.
Transaction cost measurement also requires researchers to look at the reality of how policy is
made and implemented. Kuperan et al. (1998) demonstrate the importance of detailed
knowledge of the political and natural resource system to ensure that all costs are accounted for.
Such knowledge allowed them to recognize that the government is involved at many different
stages with respect to both central management and co-management of a fishery. There are

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numerous definitions of transaction costs and inconsistencies among them that confound the
development of consistent transaction cost measures.

A very narrow definition was used by Demsetz (1968): Transaction cost may be defined as the
cost of exchanging ownership titles, while Barzel (1985) used the somewhat broader costs of
effecting exchange. Gordon (1994) defines transaction costs as the expenses of organizing and
participating in a market or implementing a government policy. Coase (1960) uses the phrase
the cost of carrying out market transactions to refer to interactions between firms or between
individuals and firms.

Coase refers to administrative costs when the resolution of the externality comes about within a
firm or by government regulation. Allen (1991) presents a definition that, while designed to be
generally applicable, is particularly well suited to environmental and natural resource policies
since many market failure issues stem from incomplete property rights: Transaction costs are the
resources used to establish and maintain property rights. They include the resources used to
protect and capture (appropriate without permission) property rights, plus any deadweight costs
that result from potential or real protecting and capturing.

Some of these costs may represent lost opportunities for productive innovations since human
competence is scarce (Eliasson, 1996). North (1984) indicates that measuring valued attributes
embodied in a good, such as an orange, is costly. Therefore, a broader definition is used in this
paper: transaction costs are the resources used to define, establish, maintain, and transfer
property rights. There are a number of issues that relate to the boundaries of transaction costs and
their measurement, which are illustrated in
the following fig.

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Fig4.1: Boundary issues relating to transaction costs

4.1. The Effect of Time on Transaction Costs

Transaction costs consist of both ex-ante and ex-post costs-those occurring before and after the
actual transaction. Falconer et al. (2001) have pointed out that transaction costs vary over the
life cycle of a program. They may decrease with time due to learning, similar to the literature
on learning by doing in manufacturing (Arrow, 1962), and to the presence of fixed or sunk costs,
which are incurred primarily at the beginning of a program.

Existing institutional arrangements and policies may lower the costs of one program relative to
another (OECD, 2001). History matters, in that an efficient new policy may appear to be more
costly than a less efficient program that was set up long ago. In another setting, where there is
no existing policy, it may be less costly to adopt the more efficient policy. There are tradeoffs
among costs over time. Therefore, the time period covered by the analysis and the discount rate
used become important. For instance, a policy/program might incur high initial transaction
costs as part of a broad stakeholder outreach and consensus-building process and have lower
litigation and noncompliance costs later (Egdell, 1998; Colby and Pearson d’Estree, 2000a,b).

4.2. Precision versus Measurement Cost

For the differing purposes of transaction cost measurement, how precise do our estimates need to
be? As an initial screening across policy instruments, rough borders of magnitude may be good
enough and would represent an improvement over current practice.

If these types of costs are to be used as evidence in court, as with nonmarket valuations of
natural resource damages, a much higher standard will be required. However, collecting detailed
data on transaction costs is difficult and costly. Different methodologies may be required for
these different uses. For example, if researchers only measured types of costs for which there is
abundant, reliable data and ignored other types of costs, the measured values would be biased.

The notion of “transaction costs” is taken from the field of transaction cost economics, a
theoretical development first pioneered by Ronald Coase in 1937 in the “The Nature of the Firm”

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and subsequently developed by Oliver Williamson, and by others working within the new
institutional economics tradition, such as David Teece.

Transaction costs economics place transaction in the center of economic production and
exchange activities. Transaction costs are defined as ‘the costs which allow an economic
transaction to take place but which add nothing to the value of the transaction’. These costs
arise due to the frictions involved in the exchange process as it entails transfer and enforcement
of property rights. At microeconomic level, transaction costs are considered a waste in economy.
Transaction costs represent “the difference between what a consumer pays and what a seller
gets”, a difference which is always positive.

