INSTITUTIONAL ECONOMICS

Why is it that some countries become rich while others remain poor? Do markets
require regulation to function efficiently? If markets offer an efficient way of
exchanging goods, why do individuals even create firms? How are economic
transactions organized in the absence of a state that could enforce contracts and
guarantee property rights? Institutional economics has allowed social scientists
to answer many fundamental questions about the organization and functioning of
societies. This introduction to institutional economics is concise, yet easy to
understand. It not only caters to students of economics but to anybody interested
in this topical research area and its specific subfields. Both formal and informal
institutions (such as customs, habits, and traditions) are discussed with respect to
their causes and consequences, highlighting the important part they play for
economic growth and development.

Stefan Voigt is Chair of Economic Analysis of Law at the University of

Hamburg and Director of its Institute of Law and Economics. He is also a fellow
with CESifo (Munich). Voigt is one of the editors of Constitutional Political
Economy and a member of various editorial boards, including those of Public
Choice and the International Review of Law & Economics.
INSTITUTIONAL
ECONOMICS
An Introduction
Stefan Voigt
University of Hamburg
 University Printing House, Cambridge CB2 8BS, United Kingdom

One Liberty Plaza, 20th Floor, New York, NY 10006, USA

477 Williamstown Road, Port Melbourne, VIC 3207, Australia

314–321, 3rd Floor, Plot 3, Splendor Forum, Jasola District Centre, New Delhi – 110025, India

79 Anson Road, #06–04/06, Singapore 079906

Cambridge University Press is part of the University of Cambridge.

It furthers the University’s mission by disseminating knowledge in the pursuit of education,

learning, and research at the highest international levels of excellence.

www.cambridge.org

Information on this title: www.cambridge.org/9781108473248

DOI: 10.1017/9781108573719

© Stefan Voigt 2019

This publication is in copyright. Subject to statutory exception and to the provisions of relevant
collective licensing agreements, no reproduction of any part may take place without the written
permission of Cambridge University Press.

First published 2019

Printed and bound in Great Britain by Clays Ltd, Elcograf S.p.A.

A catalogue record for this publication is available from the British Library.

Library of Congress Cataloging-in-Publication Data

Names: Voigt, Stefan, author.

Title: Institutional economics : an introduction / Stefan Voigt, University of Hamburg.

Description: 1 Edition. | New York : Cambridge University Press, [2018] | Includes

bibliographical references and index.

Identifiers: LCCN 2018030131| ISBN 9781108473248 (hardback) | ISBN 9781108461085 (pbk.)

 Subjects: LCSH: Institutional economics.

Classification: LCC HB99.5 .V65 2018 | DDC 330–dc23

LC record available at https://lccn.loc.gov/2018030131

ISBN 978-1-108-47324-8 Hardback

ISBN 978-1-108-46108-5 Paperback

Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external
or third-party internet websites referred to in this publication and does not guarantee that any content
on such websites is, or will remain, accurate or appropriate.
 Brief Contents
List of Figures
List of Tables
Preface

Introduction

1. The Basics

2. Simple Transactions

3. Repeated and Long-Term Transactions: On the Choice of

Governance Structures with Given Institutions

4. Institutions and Collective Action

5. The Relevance of Institutions for Growth and Development

6. Explaining Differences in External Institutions across Societies

7. Explaining Change in Internal Institutions

8. On the Need for Normative Theory

9. Consequences for Economic Policy

10. Outlook

References
Index
 Detailed Contents
List of Figures
List of Tables
Preface

Introduction

1. The Basics
1.1 The Standard Behavioral Model of Economics – and a Few
Modifications Made by New Institutional Economics
1.1.1 From Perfect to Bounded Rationality
1.1.2 Transaction Costs
1.2 Institutions: Functions, Types, and Interrelationships
1.2.1 Definitions of Institutions
1.2.2 Interactions between Internal and External Institutions
1.3 Research Questions
1.4 The Toolkit of Institutional Economists
1.4.1 Game Theory: A Tool for Analyzing Strategic Interaction
Situations
1.4.2 Comparative Institutional Analysis
1.4.3 Experiments in the Laboratory or the Field
1.4.4 Case Studies Including Economic History
1.4.5 Econometric Tests
1.5 NIE’s Common Ground with and Differences from Other
Research Programs
1.6 Open Questions
Further Reading
2. Simple Transactions
2.1 The Relevance of External Institutions for Simple Transactions
2.1.1 The Coase Theorem
2.2 The Relevance of Internal Institutions for Simple Transactions
2.2.1 Example 1: Norms of Cooperation and the Ultimatum Game
2.2.2 Example 2: Fairness Notions and Price Formation
2.3 The Relevance of Interplay between External and Internal
Institutions for Simple Transactions
2.3.1 Conflicting External and Internal Institutions
2.3.2 Complementary External and Internal Institutions
2.3.3 Substitutive Relationship between External and Internal
Institutions
2.3.4 Empirical Results on the Relationship between External and
Internal Institutions
2.4 On the Estimation of Transaction Costs
2.4.1 Estimations of the Size of the Informal Sector
2.5 Open Questions
Further Reading

