Lecture 16

Understanding and Analyzing Institutions:

Coordination and conflict

Types of Institutions (Ellickson 1991)

Rules Enforcement mechanism Example

1. Convention Self enforcement Language

2. Ethics Imperative self binding Being a vegetarian

3. Norms Social enforcement Social codes of conduct

4. Formal private rules Organized private enforcement

Self imposed rules inside organisations

5. Law Organized state enforcement

Business Law

Types of Institutions (Vatn 2005)

Rules Logic Function Example

1. Convention Combining a certain situation with a certain act or solution

Simplify live an a complex world

Language, dress code

2. Norms Combine a certain situation with a requested act or solution in order to support an underlying value

Creation of human character, human values and proper human relations

Greeting, Birthday gifts

3. Formally sanctioned rules

Combine a certain situation with an act that is required or forbidden and which is governed by third-party sanctioning

Solving situations with conflicting interests

Property law Liability lay

The Grammar of Institutions (Crawford and Ostrom 1995)

Institutions and problem situations

Source: Vatn (2005, p. 83)

Coordination and Conflict - Game Theory

• Games (coordination vs. conflict, non-cooperative vs. cooperative)

• Player (individual and collective actors)

• Strategies (set of conditional actions)

• Payoffs (benefits and costs, individual vs. social)

• Rules (intended or unintended, imposed or negotiated)

Assumptions in Games Theory

Player

Results (Payoffs)

Actions

Rules

Environment

Third player (Referee)

Changing the terms

Actors

Allocation, Distribution

Interactions

Institutions

Environment

Third party (e.g. court)

Simple game theoretic modeling

• Two players A and B• Each player has two strategies i and j• The payoffs are a function of the interactions

(combinations of strategies) AiBi, AiBj, AjBi,AjBj• Each player chooses the strategy the maximizes her/his

expected utility, max E(U (AiBi, AiBj, AjBi,AjBj))• Each player build expectations about the behavior of the

other player, she/he assigns probabilities p and 1-p to the other players strategies, max U (pAiBi + (1-p) AiBj, pAjBi + (1-p)AjBj)

Actor constellations (Scharpf 2000)Cooperation vs. Conflict

Englisch Spanish

Englisch 3,3 0,0

German 0,0 0,0

Heads Tails

Heads 1,-1 -1,1

Tails -1,1 1,-1

Pure coordination Pure conflict

A

B

i

j

i jB

i j

Analysis of strategies and equilibrium

• Each player builds expectations about the behavior of the other player and assigns probabilities p und 1-p to the strategies of the other player, max U (pAiBi + (1-p) AiBj, pAjBi + (1-p)AjBj)

• Each player choose the strategy that maximizes her/his utility , max U (AiBi, AiBj, AjBi,AjBj)

• Example:• A: UAi(p3+(1-p)0), UAj(p0+(1-p)0) -> Strategy i• B: UBi(p3+(1-p)0), UBj(p0+(1-p)0) -> Strategy i

• Nash-Equilibrium: where no player has anything to gain by changing only his or her own strategy. If each player has chosen a strategy and no player can benefit by changing his or her strategy while the other players keep theirs unchanged, then the current set of strategy choices and the corresponding payoffs constitute a Nash equilibrium.

• Social Optimum: Sum of the individual utilities UA+UB

• Coordination: Nash-Equilibrium is social optimum• Conflict: no single social optimum in a zero-sum game

Prisoners Dilemma and Chicken Games (cooperation games)

Deliver Don’t-Deliver

Pay 2,2 0,3

Don’t-Pay 3,0 1,1

Sign Kyoto Treaty

Refuse Kyoto Treaty

Sign Kyoto Treaty

3,3 2,4

Refuse Kyoto Treaty

4,2 1,1

Prisoners Dilemma Chicken Game

Bi j

Bi j

Ai

j

Analysis of strategies and equilibrium II

• Prisoners Dilemma (Assumption: p, 1-p = 0,5)• A: UAi(0,5*2+0,5*0)=1, UAj(0,5*3+0,5*1)=2 ->

Strategy j -> don’t pay• B: UBi(0,5*2+0,5*0)=1, UBj(0,5*3+0,5*1)=2 ->

Strategy j -> don’t deliver

• Nash-Equilibrium is not a social optimum, social Optimum is pay and deliver, trade (cooperation)