Existence of transaction costs: TC are the costs that an actor bears in order to engage in
exchange (political, economic, social etc.). TC exist because information is costly to obtain as
well as due to “bound rationality”, cognitive limits and the opportunism (self-interested
individuals will not readily disclose the information about their preferences). They are
distinguished from the “production costs” which are essential for the creation of a product or the
provision of a service. They may be broken down into “search costs”, “bargaining and decision
costs” and “policing and enforcement costs”.

Search Costs The costs necessary for potential buyers and sellers to identify the
possibility of a mutually beneficial contract being established –
essentially the costs of market research.
Bargaining & Decision Costs The costs which need to be incurred in order to define a contract:
specifically the cost of negotiating mutually satisfactory terms and
conditions.
Policing & Enforcement Costs The costs which must be incurred in order for a contract to be
enforced: the cost of supervising the fulfillment of a contract and of
seeking legal redress in the case of non-fulfillment.

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4.3. Approaches of measuring transaction cost

4.3. 1. Ordinal and Cardinal Approaches

The notion of ‘transaction costs’ is best considered as a metaphor, rather than as a precise
measureable concept. Although transaction costs represent a real concept of demonstrable
importance to the structuring of markets and organizations and to the efficiency of operations,
this is not a concept which lends itself to easy measurement. This is in large part because
investments in ‘transaction activities’ may generate benefits as well as costs.

In principle, one may identify an inflection point in the ‘transaction cost curve’ where
investments begin to generate only net costs but identifying this point would in practice be
virtually impossible. For this and other practical reasons, any serious attempt to measure the
transaction costs is likely to be expensive but ultimately futile, and is not recommended.
Unfortunately, it is rarely possible to measure the costs of internal organization and the costs of
market contracting directly. As a result, we cannot estimate the parameters of the any structural
model directly.

We do not typically have good cardinal measures of the transactional attributes. Instead,
researchers frequently must rely on ordinal proxy variables to measure variations in the elements
of transaction cost attributes. So, empirical studies often rely on observations indicating
whether or not a relationship is governed by internal organization or market contract using
various proxies for variations in transaction related variables that are elements of transaction
costs such as asset specificity, complexity, uncertainty, and frequency of transactions or repeated
interaction.

Measuring variations in the importance of specific investments to support cost minimizing

exchange is difficult. In a number of cases survey data have been used to characterize the
importance of specific investments in supporting different groups of transactions within the set
that is being studied. In other cases efforts are made to develop ordinal characterizations of the
different types of asset specificity associated with specific sets of transactions within the groups.

Ideally, it would be desirable to identify attributes of the firms in the sample that are expected to
affect the costs of internal organization as well. Then the comparative costs of alternative

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governance arrangements could be captured directly. Variables that affect the costs of market
contracting are orthogonal to the variables that affect the costs of internal organization.

4.3.2. Two Traditions of Law

The two traditions of law are: Common law and. Continental Law

A. Common Law
The common law developed differently in its two main historical places: England and in the United
States. It is the part of English law that is derived from custom and judicial precedent/models/examples
rather that statute.

It is the body of law derived from judicial decisions of courts and similar tribunals. It is the British
legal system, and is now used in former British colonies, including the U.S.

It is sometimes referred to a “judge made law” since the law itself is not written down anywhere,
but is the product of judicial decisions, and in particular the decision of appellate courts in
resolving actual disputes between individuals, or between individuals and the state. In common
law countries one has to be aware that the courts have much more independent power than in
countries with the civil law system. The law was decided by the courts and it depended on the
tradition and the precedents of the specific courts.

Thus law was not a unit, but it was linked to the court that had the jurisdiction to decide on the
specific court order. According to the concept of common law, a right or obligation can only be
created by the judge and a sentence of the court. In common law countries the courts empowered
by the basic procedural rights will implement justice even though substantial rights may not be
given constitutional priority. In a common law country one has in addition to discern also the
jurisdiction of the courts and in particular to decide how conflicts among different court
jurisdictions have to be solved.