3. Repeated and Long-Term Transactions: On the Choice of

Governance Structures with Given Institutions
3.1 Introductory Remarks
3.2 From a Black Box to the Firm as a Team
3.3 Problems Associated with Asymmetric Information: The
Principal–Agent Theory
3.4 Transaction Cost Economics
3.5 The Firm as a Collection of Assets
3.6 The Relevance of Internal Institutions
3.6.1 Example 1: Corporate Culture: On the Coordination of
 Interaction Situations within Firms
3.6.2 Example 2: On the Relevance of Reciprocity in Labor
Relations
3.7 Open Questions
Further Reading

4. Institutions and Collective Action

4.1 Introductory Remarks
4.2 Explaining Politicians’ Behavior Under Given Institutions
4.2.1 Preliminary Remarks
4.2.2 Example 1: Rent Seeking
4.2.3 Example 2: Political Business Cycles
4.2.4 The Dilemma of the Strong State
4.3 Explaining Collective Action Using Internal Institutions
4.3.1 From Non-Repeated to Repeated Games
4.3.2 Evidence from the Laboratory
4.4 The Interplay between External and Internal Institutions and its
Relevance for Collective Action
4.5 Open Questions
Further Reading

5. The Relevance of Institutions for Growth and Development

5.1 Introductory Remarks
5.2 Determinants of Economic Growth: Institutions, Geography,
Culture?
5.2.1 Institutions
5.2.2 Geography
5.2.3 Culture
5.3 The Relevance of External Institutions for Economic Growth and
Development
 5.3.1 How to Measure External Institutions
5.3.2 Early Attempts to Measure External Institutions
5.3.3 One Measurement Attempt in Detail
5.3.4 Results of Empirical Studies
5.3.5 Institutions or Policies?
5.4 The Relevance of Internal Institutions for Economic Growth and
Development
5.5 On the Interplay between External and Internal Institutions and its
Relevance for Economic Growth and Development
5.6 Open Questions
Further Reading
Appendix: A Ten-Minute Primer in Econometrics

6. Explaining Differences in External Institutions across Societies

6.1 Introductory Remarks
6.2 Origins and Change of Property Rights: A Traditional View
6.3 Origins of and Change in Property Rights and the State:
Accounting for Political Economy Factors
6.4 Explaining Differences in Institutions
6.4.1 Preliminary Remarks
6.4.2 Explaining External Institutions Based on Geography
6.4.3 Explaining External Institutions Based on Culture or History
6.4.4 Explaining External Institutions Based on Social Conflict
View
6.5 Institutional Change via Institutional Competition?
6.6 Elements of a General Theory
6.6.1 Preliminary Remarks
6.6.2 Satisficing Behavior
6.6.3 Collective Action Problems
6.6.4 Path Dependency of Institutional Change
 6.6.5 Political Transaction Costs
6.6.6 The Relative Power of the Relevant Actors
6.6.7 The Relevance of Internal Institutions
6.6.8 A Short Summary
6.7 Open Questions
Further Reading

7. Explaining Change in Internal Institutions

7.1 Introductory Remarks
7.2 The Problem in Economic Terms
7.3 Hypotheses on the Origins of Norms
7.3.1 Evolutionary Approaches
7.3.2 Repetition or Reputation as Explanatory Factor?
7.3.3 An Attempted Synthesis
7.4 Potential Triggers for Change in Internal Institutions
7.4.1 Introductory Remarks
7.4.2 Geography Again
7.4.3 External Institutions
7.5 Open Questions
Further Reading

8. On the Need for Normative Theory

8.1 Introductory Remarks
8.2 What is Normative Theory and Why Should We Study It?
8.3 Two Competing Normative Concepts
8.3.1 The Welfare Theoretical Approach
8.3.2 Hypothetical Consent: A Heuristic to Derive Normative
Statements
8.3.3 Some Critical Comments on the Unanimity Test
8.4 Requirements for a Normative Theory from the Perspective of
 Institutional Economics
8.4.1 The Approach of Williamson
8.4.2 The Approach of Hayek
8.4.3 Consequences of the Two Approaches
8.5 Open Questions
Further Reading

9. Consequences for Economic Policy

9.1 Introductory Remarks
9.2 Policy Recommendations: The Traditional – Naïve – Approach
9.3 Activation of Internal Institutions through Government Action?
9.3.1 A Specific Example: Voluntary Commitment Declarations
9.4 Policy Reforms in Practice: Case Study of New Zealand
9.4.1 The Initial Situation in New Zealand
9.4.2 Overview of the Most Important Reforms
9.4.3 Explaining the Reforms
9.5 Open Questions
Further Reading

10. Outlook
10.1 Introductory Remarks
10.2 Institutions and Mental Models
10.3 Institutions and Ideas
10.4 Institutions and Individuals
10.5 Institutions beyond the Nation-State
10.6 Institutions and Identification
10.7 Where to Turn to Start Your Own Research?
Further Reading

