INSTITUTIONAL ECONOMICS

(AgEc 731, PhD Course)

Prepared By
Fekadu Beyene (PhD)

Lectures
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 Chapter 1: Neoclassical and
Institutional Economics
1.1 Basic Concepts

Neoclassical Assumptions and Axioms

 Zero transaction costs and Perfect information

 Rational Choice

 Resource Scarcity and competition

 Institutions are given and do not matter in the

economic analysis (instrumental rationality)

 Methodological individualism
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 1.1 Basic Concepts

Defining Institutions

 No commonly agreed upon definition

 Basic premise: Institutions matter for economic

performance

 Purpose is to explain the determinants of

institutions and their evolution over time, and to
evaluate their impact on economic performance,
efficiency and distribution

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 Defining Institutions
“
Institutions are the rules of the game in a
society; more formally, they are the
humanly devised constraints that shape
human interaction. In consequence they
structure incentives in exchange, whether
political, social, or economic.”

A set of formal and informal rules of conduct that

facilitate coordination or govern relationships
between individuals.

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D.C. North (1990)
4
 What Are Institutions?

 Formal institutions are the constitutional

framework, which sets out the rules for
economic, social and political ‘players’

 Players are economic (firms), political

(Parliament) and social (churches)
organizations

 Institutions are path-dependent and country-

specific
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 How Do Informal Institutions
Work?
 Informal institutions are the norms of a society,
which also set out the rules for economic, social
and political ‘players’

 Informal institutions allow players to enforce

economic exchange, typically through reputation
mechanisms, which provide information about the
behavior of players; identify poor behavior; and
exclude and punish players that ‘cheat’ according
to the rules of the game

 Open and Kinship systems of information and

enforcement promote development—12th century
Europe and 20th century Vietnam
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 How Do Informal Institutions
Work?
 Players dependent on informal institutions
may arise when formal institutions do not
promote growth (not when they do not
exist)

 Informal institutions may resist reform to

formal institutions—e. g. The case of
Soviet Union

 Economic institutions form part of, and are

impacted by, the larger social and political
framework of society
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Common Features of institutions
 Institutions are a structural feature of the society
or polity. They are created with the only reason:
decrease uncertainty.

 Stable over time.

 They must pose constraints and affect individual

behavior of its members.

 Institutions change through time, why

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 Challenges in institutional
analysis
 Confusion with definition
 Institutions are invisible
 Multiple inputs from different disciplines are
needed
 Given multiple disciplines and concepts a
coherent institutional framework is needed.
 Multiple level of analysis

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 1.2 Why institutions economics?
 Adam Smith said that the productivity of an
economic system depends on specialization.

 Specialization will be useful only if there is an

exchange, and the lower the costs of exchange
(transaction costs) the more specialization there
will be and the higher economic productivity will
be.

 Level of transaction costs however depend on

institutions, its legal system, its political system,
its culture etc.
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 1.2 Why Institutions Economics …?
 How players play the game determines the pace
and direction of economic development

 Institutions with rules that encourage good

incentives promote economic interaction, exchange
and activity, resulting in mutually beneficial
behaviour and economic development

 Institutions with rules that encourage perverse

incentives lead to economic stagnation and decline

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 1.3 Old and new institutional
economics
Why Old Institutional economics and what is it?

 Emerged as the protest against methodological

individualism of the mainstream Neo-classical
Economics.

 Emphasized importance of institutions but lacked

rigorous and systematic theoretical foundations,
as well as empirical support.

 Concerned more with description of institutions.

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 1.3 Old and new institutional
economics…
 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.
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 NIE
 Coase R. (1937) “The
Nature ofthe Firm”

 Coase R. (1960) “The

theory of social cost”.

 Williamson O. (1971) coins

the term “New Institutional
Economics”.

 North D. (1990)
“Institutions”.