As in common law countries the courts are also law-makers, this distribution of court jurisdiction
is of central interest. Habeas corpus is considered to be the core of human rights in common law
countries. Common law is somewhat less restrictive than code law; that is, it generates less state
power. In contrast, legal codes are passed by legislatures and interpreted by judges. Thus, in
code countries judges are said to interpret the law, but not make it.

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The major difference is in the amount of deference/respect given to the state. A basic question
for law and economics is the efficiency of law. Friedrich Hayek (1960, 1973), argued that
common or judge made law was superior to statute law.

The argument was that common law was “bottom up” law, which began with judges and
individuals, while code law was “top down” and so paid more attention to the state and gave
more power to the state. The common law existed independently of the legislature or the
sovereign.

Hayek argued that common law provides more protection against predation by the state and leads
to more freedom than code or civil law. Paul Mahoney (2001) indicates that common law judges
have more autonomy/independent, and that government officials in code law countries are less
subject to legal controls than in common law countries.

Common law makes no distinction between private and public law. The same legal principles
apply to actions of government officials and private persons. More recently, Posner (1973/2003)
has of course argued often and forcefully that the common law is efficient.

The difficulty of this method is that often the conclusion regarding the efficiency of a particular
rule depends on unmeasured transactions costs of various sorts. His argument depended on utility
maximization by judges. The argument is that judges are so insulated from personal factors and
from interest group and other pressures that the only remaining decision factor is efficiency.

The only other candidate is income redistribution, and judges lack the tools needed for such
redistribution. Since this argument was unsatisfactory, scholars turned to evolutionary models to
try to explain efficiency. The evolutionary models are attempts to explain the form of legal
rules without resort to utility functions. Initially, these models aimed at explaining Posner’s
observation that the common law was efficient. However, inefficient laws can sometimes create
asymmetric stakes because the inefficiency means that there are deadweight losses than cannot
be bargained away in the settlement process.

That is, an inefficient rule creates a loss to one party that is greater than the gain to the other
because of future stakes in similar type cases. Michael Crew and Charlotte Twight (1990)
expanded on this point and found common lawless subject to rent seeking than statute law.
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Charles Rowley and Wayne Brough (1987) find that contract and property might be expected to
be efficient, but not tort/illegal act. There is less evidence on the efficiency of the common law
relative to code law then of the overall efficiency of a rule of law.

Nonetheless, Scully (1992) finds a significant relationship between protection of individual

liberties and the common law than in countries with a codified legal tradition. Common law
origin legal systems lead to significantly increased economic growth because they provide more
stable property rights and better contract enforcement.

B. Continental Law
The Continental system started with the French Revolution. Continental law system is the French
and German concepts, which with regard to administrative law and constitutional review have
developed somehow different administrative law principles. Constitutions are not only
conceived as instruments to limit governmental power, but they are also seen as the tools to set
up, organize and empower the governmental branches in order to establish the liberal state.

In the continent the main holder of sovereignty is the legislature as the only law maker. The court
is only the body that applies the law. The power to make the law has totally shifted from the
court to the legislature. Courts, which according to the continental law system can only quash
decisions, have no possibility to prohibit torture. In continental legal systems, federalism is
mainly designed along the legislature, while in the common law system federalism has to take
into account the division of sovereignty of the three traditional branches of government.

The continental view, that already statutes contain rights and obligations, is not familiar to the
common law tradition. Thus a human right may be a directive for the court in order to respect it
within its decision. However, it only an enforceable right if it has been decided by the court.
According to continental law, the statute not only limits the power of the administration, it also
empowers the administration.

As a result, absolutist Continental kings enjoyed unchecked power and interfered with relative
ease with private property rights, thus hampering the development of market relations based on
secure private property (North and Thomas, 1988).

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It has been claimed that both the lack of practice and doctrinal influences made Continental
judges more resistant to capitalist wealth accumulation and hindered their understanding of
market transactions.

Market relationships, with their considerable exposure to risk and striving for profit, were hardly
understood by a judiciary which derived most of its income and status from risk-free rents
(Taylor, 1967). Judicial respect for property rights also probably suffered because judgeships
were often expropriated by kings who were free to sell new judicial offices (Doyle, 1996; Swart,
1980). Thus, the judiciary on the Continent did not gradually erode the constraints of the Ancient
Regime.