References
Index
 Figures
2.1 Bargaining solution when P is not liable

4.1 A graphic depiction of the prisoner’s dilemma

5.1 The evolution of income in the USA, the UK, Spain, Brazil, China,
India, and Ghana between 1820 and 2000

5.2 Relationship between latitude (measured as the distance of a

country’s capital from the Equator) and income per capita in 1995

5.3 Population density in 1500 and income per capita in 1995 among
former European colonies

5.4 Direct and indirect effects of geography on income

5.5 The relationship between culture and institutions

5.6 Overview of the components of the Economic Freedom Index

5.7 The country ranking of the Index for 2015

5.8 Economic freedom and per capita income

5.9 Economic freedom and per capita income growth

5.10 Economic freedom and the income share of the poorest 10%

5.11 Economic freedom and the income earned by the poorest 10%

5.12 Instrumenting culture with historical institutions

7.1 One value can be a reference point for multiple norms; one norm
can represent the application of multiple values

7.2 Using the concept of interdependent utility functions to explain the

existence of costly sanctions

7.3 The Habsburg Empire in Eastern Europe

8.1 The interdependence cost calculus

 Tables
1.1 Types of internal and external institutions

1.2 Identification of research fields

1.3 Related research programs

4.1 Internal institutions and individual contribution to collective action

 Preface
The new institutional economics is an impressive success story. Within just a
few decades, this young subdiscipline has attracted some of the brightest
scholars around, several Nobel prizewinners among them.
The book is aimed at familiarizing anybody interested in the new
institutional economics with its most basic concepts. No prior knowledge in
economics is needed. I have attempted to use plain language and avoid economic
jargon. As the new institutional economics continues to develop at high speed, it
was impossible to do justice to every branch of its research program; instead,
this book summarizes the state of the art from a subjective point of view.
A German-language predecessor, Institutionenökonomik, was published in
2002 by Wilhelm Fink publishers. A comparison between that edition and the
current one reveals how much, and how quickly, new institutional economics has
progressed: some chapters had to be completely rewritten to reflect the progress
made during the last 15 years.
I was extremely lucky to have a group of very gifted – and highly critical –
collaborators. We discussed every single page of this introduction to the field.
Thanks to Marek Endrich, Dr. Jerg Gutmann, Dr. Stephan Michel, and
Konstantinos Pilpilidis for critically – but also constructively – reading the first
draft of this edition. Dr. Sang-Min Park and Mark Pegors helped make my
English readable. Many thanks to them, too.
 Introduction
◈

Why do a few hundred million people enjoy a very high income while billions
suffer from malnourishment and struggle to survive? Why do certain types of
constitutions – ones that have proved very successful elsewhere – often not have
their intended results, for instance, high incomes for the populace and a stable
political system? Why is it that development programs introduced with the best
intentions by the World Bank or the International Monetary Fund (IMF) often do
not induce development, but instead sometimes even make the poor worse off?
Is there a systematic relationship between individual freedom and per capita
income? In the case of formerly socialist societies, is there indeed only a single
silver bullet, namely, to privatize as fast and comprehensively as possible?
These are among the many questions that concern institutional economists.
Institutional economists do not claim to be able to answer these questions
comprehensively, but they do claim that their methods of investigating these
questions can lead to more convincing answers than those offered by traditional
economists.
The core hypothesis of institutional economics is that growth and
development are decisively shaped by the prevailing institutions. The willingness
as well as the ability not only to specialize, and thereby contribute to a deeper
division of labor, but also to make long-term capital investments depends on the
security of private property rights. Chapter 1 shows that property rights are an
essential component of the institutions we are about to analyze. The form and
content of private property rights, as well as possible costs of their enforcement,
are crucial determinants in explaining why growth and development unfold – or
do not. Douglass North, who was awarded the Nobel prize for his achievements
regarding institutional economics, writes that “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” (1990a, 54).
Another pioneer of institutional economics, Mancur Olson, asks why some
nations are rich while others are poor. After having gone through the usual
suspects (such as different access to knowledge, different access to capital
markets, differences regarding population size in relation to arable land or the
abundance of natural resources, differences in human capital, etc.), he concludes
that none of them is particularly convincing and continues: “The only remaining
plausible explanation is that the great differences in the wealth of nations are
mainly due to differences in the quality of their institutions and their economic
policies” (1996, 19).
To most non-economists, the relevance of institutions might appear so self-
evident that it is difficult to understand why a still fairly young research area in
economics puts that relevance center stage and even calls it “new.” The answer
lies in the fact that mainstream economics has long neglected institutions, albeit
usually benignly. For many decades, growth theory tried to explain differences in
growth across countries without explicitly taking into account the underlying
institutions, looking instead at changes in labor and capital goods supply.
Over the last couple of decades, however, an increasing number of
economists have become interested in how institutions might influence
economic development. Among them are a number of Nobel laureates, including
Ronald Coase, Friedrich Hayek, Douglass North, Elinor Ostrom, Herbert Simon,
and Oliver Williamson. The new institutional economics is not marginal
anymore: it is an amazing success story.
This brief introduction to the new institutional economics is aimed at a
wider audience than just economists or students. Economics does not have a
happy reputation; indeed, it is often referred to as the “dismal science.” Many
non-economists view economics as a soulless science completely divorced from
real people and real life. Scientists in other disciplines often claim that
economists abstract from so much relevant context that their results are
meaningless. The new institutional economics takes these criticisms seriously,
while still remaining “economic” in nature, taking some comfort from the fact
that some have crowned economics as the queen of social sciences. In truth,
economists have always inquired into constraints on human behavior when
explaining individual choices. Traditionally, the main focus has been on the laws
of nature as well as on budgetary constraints. The new institutional economics
takes the less-traveled path of explicitly acknowledging that both proscriptions
and prescriptions influence human behavior and, further, that these proscriptions
and prescriptions are not only state imposed and enforced (e.g., speed limits) but
are also found in the norms of a society (e.g., in many countries, if one wants to
board a bus, one must stand in line to do so, with deviations being sometimes
quite severely punished by others in the queue).
Indeed, norms, customs, traditions, and mores can channel behavior just as
much, sometimes even more, than laws. Whereas laws can be changed radically
and swiftly, such is not the case with norms, customs, traditions, and mores.
Thus the second core hypothesis of new institutional economics is that the
possibility of implementing institutions conducive to growth and development is
constrained by the cultural imprint of the respective society. Or, as Douglass
North puts it: “Although formal rules may change overnight as the result of
political or judicial decisions, informal constraints embodied in customs,
traditions, and codes of conduct are much more impervious to deliberate
policies” (1990a, 6).
If it is true that growth and development are determined by both formal and
informal rules, the interdependencies between them must be explicitly taken into
account. A general hypothesis is that the enforceability of formal rules ultimately
depends on their compatibility with informal ones (Weingast, 1995; Voigt,
1999a, ch. 5). This is not especially good news for politicians and their advisors
whose carefully designed programs optimistically intend to turn entire countries
around within just a hundred days and set them on a path to growth and
prosperity. Institutional economists view such optimism skeptically and more
cautiously hope for a sequence of incremental improvements.
Conventional textbooks usually present the (more or less) solid knowledge
of the respective field in a didactically sophisticated fashion. I have opted for a
different approach in this book. I frequently point out that our knowledge
regarding the effects of specific institutions is quite limited (yet). Every chapter
ends with a section entitled “Open Questions.” My hope is that these questions
will inspire curiosity in readers, even leading some to become researchers
themselves. If this book manages to make institutional economics seem exciting
and valuable, it will have achieved its goal.
Just a word on my use of references. In each chapter, I quote from or cite
those publications that have been seminal contributions to a particular topic.
However, I realize that such references might be somewhat daunting to a reader
just beginning to become acquainted with the topic. Therefore, the further
reading recommendations at the end of the chapters were selected to be more
accessible; surveys – either in the form of papers or books – were given priority.
 1
The Basics
◈