 International Society for

NIE (ISNIE) established in
1997.
Coase R. and North D.
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 New Institutional Economics (NIE)

The purpose of NIE is two-fold:

1) Explain (opposed to describe) the

determinants of institutions and analyze
the institutional change;

2) Evaluate impact of Institutions on

economic efficiency and distribution.
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 NIE: Economic activities are
embedded in a framework of
institutions, formal & informal

NIE
“Old”
Neo-classical
Institutionalist
Economics
school

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 What does NIE address?

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
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1.4 Externalities and Market Failure
 What are externalities and how are they related to
institutions and market failure?

 The concept largely applied in environmental

economics

 Externalities are harmful or beneficial effects

resulting from a set of activities related to
production or consumption (Can you give some
examples?)

 Markets fail when institutions fail to influence firms

to internalize negative
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externalities
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 1.5 The Coase Theorem
 Initial Assumption of Coase: Production
and exchange can be solely carried out
through the price mechanism.

 In the process of determining price rate,

there is a cost of discovering prices
(Cheung 1983)

 The idea that “Perfect markets direct all

production in the absence of transaction
costs (zero)” is a fiction, leading to the
Coase Theorem:
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 1.5 The Coase Theorem…
 “in the absence of transaction costs, the most
efficient solution to maximize aggregate income
will be obtained irrespective of the original
distribution of resources or liability” (the
Theorem)

 however, if transaction costs are positive, then

property rights institutions do matter. This occurs
in a real world.

 Later on, he introduced the notion of positive

transaction cost, which is the cost of carrying out
market transactions: costs of organization (the
contribution of Coase to NIE)
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 1.5 The Coase Theorem…
 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

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

organizing a night-club, where noise pollution can
undermine the use of the library affecting the business of
the library owner. Would private bargaining between the
two resolve the externality problem without involvement of
the state?

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 Questions for Discussions
1. Identify a set of rules in your
organization.

2. Discuss how the rule is implemented and

any challenge associated with it.

3. Suggest, if any, whether the rule should

change or continue to operate.

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 Chapter 2: Institutions and
Contracts
2.1 Four levels of institutional analysis

Williamson’s framework: 4 level of social analysis

 Level 1: Embeddedness. Informal institutions, customs,

traditions, norms and religion;

 Level 2: Institutional environment. Formal rules of the

game: property, bureaucracy.

 Level 3: Governance: play of the game - contract.

 Level 4: Resource allocation and employment (prices

and quantities; incentive alignment).

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 Frameworks for Institutional Analysis…
Level Frequency purpose
(years)
Embeddedness:
L1 informal institutions, Often non-calculative;
102 to 103
customs, traditions, spontaneous
norms

Institutional
L2 Get the institutional
environment: formal 10 to 102
rules of the game
environment right, 1st
order economizing

Governance: play of Get the governance

L3 the game, 1 to 10 structures right, 2nd
order economizing

Resource allocation
Get the marginal
L4 and employment
Continuous conditions right, 3rd
order economizing
24
Figure: Four levels of institutional analysis (Source: Williamson, 2000:597)
 2.2. Contractual Choice and
Transaction Costs
 TC are the costs that an actor bears in
order to engage in exchange (political,
economic, social etc.).

 TC exist because info 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).

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 Opportunism in contractual relations…

A (unassisted market)
h=0
B (unrelieved hazard)

s=0
h>0 C (credible commitment)

s>0 Market safeguard

Ad
mi
nis
tra
tiv
e

D (integration)
26
A simple contracting schema (Williamson, 2000: 602)
2.3 Opportunism in contractual relations
 A contract is an agreement between a buyer and a supplier in
which the terms of exchange are defined by a triple: price,
asset specificity and safeguards, where quality, quantity and
duration are specified (Williamson, 1996, p.377).

 Long terms contracts are complex and incomplete and their

enforcement cost could be higher, the source of
incompleteness being ‘bounded rationality’, where we find
limited cognitive competence to store and process information.