Because of both institutional constraints and judicial training, civil law judges ended up
constituting a barrier to the development of new market relationships. Moreover, one has to be
aware that comparative analyses among different countries within the respective system may be
very different. Countries which adopted the continental system have established their own
specific statutes and laws which differ considerably from territory to territory.

In conclusion, the common law tradition sees law as an instrument only to limit state
government, whereas according to the Continental tradition, it limits but also empowers state
government. If the constitution is seen as an instrument not only to limit state power but also to
empower state agencies to change the society, it will have a different position with regard to
development and to a peace process.

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Chapter 5: Governance Structure

What is governance? It is understood as: 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). Or 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).

Government - the "exercise of influence and control, through law and coercion, over a political
community, constituted into a state within a defined territory” (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 accept by rules.

Espino (1999) defines governance structure as an organization’s internal rules devised to guide
its daily transactions. That is the interactions among individuals within the organization and its
relations with other organizations.

Governance structure: refer to the institutional framework within which the integrity of a
transaction is decided (Williamson, 1979). Markets and hierarchies are two of the main
alternatives. They are the institutional matrix within which transactions are negotiated and
executed and vary with the nature of the transaction. Governance structures which attenuate
opportunism and otherwise infuse confidence are evidently needed. Governance structures,
however, are properly regarded as part of the optimization problem. Williamson (1996)

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associates the concept of institutions with that of governance for micro analyses of the individual
transaction.

The institutional environment (rules of the game) is taken as granted, and the economic players
willfully align transactions with governance structures to optimize revenues. Thus, institutions
are governance mechanisms and their study is directly related with the optimum decision
regarding lower transaction costs.

Arrow (as Williamson, 1996,) defines transaction costs as “costs of running the economic
system”. In this sense, the study of governance is concerned with the identification, explanation,
and mitigation of all forms of contractual hazards (Williamson, 1996).

Three broad types of governance structures will be considered:

i. Non-transaction-specific,

ii. Semi-specific, and

iii. Highly specific. The market is the classic non-specific governance structure within
which "faceless buyers and sellers meet for an instant to exchange standardized goods”. The
contractual issue is at the core of the debate on the costs of running a transaction (Coase, 1972).

For Williamson, the contract is a complex institutional arrangement involving the different
aspects of an economic transaction (basic unit of an economic relation), such as planning,
promises, competition and governance (Williamson, 1985). Based on the TCE, Zylbersztajn
(1995) infers that “the prevailing governance structures are the optimizing result of the alignment
of characteristics of the transactions and of the institutional environment. Thus optimization is
seen in the neoclassical style, meaning search for efficiency”.

Therefore, it is possible to make a Darwinian assumption that an efficient governance structure

should prevail as a winning structure. And it is a fact that there is a process of expelling
inefficient structures – which may last until the result is achieved. The path dependence may
allow for the persistence of inefficient structures. The necessary time for the most efficient
structure to win would depend on a series of factors, among which is asymmetric or incomplete
information or even institutional rules - formal or informal - that prioritize certain structures. It

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can be verified that the governance structures are distributed in three different ways, two extreme
ones, hierarchy and market, and an intermediary one, the hybrid mode.

The higher the asset specificity involved, the higher the cost of its market monitoring. The
hierarchy is characterized by internal organization (vertical integration). The governance
structure characterized by vertical integration is mainly determined by the characteristics of the
specific assets used in the chain.

The higher the asset specificity, the larger the prizes given by the adoption of the hierarchy as a
governance mode. North (2005) points out that the persistence of heterogeneous governance
structures may be a result of factors such as institutional path dependency.

Despite the same degree of asset specificity among the firms, the coexistence of different
governance structures is possible and occurs as a result of the firms’ strategies concerning target
markets. Thus it is possible to have the same production system meeting different demands,
which makes the existence of more than one type of efficient structure possible. However, it can
be observed that besides the assets, the same chain can have different strategic directions, which
makes different governance structures viable.