To deal with specific research questions and the results of a rather novel research
program, some groundwork needs to be laid here in Chapter 1. First, we take a
brief look at the standard behavioral model of economics utilized by the majority
of economists today. We also look at extensions of this standard behavioral
model proposed by representatives of the new institutional economics (NIE).
Second, we cope with the problems of defining institutions. After briefly
considering several different ways of doing this, we develop a taxonomy of our
own, one that we then use in all subsequent chapters. Third, we present a
systematic overview of the research questions with which representatives of NIE
are concerned. The structure of all subsequent chapters in the book is based on
this systematic presentation of these research questions. Fourth, we describe
instruments and methods employed by institutional economists to shed light on
these research questions. Fifth, and last, we locate NIE within the landscape of
economics by taking a look at the differences between NIE and neoclassical
economics. We then consider differences and similarities between NIE and other
related research traditions, such as public choice, constitutional political
economy, and the economic analysis of law or law & economics, as it is also
called.
 1.1 The Standard Behavioral Model of
Economics – and a Few Modifications Made
by New Institutional Economics
To explain and predict human behavior, we need a behavioral model – and we
have one. However, the standard behavioral model of economics – that of the
homo economicus – is not without its detractors.

The standard behavioral model of economics: the homo economicus

Many regard it as too simple, arguing that a behavioral model that leaves
out so many relevant details necessarily produces inaccurate predictions.
Consequently, any policy recommendations based on the standard behavioral
model will also be less than optimal. In this section, we briefly present the
standard behavioral model before considering a few modifications to it proposed
by representatives of NIE.
Let’s begin with a very basic question: What is economics?

Modern economics is defined by its approach, not by its subject matter

Traditionally, economics was defined via its subject matter, the economy. In
recent decades, however, economics has become defined via its approach (see,
e.g., Becker, 1976). Economists have realized that their approach can be applied
to a variety of subjects, many of which are completely unrelated to “the
economy.” Following this delineation, economics can be used to analyze any
decision that involves scarcity. For instance, there is an economic approach to
marriage and fertility, an economic approach to segregation, to crime, even to
teeth brushing. The economic approach can also be utilized to analyze politics
(public choice) and law (law & economics).
A key assumption of the economic approach is that all actors aim to
maximize their utility.

Definition

In economics, utility is defined as the contribution of a good to the

fulfillment of individual needs.

