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.

 North (1986, 1989, 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 is transaction 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 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
 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.
 Social Capital definition: “ 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 and civil an 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 and cooperation,

Individual/Household, Local/Community, National, International,

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.
 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 determines 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 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.