Instead of analyzing only the asset specificity to evaluate the trend to obtain a high governance
cost and a more hierarchic structure, it is necessary, based on the argumentation developed, to
bear in mind: the markets the firms serve (size, level of information necessary, type of product,
quantity of competitors and consumers); inter-relationship among the markets (dependence on
the different markets served with the same production technology); degrees of uncertainty. The
governance system ensuring transparency and accountability in the titling, registration and
transfer of property rights (the court system).

5.1 Market Governance

Market governance is the main governance structure for non-specific transactions of both
occasional and recurrent contracting. Markets are especially efficacious when recurrent
transactions are contemplated, since both parties need only consult their own experience in
deciding to continue a trading relationship or, at little transitional expense, turn elsewhere. Non-

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specific but occasional transactions are ones for which buyers (and sellers) are less able to rely
on direct experience to safeguard transactions against opportunism.

Given that the good or service is of a standardized kind, such experience rating, by formal and
informal means, will provide incentives for parties to behave responsibly. To be sure, such
transactions take place within and benefit from a legal framework. But such dependence is not
great.

As S. Todd Lowry puts it, "the traditional economic analysis of exchange in a market setting
properly corresponds to the legal concept of sale (rather than contract), since sale presumes
arrangements in a market context and requires legal support primarily in enforcing transfers of
title" (1976). He would thus reserve the concept of contract for exchanges where, in the absence
of standardized market alternatives, the parties have designed' 'patterns of future relations on
which they could rely" (1976).

The assumptions of the discrete contracting paradigm are rather well satisfied for transactions
where markets serve as a main governance mode. Thus the specific identity of the parties is of
negligible importance; substantive content is determined by reference to formal terms of the
contract; and legal rules apply. Market alternatives are mainly what protect each party against
opportunism by his opposite. Litigation/legal action is strictly for settling claims/rights;
concentrated efforts to sustain the relation are not made, because the relation is not
independently valued.

5.2. Trilateral Governance

The two types of transactions for which trilateral governance is needed are occasional
transactions of the mixed and highly specific kinds. Once the principals to such transactions
have entered into a contract, there are strong incentives to see the contract through to completion.

Not only have specialized investments been put in place, the opportunity cost of which is much
lower in alternative uses, but the transfer of those assets to a successor supplier would pose

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inordinate difficulties in asset valuation. The interests of the principals in sustaining the relation
are especially great for highly idiosyncratic/distinctive transactions.

Market relief is thus unsatisfactory. Often the setup costs of a transaction-specific governance
structure cannot be recovered for occasional transactions. Given the limits of classical contract
law for sustaining such transactions, on the one hand, and the prohibitive cost of transaction-
specific (bilateral) governance, on the other, an intermediate institutional form is evidently
needed.

Neoclassical contract law has many of the sought-after qualities. Thus rather than resorting
immediately to court-ordered litigation-with its transaction-rupturing features-third-party
assistance (arbitration) in resolving disputes and evaluating performance is employed instead.

The use of the architect as a relatively independent expert to determine the content of form
construction contracts is an example (Macneil, 1978). Also, the expansion of the specific
performance remedy in past decades is consistent with continuity purposes-though Macneil
declines to characterize specific performance as the "primary neoclassical contract remedy"
(1978). The section of the Uniform Commercial Code that permits the "seller aggrieved by a
buyer's breach unilaterally to maintain the relation" is yet another example.

5.3. Bilateral Governance

The two types of transactions for which specialized governance structure are commonly devised
are recurring transactions supported by investments of the mixed and highly specific kinds. The
fundamental transformation applies because of the non-standardized nature of the transactions.
Continuity of the trading relation is thus valued. The transactions' recurrent nature potentially
permits the cost of specialized governance structures to be recovered.

Two types of transaction-specific governance structures for intermediate product market

transactions can be distinguished: bilateral structures, where the autonomy of the parties is
maintained, and unified structures, where the transaction is removed from the market and
organized within the firm subject to an authority relation (vertical integration). Bilateral
structures have only recently received the attention they deserve, and their operation is least well
understood.
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Highly idiosyncratic transactions are ones where the human and physical assets required for
production are extensively specialized, so there are no obvious scale economies to be realized
through inter-firm trading that the buyer (or seller) is unable to realize himself (through vertical
integration).