However, the means for attaining utility are scarce. Moreover, utility does not
only involve monetary aspects but can also refer to non-pecuniary aspects. For
instance, one’s utility can be increased by being liked by one’s neighbors. The
traditional economic approach also assumes that actors’ preferences are constant,
but that constraints – that is, restrictions on behavior – are not. Preferences are
defined as an expression of how alternative goods are valued relative to each
other: for instance, A is preferred over B. Restrictions encompass not only laws
of nature and an actor’s resources, but also man-made laws, the violation of
which can incur sanctions (which raise the “price” of illegal behavior). Further
restrictions include norms, customs, and traditions (these, too, raise the price of
certain, nonconforming actions), temporal constraints (one can only work 24
hours per day), and informational constraints (one cannot desire a good without
knowing about it).

Definition
 Models are purposefully simplified depictions of reality that can help in
understanding specific important aspects of reality.

In many economic models, it is assumed that actors are rational in their pursuit
of maximizing utility, subject to given restrictions. As a whole, these
assumptions are subsumed as the homo economicus model. It is important to
remember, however, that this is a model – and thus it does not claim to describe
reality completely or even necessarily correctly.

Homo economicus: rational, utility-maximizing agent with stable

preferences

Nevertheless, the homo economicus model can help explain human

behavior and predict how such behavior will change when restrictions change.
Changes in behavior are never ascribed to changes in preferences, as that would
not be an explanation but, rather, a reformulation of the problem.
Furthermore, economics is based on the assumption of methodological
individualism; that is, it is only individuals who act, not collectives, such as
firms or governments.

Definition

Methodological individualism is based on the assumption that only

individuals can be actors and implies that all outcomes – even at the
macro level – must be explained by referring to individual behavior.
When we observe results on a collective level that are the consequence of the
interactions of many people and yet these results were not intended by any of the
involved actors, it is the task of social scientists, including economists, to
explain how the interplay of individual action unintentionally produced this
collective result.
It seems fair to say that by now, most economists work with these
assumptions. What, then, are the contributions of NIE that distinguish it from
more traditional economics? There are two main differences between the two
approaches:

1. Their subject matter.

2. The assumptions made.

With regard to subject matter, traditionally, rules that help structure interactions
were thought of as part of the reference data used in decision-making. In other
words, they were assumed to be given. By employing the economic approach, it
is possible, however, to investigate the choice of rules and changes thereof over
time. With regard to the assumptions made, institutional economists promote two
modifications to the traditional behavioral model. The first is to assume bounded
rationality instead of perfect rationality. The second is to consider the costs of
economic exchange. Traditionally, economists assumed that such exchange is
costless. Institutional economists emphasize that economic exchange entails
information costs, search costs, negotiation costs, and fulfillment costs, the level
of each depending on the type of institutions in effect. These costs are called
transaction costs and in economics they were usually assumed to be zero. The
concepts of bounded rationality and transaction costs are closely related to each
other.
 The distinctive features of institutional economics: bounded rationality
and transaction costs

1.1.1 From Perfect to Bounded Rationality

Traditionally, it was assumed that individuals attempt to maximize their utility in
a perfectly rational manner. This implies that they can predict every possible
state of the world and that they are able to choose from all available courses of
action the one that delivers the highest individual utility. In this far-from-the-real
world, individuals are capable of evaluating the consequences of all possible
actions immediately and without cost. Or as Kreps (1990, 745) put it, completely
rational individuals possess “the ability to foresee everything that might happen
and to evaluate and optimally choose among available courses of action.”
Uncertainty, that is, a situation in which actors are not capable of computing
expected utility because they are not able predict all possible states of the world,
was introduced to economics by Frank Knight (1922). He distinguishes between
uncertainty and risk. In the face of risk, actors are able to assign probabilities to
a finite number of possible states of the world. Thus, in a risky situation, actors
are able to compute expected utility, meaning that established decision theory is
applicable. However, once we move from a situation with risk, that is, one in
which consequences are relatively predictable, to a situation with uncertainty,
that is no longer possible.

Boundedly rational individuals attempt to satisfice acceptability

thresholds
 Herbert Simon (1955), recognizing that the assumption of perfect
rationality is inappropriate given an environment characterized by uncertainty,
introduced the notion of bounded rationality into economics. He replaced the
assumption of individual utility maximization with satisficing behavior, which
involves individuals defining realistic acceptability thresholds. Only when those
thresholds are not met, do individuals begin to consider courses of action
different from their routinely chosen ones. It has been demonstrated that in a
situation with uncertainty, it can be rational to utilize rules in deciding how to
behave (Heiner, 1983). This type of rationality is often called “rule rationality,”
and it is a way for actors to rationally cope with uncertainty.