Institutions, Games and Enforcement

Deliver Don’t Deliver

Pay 2,2 0,3

Don’t Pay 3,0 1,1

Prisoners Dilemma Prisoners dilemma with sanctions s

Bi j

Bi j

Ai

j

Deliver Don’t Deliver

Pay 2,2 0,3-s

Don’t Pay 3-s,0 1,1

Institutions and Enforcement II

Sanction Don’t sanction

Comply Ui,-sc Ui,0

Don’t comply Uj-f,f-sc-l Uj,-l

Comply with the rules or not Sanction non-compliance or not

Ci j

Ai

j

l – loss from non-compliancesc – sanctioning costsf - fine

• Rules or convention may also emerge spontaneously, example:

• At a crossroad two drivers may stop or continue to drive

• For each driver it is beneficial to continue to drive while the other stops

• The worst case is that both drivers continue and cause and accident

• A convention right before left of left before right may emerge spontaneously

Emergence of Conventions- the Crossroad Game (evolutionary game theory

stop continue

stop 0, 0 2, 3

continue 3, 2 -10, -10

Vatn's Example: Housing Rules IPrefer Common Style

Prefer Individual Style

Vatn's Example: Housing Rules IIPrefer Common Style

Prefer Common Style

Vatn's Example: Housing Rules IIIPrefer Common Style

Prefer Individual style

Side payments require: (1) accepted property rights and (2) transaction costs lowerthan 15 units.

Whose rights should be protected?

• Transaction costs lower than 15 units: protection of rights effect the wealth of actors

• Transaction costs higher than 15 units: protection affects the resource allocation and the wealth of actors

Main Positions within Institutional Economics

Political Environment

Institutional Context

ActeursOrientations

and capacities

Action situa-tion

Forms of

inter-action

Pro-blems

Political decision

Source: Scharpf (2000: 85)

Games real actors playActors-oriented Institutionalism (Scharpf)

A Framework for Institutional Analysis (Ostrom 1998)

Attributes of Physical World

Attributes of Community

Rules-in-use

Action Arena

Action Situations

Actors

Patterns of Interaction

Outcomes

Evaluative Criteria:

Social AuditingCost-Benefit

EquityEnvironment

Case Study: LitteringIncreased fines to crack down on littering01/07/2003The fixed penalty fine for littering today increased from £25 to £50.The Executive announced the increase in fixed penalty fines on the 27 th of March. These new powers come into force today and fulfill the Partnership Agreement to increase and encourage enforcement of penalties for litter.Environment Minister Ross Finnie today joined Edinburgh City Council environmental wardens on patrol. The Minister said:"Too many communities throughout Scotland are blighted by litter and the environmental problems it causes. Edinburgh City Council and their team of wardens have done excellent work to crack down on this environmental menace. This work sets an example to many Local Authorities across Scotland."The Scottish Executive is committed to tackling the scourge of littering. Through the consultation paper 'Putting Communities First' launched last Thursday we are looking to tighten enforcement of litter laws."Littering is unnaceptable. Doubling the fixed penalty fine shows we arecracking down on this anti-social behaviour."The Environmental Protection Act 1990 provides a. that littering is an offence and b. powers to local authorities allowing them to issue notices offering the offender the opportunity of discharging any liability to conviction for the offence by payment of a fixed penalty.The Litter (Fixed Penalty) (Scotland) Order 2003 increases the fixed penalty fine for littering from £25 to £50 and came into effect on Tuesday, 1 July 2003.The Scottish Executive announced the intention to increase the fixed penalty fine for littering on March 27 2003, following the review of litter and flytipping legislation.Increasing the level of fine to £50 matches the level already in place in England and Wales.

Littering Rules in Georgia, USA

Nanjing, China

Literature and Sources

• Fehr, E. and Gächter, S. (2000) Cooperation and Punishment in Public Goods Experiments. American Economic Review 90(4), 980-994.

• Scharpf, Fritz (1998) Games Real Actors Play. Actor-centered Institutionalism in Policy Analysis.

• Ostrom, Elinor (2005). Understanding Institutional Diversity. Princeton: Princeton University Press.

• Institut für Empirische Wirtschaftsforschung (http://www.iew.unizh.ch/home/fehr/)

Lecture 3

Transactions and Transaction Costs

What is a Transaction? I

• (1) „A transaction occurs when a good or service is transferred across a technological separable interface. One stage of activity terminates and another begins.“ (Williamson 1985, p.1)

• A transaction is an elementary coordination problem connected with the question how to solve this problem institutionally (and technically)

• Example: Somebody wants to get a transfer of 1000 Euro. What’s the problem? How can it be solved?

• (2) A transaction is the „alienation and acquisition between individuals of the rights of future ownership of physical things.“ (Commons 1935, S.58)

• A transaction is a transfer of property rights

• Example: Somebody acquires the right to get 1000 Euro transferred. What’s the problem?