 “Contractual incompleteness poses added problems when

paired with the condition of opportunism—which manifests
itself as adverse selection, moral hazard, shirking and other
forms of strategic behavior” (Williamson 2000, p.601).

 The basis for opportunism

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is information asymmetry.
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 Forms of contracts
 Markets are short term contracts (instantaneous) where
identity is irrelevant since a transacting party can go its
own way at negligible cost to the other.

 Hierarchy Transactions that are placed under unified

ownership (buyer and supplier are in the same enterprise)
and subject to administrative controls (an authority
relation, to include fiat) are managed by hierarchy. The
contract law of hierarchy is that of forebearance, according
to which internal organization is its own court of ultimate
appeal.

 Hybrid Long-term contractual relations that preserve

autonomy but provide added transaction-specific
safeguards, compared with the market.

 Hybrid contracts and hierarchy emerge as asset specificity

builds up and identity matters.

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 Factors affecting effectiveness of contracts
 Asset specificity A specialized investment that cannot be
redeployed to alternative uses or by alternative users except at a
loss of productive value. Asset specificity can take several forms,
of which human, physical, site, and dedicated assets are the most
common. Specific assets give rise to bilateral dependency, which
complicates contractual relations.

 Safeguard The added security features, if any, that are

introduced into a contract in order to reduce hazards (due mainly
to asset specificity) and to create confidence. Safeguards can take
the form of penalties, a reduction in incentive intensity, and/ or
more fully developed private-ordering apparatus to deal with
contingencies.

 Extent of Using Private ordering The self-created mechanisms

to accomplish adaptive, sequential decision making between
autonomous parties to a contract, including information
disclosure, dispute settlement, and distributional mechanisms to
deal with gaps, errors, omissions, and inequities.

 Question: What other features affect contractual relations?

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 Chapter 3: Theories of Institutional
Change
 Competing theories

 Basic questions:
a) What are the reasons for institutional change?

b) Who are the key actors involved in the processes of

institutional change?

c) Is institutional change induced or imposed?

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 Components of the NIE

Public Choice & Political Economy

(Buchanan, Tullock, Olson, Bates) Social Capital
(Putnam, Coleman)

NIE
Property rights literature
(Alchian, Demsetz)
Transaction Costs Economics
(Coase, North, Williamson)
Economics of information
(Akerlof, Stigler, Stiglitz)
Theory of Collective Action
(Ostrom, Olson, Hardin)

Law and Economics

(Posner)
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 3.1. Theory of Induced Institutional
Innovation
 The driving forces for institutional change
is 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.

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 3.2 Transaction cost economics
 According to this theory, institutional change takes
place to reduce transaction costs, including:

• Cost of screening and selecting a buyer or seller

• Cost of obtaining information on the good or

service

• Cost of bargaining & negotiating a contract

• Cost of monitoring & enforcing the contract

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 3.2 Transaction cost economics

 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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 3.2 Transaction cost economics
 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.”

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 3.2 Transaction cost economics
How is transaction cost economics
relevant?

Globalization & Market liberalization &

industrialization of government
world agriculture devolution

Increasing reliance on vertical linkages, long-

term contracts, and coordinated relationships

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 3.2 Transaction cost economics
How is transaction cost economics relevant?

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

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 3.2 Transaction cost economics

How is transaction cost economics

relevant?
 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
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 Example: Contract farming
 Contract farming as a way to cut transaction costs
and include small farmers in high-value markets

 Questions:

• 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?

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 3.3 Distributive bargaining theory

 The driving forces for institutional change is

distributional conflict over resources of significant
economic importance (Libecap, 1989: Knight
1992, 1997).

 In this theory, institutions are the by-products of

social conflict

 Institutional change is a response to conflict to

correct for distributional imbalances

 Take an example of property rights change

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 3.3 Distributive bargaining theory…
 To apply bargaining theory, one needs to allow for the
possibility that some social actors are more powerful than
others and investigates the effect of those differences
(Knight 1992:127).

 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 non-compliance to the rules
of the game.