1.1.2 Transaction Costs

Transaction costs were introduced into economics by Ronald Coase (1937). He
defines them as the costs of using the market. Ignoring transaction costs (or
setting them to zero) is equivalent to assuming markets that function efficiently
and costlessly. However, when markets function efficiently and without costs,
there is no reason for firms to exist. Why? Let us assume that firms are primarily
characterized by interactions not being organized via voluntary exchange (like in
markets) but via commands issued from higher-ranked to lower-ranked members
of a firm. Relying on instructions and hierarchy entails various costs: those
receiving the instructions might not be motivated to complete them to the full
satisfaction of their bosses; a costly need to monitor their behavior might arise,
and so forth. Let us call the resulting costs “organization costs.” Now, if using
hierarchies (firms) is costly whereas the use of markets is costless, there is no
reason for firms to exist. Coase now explains the existence of firms by saying
that – for some activities – the costs of using the market (i.e., transaction costs)
are higher than the costs of using hierarchies like firms. Carl Dahlman (1979,
148) describes transaction costs as “search and information costs, bargaining and
decision costs, policing and enforcement costs.”
Imagine that temperatures begin to fall and you are thinking about buying a
winter coat. Since it is already quite cold outside, you decide to shop online. You
want something that is fashionable and well-made and to buy it from a store that
has a good reputation not only for quality but for customer service, too. And, of
course, you would like to pay as little as possible. Finding a coat that meets all
these requirements will cost you some time and this cost is here subsumed under
search and information costs. Suppose that you finally find a coat that you would
really like to have, but not at the price currently shown. So, you use a search
engine to locate a better price and you even try to find webstores that allow you
to make an offer. But now you need to assess the reliability of some of these
offers. Will that store in East Asia really deliver the original product? Do you
trust it enough to give out your credit card information? Dahlman calls the costs
of this type of activity “bargaining and decision costs.” You take the plunge and
buy the coat. You are delighted when the coat arrives before the first snow falls,
but this feeling quickly turns to disappointment when you discover that the coat
keeps you neither warm nor dry. You search the store’s webpage and eventually
find the fine print regarding its returns policy. Packaging up the coat and taking
it to the post office costs you additional time and money. Much to your chagrin,
the store never sends you a replacement coat, nor does it even acknowledge,
much less reimburse you for, the return of the first coat. By this time, you are so
angry you are even thinking of taking legal action. You have now incurred what
Dahlman calls “policing and enforcement costs.”
The assumption of nonzero transaction costs is a logical consequence of
bounded rationality, whereas perfectly rational individuals, by definition, face no
transaction costs. An individual with perfect knowledge does not have to incur
costs of collecting information, negotiating, or enforcing the terms of a
transaction.

Close relationship between bounded rationality and transaction costs

The significance of transaction costs not only for the existence of firms, but
for economic development in general, should now be clear. Generally, the higher
the transaction costs, the lower the number of transactions. And a lower number
of transactions implies a lower degree of specialization and, at the end of the
day, less income.

Transaction costs and bounded rationality in economics

Both transaction costs and bounded rationality have found their way into
other subdisciplines of economics. Information and search costs, as one
important component of transaction costs, play a central role in what is
called “information economics,” which deals with the peculiar properties
of information such as how easily it spreads but how difficult it is to
verify. Information asymmetry, the situation in which one actor in an
interaction has better or different information than another actor, will be
discussed in Chapter 3.
Behavioral economics is a subdiscipline of economics that is
interested in how real people really behave – not in how they would
behave were they fully rational. In a sense then, the limited – or bounded
– rationality of real people is the starting point for behavioral economics.
The concept of transaction costs is not restricted to the economy. For example,
analysts of political markets employ the same idea, and call these costs political
transaction costs (North, 1990b, 1993). Given that political markets are subject
to much more inefficiency than traditional goods markets due to the difficulty of
quantifying the goods to be exchanged or committing to binding promises
regarding the services to be rendered, the relationship between a politician and
his or her electorate can be viewed as a barter exchange. Votes are exchanged for
promises to enact certain policies. However, after the election, voters have very
few, if any, means of forcing politicians to keep their promises. New institutional
economists are actually not the first to realize this. Jean-Jacques Rousseau, for
example, said: “The English people think they are free, but they are greatly
mistaken. They are free only at the moment when they elect members of
Parliament, and once those are elected, the people are slaves, they are nothing.”
The first German chancellor after its unification in the nineteenth century, Otto
von Bismarck, wrote that “[p]eople never lie so much as after a hunt, during a
war or before an election.” And finally, American writer H. L. Mencken quipped
“[e]very election is a sort of advance auction sale of stolen goods.” Applying the
concept of political transaction costs to this situation, it follows that these costs,
in the form of monitoring and enforcement costs, are high.

Alternative delineations of transaction costs

It is frequently the case that terms central to a novel research program are
defined very differently by different scholars, and the term “transaction
costs” is no exception. Doug Allen (2011, 19), for instance, defines them
as “those costs necessary to establish and maintain any system of rules
and rights.” Whereas our preferred definition focuses on the costs that
participants to an interaction situation incur individually, Allen’s
 definition focuses on the overall costs necessary to maintain functioning
institutions. His definition is thus not concerned with the costs incurred
by individuals but in those incurred by society as a whole.
In the Encyclopedia of Law and Economics, under the topic
“Transaction Costs,” Allen (2000) distinguishes between a neoclassical
definition that focuses on the costs of trading in a market and a property
rights definition that centers on the costs of establishing and enforcing
property rights. Allen presents a very detailed survey not only of the
various definitions of transaction costs, but also of the history of the
term, as well as the difficulties in measuring transaction costs and the
possible implications of this difficulty.
In our preferred definition of transaction costs, information costs are
at the root of transaction costs. This view is not uncontested. Yoram
Barzel (1977), for example, argues strongly in favor of strictly separating
information from transaction costs. As definitions cannot be true or false,
the most appropriate definition might well depend on the specific
research question being investigated.