How do both perspectives differ?

What is a Transaction? II

What is a transaction? III

aiai+1

I1I2

Technological - separable Interface

Transfer

Property RightsOver a good or service

Goods or services

Definition of Property Rights of

I1 over ai

Definition of Property Rights of

I2 over ai+1

Source: Beckmann (2000)

Markets vs. Hierarchy

I1 I2 I2 I2

I4

I3 I3

Flow of goodsMoney flow

Market Hierarchy

Centralized vs. Decentralized Resource Management

Source: JAHAN et al (undated)

Transactions Costs

• Costs of running the economic system (Arrow 1969)

• „Cost of establishing, using, maintaining and changing institutions...“ Richter und Furubotn 1996, S. 49

• Resources spend on initiating, negotiating, safeguarding, monitoring, enforcing and adjusting transactions

• Utility losses due to imprecise arrangements, inefficient safeguarding, monitoring, enforcement or adjustment

Types of Transaction costs I

• Search and information costs– Cost of searching for suppliers, customers, products, technologies, etc.– Information about qualities, prices, etc. Function of the distribution of information and the information and

communication technology

• Negotiation and decision making costs– Negotiation, balancing diverse interests – Decision making costs, time and resources spend on decision making,

cost of wrong decisions (bounded rationality) Function of differences in preferences, number of people involved and

the decision making rule

Types of Transaction costs II

• Monitoring- and Enforcement Costs– Costs of monitoring, identification of non-compliance with the rules– Costs of enforcement, sanctioning non-compliance Function of the measurability and verifiability of activities and the

monitoring and enforcement technology

• Adjustment costs– Costs of adjusting the rules to changing environmental circumstances– Costs of maladaptation Function of the environmental uncertainty and the flexibility of rules

Categories of Transaction Costs I• Sunk and running transaction costs

– Sunk: lost inputs, no opportunity costs– Running: inputs for which opportunity costs exist

• Fixed und variable transaction costs– Fixed – not depending on the size and the frequency

of transaction – Variable - depending on the size and the frequency of

transaction • Ex-ante and ex-post transaction costs

– Ex-ante costs: before the contract has been made– Ex-post costs: after the contract has been made

Categories of Transaction Costs II

• Market transaction costs

– Costs of market organization

– Searching, preparation, agreement, supervision, monitoring, controlling, enforcement, adjustment

• Transaction costs in firms

– Costs of firm organization

– Instruction, controlling, enforcement, adjustment

• Political transaction costs

– Costs of the establishment and maintenance of a political order

– Decision making, implementation, administration, enforcement

Modeling effects of transaction costs I• Market transaction costs II

X - quantity

P - price S – supply without TC

D – demand without TC

S+TC

XX+

p

p+

Source: Furubotn and Richter (2000)

D-TC

Modeling effects of transaction costs II• Transactions costs inside the firm

Z - Input

Y - OutputY =F(Z)

Y =F+(Z)B

A E

F

D

0

Source: Furubotn and Richter (2000)

Modeling Causes and Effects, Optimality ITransaction and production costs

0Division of Labor

MTC

MPC

MC

MC-Marginal CostsMTC-Marginal Transaction CostsMPC-Marginal Production Costs

Modeling Causes and Effects, Optimality IIOptimal monitoring frequency

Monitoring frequency (MF)

CostsMonitoring costs

Utility losses

MF*

Institutions and Enforcement II

Sanction Don’t sanction

Comply Ui,-sc Ui,0

Don’t comply Uj-f,f-sc-l Uj,-l

Comply with the rules or not Sanction non-compliance or not

Ci j

Ai

j

l – loss from non-compliancesc – sanctioning costsf - fine

Modeling Causes and Effects, Optimality IIIOptimal searching activities

Search activities S

CostsSearch costs

Utility loss

S*

Modeling Causes and Effects, Optimality IITransaction costs and institutional choice

• I1 and I2 differ with regard to fix and variable transaction costs

0

TC

Frequency

I1

I2

Modeling Causes and Effects, Optimality IITransaction costs and institutional choice

• Alternatives differ with regard to fix and variable transaction costs and utility losses

0

TCUL

Expected utility losses (UL)

No sanctioning system

Introduce sanctioningsystem

Emergence of hierarchical firmsTeam-Production

number of communication channels

N(N-1)/2 N-1

Peer Group Hierarchy

25. September 2006 Volker Beckmann - Asia-Link RECREATE

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Transactions costs of the internal organization of firms

TC

Number of worker

Peer Group

Hierarchy