 The theory can be applied where there is conflict over

resource uses between groups or individuals.

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 3.3 Theories of Institutional Change…

The payoff structure for the bargaining game

AP

Strategies C G
P
C ∆P, ∆AP X, X + εp
G X+ εp, X ∆P, ∆AP

if P,AP < x, there will be two equilibrium outcomes.

If P chooses strategy G and AP chooses C, then P gains more
than AP. This difference (P > 0) is known as ‘distributional
42
advantage’ and each group tries to achieve .
 3.4. Political-Economy Theory
3.4.1 Interest Groups

 there is a political exchange between interest groups

(Olson 1982)

 “Politicians hear nothing from many, but a lot from few”;

 Dedicated group of voters influence processes of

institutional change in return for their political support

 rent-seekers emerge in the process, having access to public

fund in a very unnoticeable way to the public

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 3.4. Political-Economy Theory
3.4.2 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)
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 3.5 Property rights theory
3.5.1 Concept of Property Rights

 many people regard property as a tangible ‘physical object’.

Institutional economists use a different conceptual language.

 Property is considered as a “benefit (or income) stream” in that

the owner controls this benefit stream (Bromley 1991).

 A right may be a ‘set of actions and behaviors that possessor of

a property may not be prevented from undertaking, or a duty
on all others to refrain from preventing those actions or
behaviors’.

 Therefore, rights are not relationships between the right holder

and an object, but rather are relations between the right holder
and other people with respect to the object (Bromley 1991:15).

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 3.5 Property rights theory…
Alternative definitions

1. property right is defined as “the capacity

to call upon the collective to stand
behind one’s claim to benefit stream”
from an asset of economic importance
(Bromley 1991:15).

2. “ property rights over assets consists of

the rights, or the powers, to consume,
obtain income from, and alienate these
assets” Barzel (1989:2).
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 3.5 Property rights theory…

3. “bundles of rights” including access and withdrawal,

exclusion, management and alienation rights (Schlager and
Ostrom 1992: 249-251)

4. Furubotn and Richter (2005) review and classify property

rights as “absolute” and “relative”, the former involving
assignment of exclusive individual property rights to
physical objects, whereas “relative” property rights include
all rights related to contractual obligations and agreements

Relative PRs: Exchange. Contractual obligations -

particularly when time is an important part of the
“transaction” -> monitoring and enforcement of the contract

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 3.5.2 Property rights regimes
1) Private property:

- is any property that is not public property. Private property may

be under the control of a single individual or by a group of
individuals collectively.

- a set of ordered institutional arrangements in which the state

protects the rights of certain individuals to access, control and
manipulate resource benefit steams. Others have a right to
expect that only socially-acceptable uses will occur, and a duty
to refrain from preventing those uses.

- What are the advantages of private property? Some agree on

its role in the efficient allocation of resources and investment in
resource improvements

- Why have claims to private land use emerged in pastoral and

agropastoral areas? (e.g. In the case of priavte ranches among
the Maasai)
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 3.5.2 Property rights regimes…
2) Common Property: distinction of “common-pool” and “common
property”.

 a common-pool resource (CPR) is a particular type of good

consisting of a natural or human-made resource system, the size
or characteristics of which makes it costly, but not impossible, to
exclude potential beneficiaries from obtaining benefits from its
use.

 Common Property is the private property of a group of co-owners.