In the case, however, of mixed transactions, the degree of asset specialization is less complete.
Accordingly, outside procurement/gaining for those components may be favored by scale
economy considerations. As compared with vertical integration, outside procurement also
maintains high-powered incentives and limits bureaucratic distortions.

5.4. Unified Governance

Incentives for trading weaken as transactions become progressively more idiosyncratic. The
reason is that as human and physical assets become more specialized to a single use and hence
less transferable to other uses, economies of scale can be as fully realized by the buyer as by an
outside supplier.

The choice of organizing mode then turns entirely on which mode has superior adaptive
properties. Vertical integration will ordinarily appear in such circumstances. The advantage of
vertical integration is that adaptations can be made in a sequential way without the need to
consult, complete, or revise inter-firm agreements. Where a single ownership entity spans/covers
both sides of the transaction, a presumption of joint profit maximization is warranted/necessary.

Thus price adjustments in vertically integrated enterprises will be more complete than in inter-
firm trading. And, assuming that internal incentives are not misaligned, quantity adjustments will
be implemented at whatever frequency serves to maximize the joint gain to the transaction.

Unchanging identity at the interface coupled with extensive adaptability in both price and
quantity is thus characteristic of highly idiosyncratic transactions. Market contracting gives way
to bilateral contracting, which in turn is supplanted by unified contracting (internal organization)
as asset specificity progressively deepens.

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The efficient match of governance structures with transactions that results from the foregoing is
shown below.

5.5. Efficient Governance (Vertical Integration)

As transaction costs increases, governance structure moves from spot markets to hybrid to
hierarchical forms of governance, the last form involving vertical integration or a variety of
alternative governance structures or institutional arrangements of economic organization.
Vertical integration represents an alternative governance structure to bilateral contracts for
mediating the supply of a product that requires specific investments to support cost minimizing
exchange.

Rather than fiddling with contractual protections to mitigate the inherent conflicts of interest that
may arise between independent buyers and sellers in the presence of specific investments, and
dealing with other distortions and rigidities that such contracts may involve, the buyer may
choose instead to integrate backward (or the seller integrate forward) into the supply of the input
at issue (or sale of the downstream good).

As assets become more specific and more appropriable, quasi-rents are created and therefore the
possible gains from opportunistic behavior increase. The costs of contracting will generally
increase more than the costs of vertical integration. Hence, ceteris paribus, we are more likely to
observe vertical integration.

The solution that neo-institutionalist find to the problem of asset specificity that generate
opportunistic behavior and high transaction costs is the organization of activities inside the firm
by adopting forms of vertical integration, with a view to save on transaction costs.

Vertical integration is favored when the benefits of mitigating opportunism problems by moving
the transactions inside the firm, by reducing ex-ante investment and ex-post performance
inefficiencies, are greater than other sources of static and dynamic inefficiency associated with
resource allocation within bureaucratic organizations. Continuum of organizational form (from
vertical integration to cash markets) that depends largely on the magnitude of transaction costs.

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Chapter 6: Institutional Changes in The Process of Development

Institutions matter" is crucial to implement institutional policies. Institutions are path-dependent
and country specific.

Path dependence is the dependence of economic outcomes on the path of previous outcomes,
rather than simply on current conditions. Hence, the problem is to implement appropriate
institutions that bring about economic development.

Development is defined by institutional economists as a process of "institutional change and

economic growth" (Toye 1995). However, since institutions are "standardized behavior
patterns" then in order to change institutions those behavioral models must change, breaking off
old rules, social norms and customs that impeded a development process before (Kuznets, 1965).

Kuznets says: “The transformation of an underdeveloped in developed country is not merely the
mechanical addition of a stock physical capital. It is a thoroughgoing revolution in the patterns
of life and a cardinal change in the relative powers and position of various groups in the
population. The growth must overcome the resistance of a whole and complex of established
interest and values” (1965).