1.2 Institutions: Functions, Types, and

Interrelationships
Two cars approach each other on a street so narrow that they cannot pass each
other without reducing their speed. Each driver wonders what the other will do.
Two strangers would like to exchange goods, the quality of which is not
immediately obvious. Under what conditions will the strangers agree to the
exchange? Two students decide to found a firm. How can either of them
ascertain that the other will not cheat? These are three examples of interaction
situations in which there is strategic uncertainty. Strategic uncertainty is
present when the result of an action depends not only on one’s own behavior, but
also on that of another actor. This is different from parametric uncertainty, in
which the result of an action depends on the realization of some exogenous
event, for instance, on whether it rains or snows. One possible consequence of
strategic uncertainty is that some exchanges simply do not occur. For example,
with regard to the interaction situations described above, it is possible that the
good will not be traded or the firm will not be founded.

Two types of uncertainty

As soon as two real people interact, there is strategic uncertainty. If the

interacting individuals are unable to form expectations concerning the actions of
each other, long-term interactions are unlikely to take place. Trade relations, for
example, will tend to be restricted to simultaneous exchanges and the extent to
which labor specializes and division of labor is worthwhile will be limited.
Ultimately, living standards will be low. This suboptimal environment can be
improved, however, if strategic uncertainty can be reduced by behavioral
restrictions. And this is one of the main functions of institutions – to reduce
uncertainty, thus lengthening the time horizon of actors and providing
incentives to specialize, which leads to a higher degree of division of labor. In
short, institutions can help to improve living standards.

Consequences of strategic uncertainty

 To this point, the concept of institutions has been presented from a
functional perspective. However, if we are interested in explaining the
development of institutions, we must be careful not to commit a functionalist
fallacy, which occurs when the existence of some phenomenon is explained by
its positive effects. For example, a law should not be assumed to pass because it
can be expected to have positive effects on welfare, but because certain actors
expect to gain from it. Within the framework of methodological individualism,
we can explain the origins of institutions only if we understand the incentives of
the actors involved in their establishment.

1.2.1 Definitions of Institutions

NIE is a young research program and has not yet arrived at a universally
accepted definition of institutions. According to North (1990a, 3), “[i]nstitutions
are the rules of the game in a society or, more formally, are the humanly devised
constraints that shape human interaction. In consequence they structure
incentives in human exchange, whether political, social, or economic.”
In this book, we propose a definition that is more similar to that of Ostrom
(1986) but fully compatible with the one proposed by North. We think it is
important to distinguish between two components of institutions: the rule
component and the sanction (or enforcement) component. We can then define
institutions as commonly known rules used to structure recurrent interaction
situations, such rules being endowed with a sanctioning mechanism in case of
noncompliance. This definition is explained in greater detail in Voigt (2013).

Institutions as rule plus sanction

 Definition: Rules

1.2.1.1 Characteristics of Rules

Following Ostrom (1986, 5), we define rules as “prescriptions commonly known

and used by a set of participants to order repetitive, interdependent
relationships. Prescriptions refer to which actions (or states of the world) are
required, prohibited, or permitted. Rules are the result of implicit or explicit
efforts by a set of individuals to achieve order and predictability within defined
situations.” Two characteristics of this definition are of particular note:

1. A rule is commonly known. This does not mean that every individual of
a society knows all the rules by heart. Such would not be possible. Instead,
“commonly known” means that purely private rules not shared by other
members of society are not rules.

2. Rules are the result of human action, but not necessarily the outcome
of deliberate human design, as their origins can be traced to both explicit
and implicit attempts of individual actors to structure interaction.

Result of human action, but not of human design

A rule can emerge over time due to the actions of individual actors even
though those actors did not intend to create the rule. Take, for instance,
rules of speech, which have emerged from human action without anyone
designing them. The Nobel prize winning economist Friedrich A. Hayek
often used the expression “result of human action, but not of human
design” in order to point out the evolutionary component of rule
 development. He credits Adam Ferguson (an eighteenth-century Scottish
moral philosopher) as source for this idea. Ferguson, for his part,
attributes the idea to Jean François Paul de Gondi, Cardinal de Retz

(Ferguson, 1995 [1767])

Rules can take one of two forms: (1) commandments that prescribe specific
behavior or a range of allowed actions or (2) prohibitions that disallow one or
more specific actions.

Five types of rule enforcement

1.2.1.2 Types of Enforcement

Rules are without consequence unless they can be enforced. There are several
archetypal forms of rule enforcement. First, there are some rules that are in one’s
self-interest to comply with because noncompliance would make you worse off.
Such rules are referred to as self-enforcing. From a game-theoretic perspective,
interactions governed by this type of rule can be described as pure coordination
games in which rule compliance is the dominant strategy for all players. The
most commonly cited example of a self-enforcing rule is the one that requires all
drivers in a country to drive on the right side of the road; an individual rational
driver will in no way benefit from not complying with this rule.