 "common property regime" refers to a particular social

arrangement regulating the preservation, maintenance, and
consumption of a common-pool resource.

 common-pool resources are not necessarily governed by common

property regimes, they may be owned by national, regional or
local governments as public goods, by communal groups as
Common property resources, or by private individuals or
corporations as private goods.
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 3.5.2 Property rights regimes…
 Property rights in productive resources – land itself, trees,
pasture, many water sources, fish, etc. often characterized by
non-private property rights structures

 Substantial part of income generation, especially in SSA

 Poor, and reliance on non-private resources as safety net

 Almost all “big” environmental problems are a function of

resources under non-private, non-market property rights
(desertification, forest management, soil erosion, pollution,
over-fishing, overgrazing)

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 3.5.2 Property rights regimes…
2) Common property…

 Examples of common-pool resources include irrigation

systems, fishing grounds, pastures, and forests

 common-pool resources are generally subject to the

problems of congestion, overuse, pollution, and potential
destruction unless harvesting or use limits are devised and
enforced, which could lead to the deterioraton of
livelihoods.

 in a common property regime, a common-pool resource

has the appearance of a private good from the outside and
that of a common good from the point of view of an insider.
The resource units withdrawn from the system are typically
owned individually by the appropriators. A common
property good is rivaled in consumption.
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 3.5.2 Property rights regimes…

Design principles for a long-enduring CPR institutions

1. Clearly defined boundaries

2. Congruence between appropriation and provision rules
3. Collective-choice arrangements allowing for the participation
of most of the appropriators in the decision making process
4. Effective monitoring by monitors who are part of or
accountable to the appropriators

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 3.5.2 Property rights regimes…
Design principles for a long-enduring CPR institutions
5. Graduated sanctions for appropriators who do not
respect community rules
6. Conflict-resolution mechanisms which are cheap
and easy
7. Minimal recognition of rights to organize (e.g., by
the government)
8. In case of larger CPRs, Organisation in the form of
multiple layers of nested enterprises

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 3.5.2 Property rights regimes…
3) State Property:

- Resources are nationalized and citizens may have use

rights, while the state has all forms of rights to the
resources in question.

- a state property regime is a set of institutional

arrangements in which the state retains direct control of
the benefits derived from a resource by determining access
and use rules for individuals (Bromely, 1989, 1991).

- In many socialist countries, individuals are entitled to use

resources but not to transfer rights to the resources
without the interference of the state.

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 3.5.2 Property rights regimes…
However, such state property regimes fail due to:

 rigidity of the state agencies in their application of rules;

 state agencies usually ignore, or even attempt to

undermine, indigenous political structures and institutions;

 state agencies often lack the power, authority and/or will to

implement rules prescribed at regional or national levels;
and,

 state employees who are responsible for the enforcement

of resources use rules are often remunerated, legally or
illegally, through the collection of fines. (e.g. corruption
and bribes)

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 3.5.2 Property rights regimes…

4) open access:
 When resources are owned by no one or are used
by all without any restriction, they exihibit open
access resources

 Such lack of property regime leads to resource

destruction and increases behavioral uncertainty

 Often termed as “tragedy of open access” or

formerly coined as “the tragedy of the commons”
(G. Hardin 1968)

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 3.5.2 Property rights regimes…
Bundles of rights

 Note: we do not find very much distinction in

property rights as such, rather a bundle of rights
approach is important.

 The bundle of rights is a common way to

explain the complexities and interdependence of
rights to resources among actors having different
positions

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 3.5.2 Property rights regimes…
Bundles of rights associated with positions
Full owner Proprietor Authorized Authorized Authorized
claimant user entrant

Access X X X X X

Withdrawal X X X X

Management X X X

Exclusion X X

Alienation X

Source: Ostrom and Sclager, 1996:133

58
 3.5.3 Forces of change in property rights
1) Equity versus efficiency

 There is tradeoff in achieving economic efficiency and

attaining equity (distribution); one is satisfied at the
expense of the other, i.e. efficiency cannot be
materialized when distributional inequality is at stake
(Wang 2001; Eggertsson 1990).
 The distribution view recognizes that the forces of change
in property rights are the inherent dissatisfactions by
certain groups or individuals from the existing property
rights structure. The existing distribution of property
rights may benefit some but harms others.

 In such contexts, change is determined by the capacity of

actors to ‘contract’ for property rights change or
persistence of existing ones (Libecap 1989).

