InstitutionsInstitutions

The Coase Theorem – The Link to The Coase Theorem – The Link to InstitutionsInstitutions Institutions and Economic Institutions and Economic PerformancePerformance

The Static CaseThe Static CaseThe Dynamic CaseThe Dynamic Case

The Polity as Creator of The Polity as Creator of InstitutionsInstitutions

The Coase Theorem – The The Coase Theorem – The Link to InstitutionsLink to Institutions

Economic EfficiencyEconomic Efficiency Neoclassical economic theory Neoclassical economic theory usually usually

works with following implicit works with following implicit assumption:assumption: the process of exchange is the process of exchange is costlesscostless = = transaction costs transaction costs are zero are zero

In this case the best things are:In this case the best things are: Perfect Competition Perfect Competition Laissez-faireLaissez-faire

The Coase Theorem – The The Coase Theorem – The Link to InstitutionsLink to Institutions

Transaction CostsTransaction Costs Negotiation CostsNegotiation Costs Measurement CostsMeasurement Costs Costs of Enforcing ExchangesCosts of Enforcing Exchanges

Decreasing transaction costs Decreasing transaction costs increases market efficiencyincreases market efficiency

The Coase Theorem – The The Coase Theorem – The Link to InstitutionsLink to Institutions

Asymmetric InformationAsymmetric Information increases increases measurement costsmeasurement costs

Reputation, Repeated Dealings and Reputation, Repeated Dealings and Competition decrease Competition decrease Costs of Enforcing Costs of Enforcing ExchangesExchanges

The Coase Theorem – The The Coase Theorem – The Link to InstitutionsLink to Institutions

Coase TheoremCoase Theorem With zero transaction costs, the With zero transaction costs, the

efficient outcome always prevails efficient outcome always prevails regardless of property rights regardless of property rights assignmentsassignments

If transaction costs are positive, If transaction costs are positive, property rights assignments have a property rights assignments have a big impact on economic outcomesbig impact on economic outcomes

The Coase Theorem – The The Coase Theorem – The Link to InstitutionsLink to Institutions

Question for discussion:Question for discussion: Suppose someone enters a room full of Suppose someone enters a room full of

people and begins to smoke a cigarette, people and begins to smoke a cigarette, generating a negative externality. generating a negative externality. Smoking is allowed in this room. What Smoking is allowed in this room. What sort of agreement must be reached in sort of agreement must be reached in order to eliminate the externality? What order to eliminate the externality? What are the transaction costs that make it are the transaction costs that make it difficult to reach such an agreement?difficult to reach such an agreement?

Institutions and Economic Institutions and Economic Performance - The Static Performance - The Static

CaseCase

Institutions and Economic Institutions and Economic Performance - The Static Performance - The Static

CaseCase A nation’s institutional framework, the A nation’s institutional framework, the

complex network of rules, customs complex network of rules, customs and enforcement systems, determines and enforcement systems, determines transaction coststransaction costs

A well functioning economy requires a A well functioning economy requires a well functioning governmentwell functioning government

Formal rules impact on measurement Formal rules impact on measurement and enforcement costsand enforcement costs

Institutions and Economic Institutions and Economic Performance - The Static Performance - The Static

CaseCase Informal rules – four fundamental Informal rules – four fundamental

cultural factorscultural factors Society’s radius of trustSociety’s radius of trust The rigor of the ethical systemThe rigor of the ethical system The way in which authority is exercisedThe way in which authority is exercised Society’s attitudes regarding work, Society’s attitudes regarding work,

innovation, saving and profitinnovation, saving and profit

Institutions and Institutions and Economic Performance - Economic Performance -

The Dynamic CaseThe Dynamic Case

Institutions and Institutions and Economic Performance - Economic Performance -

The Dynamic CaseThe Dynamic Case Three key elements of the Three key elements of the

development and integration of new development and integration of new technologytechnology

1.1. A nation must foster human creativityA nation must foster human creativity Freedom and incentives to think about and Freedom and incentives to think about and

experiment with new ideasexperiment with new ideas Society must be open to change and Society must be open to change and

willing to deal with the disruptions in the willing to deal with the disruptions in the status quo that the new technology bringsstatus quo that the new technology brings

Institutions and Economic Institutions and Economic Performance - The Performance - The

Dynamic CaseDynamic Case2. A well functioning capital market2. A well functioning capital market

3. Competitive environment that forces 3. Competitive environment that forces firms to continually improve their products firms to continually improve their products or risk being forced out of businessor risk being forced out of business Joseph Schumpeter in the early 1940s – The Joseph Schumpeter in the early 1940s – The

process of creative destructionprocess of creative destruction A successful economy must be adaptively A successful economy must be adaptively

efficientefficient Perfect competition is not necessarily optimal Perfect competition is not necessarily optimal

for creative destructionfor creative destruction Complementarity of macro and micro Complementarity of macro and micro

inventionsinventions Institutions themselves cannot be stagnantInstitutions themselves cannot be stagnant

Institutions and Economic Institutions and Economic Performance - The Performance - The

Dynamic CaseDynamic Case The persistence of poor economic The persistence of poor economic

performanceperformance: path-dependency – : path-dependency – Why?Why? Informal institutions evolve very Informal institutions evolve very

slowly over timeslowly over time

Institutions and Institutions and Economic Performance - Economic Performance -

The Dynamic CaseThe Dynamic Case Questions for discussion:Questions for discussion:

Think of some example how an inferior Think of some example how an inferior technology has won out over a superior technology has won out over a superior technology. Explain why this has technology. Explain why this has happened.happened.

Can you rank countries according to the Can you rank countries according to the level of institutions?level of institutions?

The Polity as Creator of The Polity as Creator of InstitutionsInstitutions

Government strong enough to Government strong enough to protect property rights and enforce protect property rights and enforce contracts is also strong enough to contracts is also strong enough to confiscate the wealth of its citizensconfiscate the wealth of its citizens

Contract Theory x Predatory TheoryContract Theory x Predatory Theory The Role of Time Horizon – A Time The Role of Time Horizon – A Time

Inconsistency (Dynamic Inconsistency (Dynamic Inconsistency) ProblemInconsistency) Problem

The Polity as Creator of The Polity as Creator of InstitutionsInstitutions