In a nut shell, there is no short cut to get institutions right. But the good news is, once
institutional change begins, the change is then incremental.

6.1. Types of Institutional Changes

Path Dependence: When the institutional framework poses certain constraints for the
downstream institutional choices and therefore influences the whole process of institutional
change.
Power: Institutional change is the result of the power circles action in their own interest.
Institutional change can also be: a) Elite-driven versus conflict-driven:
Elite-driven: when the politically powerful elite wish to change institutions in order to
increase its rents/utility.
Conflict-driven: when institutional change forced from the non-elites.

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b) Internal versus external: Internal: because of internal shocks or dynamics. External:

because of external imposition, shocks, or external incentives.
Institutional change implies the creation of a new set of institutions which provide the basis
for a new economic and social order. New patterns of correlated behavior underlying
development must be conceptualized before they can emerge. Although these new patterns
can originate in the mind of an individual or group of individuals, any new structure will
arise from some conjoint (often legal or legislative) mechanism.
One can conceptualize three paths of institutional change: path-determinant, path-
dependent, and path-independent
I. Path Determinacy

Differences among countries in their pace of economic development is largely attributed to their
path of institutional change (path dependence). Path-determinant change implies significant
discretionary/free ability/ intervention, where design is fairly open, but also referenced to the
existing past. New ideas arise from a causal understanding of historical patterns and
relationships with ideational influences. Yet the approach is not contained/restricted by the past,
but builds upon and is an instrument of transformation.

The path-determinant approach is aimed at not only understanding what is transpiring/happen,

but what could transpire. Cognition/process of knowing/ is both expansive and continuous.
Institutions transform and are transformed by the elements of the matrix in a continuous fashion.
Change is both discretionary and referenced to past and present institutions.

II. Path Dependence

The path-dependent change - opposite view- has a minimal element of discretion and is heavily
informed by existing arrangements. There is room for only moderate change which largely
reflects prior correlations. New knowledge or approaches that are introduced are largely
ceremonial-the status quo (existing state of affairs) defines any adjustment. If institutional
changes are incremental, why then some countries stagnated? The direction of change is
determined by path dependence. Path dependence means the past situation determine the future
path.

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Stagnation perpetuate stagnation, decline produce decline and increment induce increment. Path
dependence is produced by existing organizations: political, economic, social, and religious
organizations. Institutional path dependence is then defined as the fact that "the process by
which we arrive at today's institutions is relevant and constrains future choices" or "a way to
narrow conceptually the choice set and link decision making through time; it is not a story of
inevitability in which the past neatly predicts the future’’.

We will adopt an encompassing definition of path dependence, considering that "history matters"
because of legacies and also because of strategic path shaping actions that influence the process
of institutional change. Organizations favor policy changes that favor their interest.

In addition, the mental models of the actors-the entrepreneurs-produce ideologies that

"rationalize" the existing institutional matrix and therefore bias the perception of the actors in
favor of policies conceived to be in the interests of existing organizations. Path dependence is
(when the institutional framework poses certain constraints for the downstream institutional
choices and therefore influence the whole process of institutional change).

Liebovitz and Margolis (1995), distinguish among three forms of path dependence.

1. The first-degree path dependence is a situation whereby the influence of some initial events
on the final outcome does not create any inefficiency in the economy.

2. The second-degree path dependence is characterized by the scarcity of information in the

initial phases of decisional process, which leads to regrettable outcomes that are not
remediable.

3. Finally, the third-degree path dependence refers to situations in which an inefficient

outcome could have been avoided because of the existing better alternatives.

III. Path Independence

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Path-independent change- arises deductively from a logical set of propositions and is

independent of any locally generated pattern of culture, ideation, or behavioral regularity.
Inspired by the neoclassical vision, the approach has dominated reform in Africa.

6.2. Theories of Institutional Change

6.2.1. Theory of Induced Institutional Innovation

The driving forces for institutional change are the technical progress and change in relative factor
prices (Hayami and Ruttan 1985). Institutional change is the product of the interaction between
demand and supply, basically influenced by the neoclassical equilibrium model. Market forces
create a demand for institutional change.