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 3.5.3 Forces of change in property rights
 the economic efficiency - property rights change results
from opening of new markets, change in relative prices of
factors of production, demographic shift and technological
innovation.

 change in these factors in an economy creates a pressure

for change in property rights (Demsetz 1967; Boserup
1965; North 1981; Bromley 1991; Ensminger 1997).

 They argue that efficiency of land use increases when

property rights change from a purely open access (no
property rights) to common and then to private due to
population growth and resource scarcity leading to more
commercialization.

 Though transaction costs of enforcing rights are increasing

at each stage, the return from improved efficiency largely
outweighs the costs (Bromley 1991)
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 3.5.3 Forces of change in property rights…
2) The ‘ cost-benefit’ versus ‘scarcity-incursion’ analysis

a) Cost-benefit argument –

 property rights emerge when the benefits obtained from controlling access
to resources exceed the transaction costs of defending the resource from
others, i.e. the ‘social cost-benefit’ comparisons or ‘internalization of
externalities’ from introducing new property rights.

 gains from internalization of externalities must exceed the costs to cause

alteration of property rights regime. Those economic forces fetching new
opportunities (e.g. emergence of markets or newly introduced technology)
should ensure cost-effective way of internalizing external effects (Demsetz
1967) (e.g. controlling of hunting areas as a result of the rise of fur
industry)
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 3.5.3 Forces of change in property rights…

b) the scarcity-incursion analysis - a counterargument challenging Demsetz’s

view and that of his proponents (Field 1989). This is particularly the case
in terms of predicting the direction of change in property rights when the
value of a resource rises.

An increase in resource value would rather lead to less exclusive property

rights since the more valuable resource will attract greater incursion (Field
1989).

According to Field, a higher resource value will cause pressure from

outsiders intending to use the resource. This will cause the exclusion cost
to rise much more than the benefits obtained from excluding others.

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 3.5.3 Forces of change in property rights…

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 3.5.3 Forces of change in property rights…

 An increase in the number of these commons (from a single large commons to

completely divided parcels for individuals N) will lead to a decline in the marginal
governance cost (Tm) because of reduced cost in organizing collective action.

 However, such an increase in the number of commons will lead to a rise in the
marginal cost of exclusion (boundary management, Em), where an increasing
exclusion costs saves transaction costs.

 A point where marginal governance costs and marginal exclusion costs intersect
(M*), one may find an optimal number of parcels for the commons and size of
users.

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 3.5.3 Forces of change in property rights…

 An increase in resource value (EmR) and an introduction of new

technology of exclusion (EmT) will again affect the optimality,
where both having the opposite effect, but again maintaining
the optimal point.

 Field’s model does not completely deny the influence of

population and economic growth as determining factors for
private property to emerge.

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 3.5.4 Property rights and legal pluralism (LP)
 state (or statutory) law as made by legislatures and enforced by
the government;

 religious law, including both law based on written doctrines and

accepted religious practice;

 customary law, which may be formal written custom or living

interpretations of custom;

 project (or donor) law, including regulations associated with

particular projects or programs, such as an irrigation project;

 organizational law, such as rules made by user groups; and

 a range of local norms, which may incorporate elements of other

laws.
 Thus, LP can be a possible source of conflict and uncertainty
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 3.6. 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.
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 Chapter 4: Trust, collective action
and social capital
4.1 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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 4.1 Basic Concepts
 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:
184).
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 4.2. 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)

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 4.2. The Theory of Collective Action
 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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 4.2. The Theory of Collective Action…

The Core relationships at the individual level affecting levels of 72

cooperation in a social dilemma (Source: Ostrom, 2005, p.23.)