6.2.2. Transaction Costs Theory

Existing institutions are inefficient in terms of reducing transaction costs. Hence, new institutions
that could reduce transaction costs are required.

6.2. 3. Distributive Bargaining Theory

The driving forces for institutional change are 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.

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 those differences (Knight 1992). The
success of an actor in bargaining is directly related to the ability of an actor to produce strategic
commitments (or threats), i.e. compliance or noncompliance to the rules of the game. The theory
can be applied where there is conflict over resource uses between groups or individuals.

6.2.4. 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

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change in return for their political support. Emergence of rent-seekers in the process, having
access to public fund in a very unnoticeable way to the public (e.g. money spent on lobbying to
manipulate rules of the game)

b) Public Choice Theory; James Buchanan came up with public choice theory, the principal-
agent relationship between the voters and politicians (Tullock 1987). Thus, institutional change
arises from the influence of the principals (constituents) on their agents who are expected to
maintain their promises or commitments (political market)

6.2.5 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 1989:97). It includes rules that have never been consciously
designed but are in the interest of everyone to keep (North 1990). Rules evolve in unintended
way rather being designed on calculative basis contrary to the rational choice.

Chapter 7: General Framework for Collective Action

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-riders). R. Hardin (1982) criticizes Olson as he considers economic
incentives as the main drivers by ignoring non-economic 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).

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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-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” (Marshall 1998).

It can also be defined as “a coordinated behavior of groups toward a common interest or

purpose” (Vermillion 1999).

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 about one another’s action (Hardin 1982). As a
result, studies on collective action tend to examine factors motivating individuals to coordinate
their activities to improve their collective well-being (Sandler 1992:19). Trust, reciprocity and
reputation are the three core individual level variables determining individual cooperative
behavior in collective action (Ostrom, 1998). Individuals gain reputation for being trustworthy
(or keeping 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.

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 2002).

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Cooperation in a social dilemma (Source: Ostrom, 2005)

A framework linking the structural variables to the core relationships (Ostrom, 2005)

7.3. Fairness, Trust, Reciprocity and Cooperation

Fairness, trust and reciprocity - important factors affecting cooperative behavior in collective
action; Reciprocity: A norm that generally 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

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and Ockenfels 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;
Self-enforcing agreements could emerge and mutual reinforcement of 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, McCabe and Smith 1998); Positive and negative reciprocity – based on the responses
of the first mover (involving retaliatory actions);

Altruism: A characteristic in which an agent continues to cooperate while the opponent fails to
reciprocate; a behavior which slightly differs from that of conditional cooperators.

Inequity 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: An individual is poorly motivated by private benefits to be consistent

irrespective of that of others.

7.4. Determinants of Collective Action

Some of the factors that determine participation in collective action include: Heterogeneity
(economic, socio-cultural), Mutual vulnerability of group members, Rule enforcement capacity,
Established selective incentives (punishments, rewards), Effectiveness of leadership, the nature
of property rights and Attributes of resources (size, predictability).

Social capital plays a great role in collective action. NB : “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” (Coleman1988).

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NB: Social capital: lowers transactions costs of exchange, Reduces cost of enforcing rules in the
provision and appropriation, strengthens informal insurance, and improves local authority
performance by drawing them into networks.

But measurement is difficult and is often indirect using some proxies.

As a stream of the New Institutional Economics, collective action is applied in: Agro-
biodiversity management, Soil and water conservation, Watershed management /management of
irrigation systems, marketing of agricultural products (cooperatives, improving access to

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services) and improving the supply of public goods (provision and maintenance of
infrastructures).

A Framework for Institutional Analysis (IAD)

Source: Ostrom, Gardner and Walker (1994)

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Framework for Institutional Analysis (IAD)

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-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 all elements of the framework in one particular study.

Dorward and Omamo (2009) refine IAD and focus on initial context (the environment- policy,
physical infrastructure and socioeconomic) and the action arena (action domain- actors,
institutions, activities, and 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.

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Empirical example: A framework used for a case study in Somali Region of Ethiopia
(Source: Beyene, F. (2008)

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