 4.2 The Theory of Collective Action…
Information from Subtractive or
the past actions shared resources

Linkage structure
The Core
Relationships

Number of
participants

Face to face
communication

Heterogeneity of
participants

Freedom to enter Shape of the production

and exit function
73

A framework linking the structural variables to the core relationships (Ostrom

 4.2. The Theory of Collective Action
Determinants of collective action

1. Heterogeneity (economic, socio-cultural)

2. mutual vulnerability of group members,
3. rule enforcement capacity,
4. established selective incentives (punishments, rewards)
5. Effectiveness of leadership
6. the nature of property rights
7. Attributes of resources (size, predictability)

Case studies report controversial results causing difficulties to develop

standard theory.
Question: What other factors do you think affect cooperative
behavior in collective action?
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 4.3 Definition of social capital
 Isn’t “standard” economics enough? What is social capital?
How does it operate? How is it currently measured?

 “Social capital refers to features of social organization [in

particular, horizontal associations] such as networks,
norms and social trust that facilitate coordination and
cooperation for mutual benefit.” Putnam (1995).

 “a variety of different entities, with two elements in

common: they all consist of some aspect of social
structure, and they facilitate certain actions of actors …
within the structure” Coleman (1988).

 Coleman makes distinction between types of social capital

as “bonding social capital” (within a group) and “bridging
social capital” (Coleman 1988).
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 4.3 Definition of social capital
 “includes the social and political environment that enables norms to
develop and shapes social structure. .. Or a more formalized
institutional relationships and structures, such as government, the
political regime, the rule of law, the court system and civil and
political liberties” Grootaert (1998)

 “Social capital is defined as the norms and social relations embedded

in the social structures of societies that enable people to coordinate
action to achieve desired goals.” The World Bank (2000).

 Based on accounts of previous works (Coleman 1988; Ostrom 1990,

92 and Putnam 1993), Ostrom (1999) defines it as: ‘shared
knowledge, understandings, norms, rules and expectations about
patterns of interaction that groups of individuals bring into a recurrent
activity’ (p.176).

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 Levels and Forms of Social Capital
Forms Levels
 Norms
 Networks
 Individual/Household
 Trust  Local/Community
 National
 Coordination and  International
cooperation

Question: Is social Capital a Private or Collective

good?
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4.4. The role of social capital in collective action
How is social capital hypothesized?

• lowers transactions costs of exchange

• Reduces cost of enforcing rules in the provision and appropriation

• strengthens informal insurance by facilitating adaptation in risky

environment mainly in traditional societies (e.g. social connections
assist livestock spread over a larger geographical area as risk
management activities Collier and Gunning 1999)

• improves local authority performance by drawing them into

networks

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 4.4 The role of social capital in collective action

Empirical analysis: How is

social capital quantified?

79

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

 Chapter 5: Frameworks for
Institutional Analysis
 Institutional analysis requires a framework for analysis of how institutions
change, affect behavior and coordinate human action (for testing
hypothesis and falsify propositions)

 Two frameworks: Institutional analysis and development framework (IAD)

and Institutions of Sustainability (IOS), where the former is very popular
and has been widely applied and tested in various circumstances

 First, we start with IAD, having three basic parts (initial context, action
arena and outcomes, each being further decomposed to guide the analysis)

 Choice of a component is determined by the nature of an empirical study

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 5.1 Frameworks for Institutional Analysis…
c) A Framework for Institutional Analysis (IAD)

Physical/
material
conditions
Action arena

- Actors Patterns of
Evaluative
- Action situations interaction
Community criteria
attributes

Outcomes
Rules-in-use

81
Source: Ostrom, Gardner and Walker (1994: 37)
 A case study from Somali Region

Source: Beyene, F. (2008)

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 Institutions of Sustainability Framework

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 5.2 The complexity of multilevel institutional
analysis
 Complexity in the nested nature of rules

 Operational rules, collective-choice rules, constitutional-choice

rules and even meta-constitutional rules

 Meta-constitutional rules rarely analyzed and the link among the

levels increases complexity of the analysis

 Sometimes, we consider (or assume) the next higher level as given

and focus at one level in the analysis of determinants or effects of
institutional change

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 5.2 The complexity of multilevel institutional
analysis

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5.3 Game Theory and the Nash-Equilibrium
 What is game theory and why?

 Interaction of individuals involving how they make decisions and how

these decisions lead to an outcome is studied using game theory (e.g. in
studying conflict and cooperation).

 As Morrow (1994) explains, game theory is based on utility theory that

deals with how preferences of an actor over certain outcomes are
measured. It is also guided by rational choice theory.

 By “rational”, it means a condition in which one will choose “the best

means to gain a predetermined set of ends” (Morrow, 1994:17).

 In employing game theory as analytical tool, we move from forming thick

accounts to thin form of reasoning to build explanation on why a certain
equilibrium outcome is preferred over any other (Bates et al. 1998:14)

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 5.3 Game Theory and the Nash-Equilibrium..

A Nash-Equilibrium is a pair of strategies that are best replies to

each other on the equilibrium path where institutions are
likely to emerge,

A game has at least two players with a set of strategies and

expected outcomes (also called payoffs), where different
strategies lead to different payoffs and each player tries to
maximize the benefits by changing her strategies

A game can be represented in a strategic form or in an extended

form where the latter shows the sequence of moves unlike
the former

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7.10 Game Theory in Institutional Analysis …

a) Extended form of a game

(1,1)
2 u

U
 1 d
(1,1)


D
 2 u
(0,-3)

d
(2,-2)
88
7.10 Game Theory in Institutional Analysis …

b) Strategic form of a game

Player 2
u d
Player 1
U (1,1) (1,1)
D (0,-3) (2,-2)

89
 5.4 Methodological Issues in the New
Institutional Economics
 Methodology connects theory, framework
(models) and empirical facts

 NIE uses methods familiar in the

mainstream economics

 The challenge in using mathematical

models is the requirements they need in
terms of assumptions
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Chapter 6: Reform, Resource Governance and
Public Policy

6.1 The concept of governance

What is governance? It is understood as:

1) the process of deciding what the collective will do and how

it will do in such a way that institutions are created through
the process of governance to provide order to the relations
among members of the collective (Bromley 1989).

2) the exercise of legitimate authority in transacting affairs,

broadly understood to refer to the maintenance of social
order through endogenously evolved sets of rules or
authority structures, or some combination of locally
evolved and externally imposed rules sets (Mearns
1996:300)"
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 6.1 The concept of governance

 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 abide by rules
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 6.2 Institutions and Decentralization of Natural
Resource Governance
 Institutions are vital in natural resource governance

 Resource user-groups are always in competition, conflict

and overuse of natural resources

 To overcome overuse and achieve sustainable use of

natural resources, institutions play a regulatory function

 Degradation of natural resources in Ethiopia are the effects

of institutional failure (can you give some examples?)

 Decentralization is recommended as a solution to effective

resource governance, why? Would decentralization work in
our context? Is our problem related to governance
structure or the institutions?

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 Resource and users’ attributes affecting
resource management outcomes

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 6.3 Governance failure and corruption
 Governance fails when there is no effective
communication among actors at different levels
of governance

 Corruption is a product of information asymmetry

resulting from lack of transparency and little or
no public concern

 What are the fundamental reasons for corruption

and governance failure?

• absence of effective decentralization

• Poor accountability to public interest
• Ineffective representation
• Elite capture and opportunism undermining sanctioning
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 6.3 Governance failure and
corruption
Remarks

 Development policies without appropriate local resource

management institutions do bring little economic
progress

 Resource management policies and institutions should

combine resource attributes and users’ characteristics

 Establishing a self-organized resource management

institutions with minimum interventions of state
agencies could lead to sustainable management of
natural resources

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 6.3 Governance failure and
corruption
Purpose of Institutional Research:

 To sufficiently capture the institutional context so that we can

more accurately predict how other policies are likely to impact
on different groups and communities

 To capture the institutional context, and how any particular

policy may in turn affect the functioning of the institutions

 To determine factors that directly affect institutions, and so as

to develop insights that help derive policy recommendations to
directly change the institutions
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