(1) Self-enforcement
 A second way to enforce rules is self-commitment by the actors. What
distinguishes this form of monitoring from self-enforcement is that in this case
actors are likely to have internalized certain ethical rules. Suppose you intend to
always follow the golden rule but then a situation arises that makes you
contemplate deviating from it. But then you begin to think how bad you are
going to feel about yourself if you act against your principles. In the end, you
might well decide to follow the golden rule even in this instance.

(2) Self-commitment

Definition

Internalize: to give a subjective character to; specifically: to incorporate

(as values or patterns of culture) within the self as conscious or
subconscious guiding principles through learning or socialization
(Merriam-Webster)

When internalized rules involve culturally handed down modes of conduct, they
fulfill the criterion of being commonly known. Via the shared beliefs and
opinions of a social group, these rules induce observable behavioral
conformities, regardless of specific personal situations. Take, for instance,
someone visiting a beach who is sure that no one is watching him and who never
plans to return to the beach. Even so, he might incur the “cost” of walking over
to the next trashcan to throw away his garbage instead of just leaving it on the
beach.1
Not every interaction situation lends itself to a self-enforced rule or self-
commitment by the actors. Some types of interactions are governed by rules that
require enforcement via explicit sanctions by other actors and thus may involve a
collective action problem.

Note

Collective action problem: When all actors potentially could benefit from
a certain action – in this case a particular sanction – frequently none of
the actors will take that action, hoping that the other actors will do so

The collective action problem of sanctioning rule breakers becomes relevant

with regard to spontaneous societal enforcement. This involves an unknown
number of persons informally monitoring compliance with societal rules.
Supposedly, every member of the group has an interest in rule breakers being
sanctioned. But since sanctioning is connected with disutility and, hence, costly,
every member of the group hopes that some other group member will do the
costly sanctioning. If, ultimately, nobody does the sanctioning, the rule is likely
to erode. A somewhat indirect sanction for noncompliance is to inform others
about the rule breaking and thus damage the rule breaker’s social reputation. If
a poor reputation makes it more difficult to interact with others in the future, the
threat of losing one’s reputation might be sufficient to ensure compliance with
the rule.

(3) Spontaneous societal enforcement

There are two other types of enforcement that are different from the ones
just discussed in that they are organized: organized private enforcement and
organized state enforcement. An example of organized private enforcement is
private arbitration courts. State courts are an example of organized state
enforcement. The two types differ in that organized state enforcement, in
contrast to organized private enforcement, contains an element of hierarchical
order in that private actors are subordinated to state control.

(4) Organized private enforcement

(5) Organized state enforcement

To better understand the concept of institutions, consider the following two

points:

1. The first component of an institution (in our definition) is a rule. This

rule always constrains behavior. However, not every behavioral constraint
is a rule; for example, constraints due to natural laws (e.g., the law of
gravity) are not rules. Second, promises as such are not institutions.
Contracts contain mutual promises to act in specific ways and they do
constrain future behavior. But they are not rules in the sense of commonly
known prescriptions. In other words, most contracts are not institutions but
they may be, and often are, based on institutions if they are framed within
the boundaries of the relevant contract law.2

2. Institutions provide information and thus help reduce strategic

uncertainty. Other phenomena also provide information, such as
newspapers, news broadcasts, or prices, without necessarily reducing
strategic uncertainty. But none of these involve a rule or an enforcement
mechanism and, hence, do not qualify as institutions.
Table 1.1 provides a summary of what we have thus far covered. We suggest
distinguishing between five types of institutions. We propose to classify
institutions that are not enforced by the state as internal institutions. Institutions
that are enforced by the state are classified as external institutions. This
typology is based on a conceptual distinction between state and society. Thus,
internal institutions are those for which noncompliance is sanctioned from within
society, and external institutions are those for which noncompliance is
sanctioned by the state – external to society.

Society vs. state ↔ internal vs. external institutions

Table 1.1. Types of internal and external institutions

Form of Type of
Rule enforcement institution Example

1. Self-enforcement Internal type Grammatical rules

Convention 1

2. Ethical Self-commitment Internal type The Ten

rule 2 Commandments, the
Categorical Imperative

3. Custom Spontaneous Internal type Rules of social

informal societal 3 conduct
enforcement

4. Formal Organized private Internal type Private arbitration

private rule enforcement 4 courts

5. Rules of Organized state External Private law, criminal

man-made enforcement law
 law

Source: Voigt and Kiwit (1998, 86).

The values and norms shared by a significant part of a society’s members

are particularly represented in internal institutions of type 2 and type 3. Values
can be defined as “conceptions of the desirable, influencing selective behavior
… Values are not the same as norms for conduct … Values are standards of
desirability that are more nearly independent of specific situations. The same
values may be a point of reference for a great many specific norms; a particular
norm may represent the simultaneous application of several separable values”
(Darity, 2007). Thus, justice could be a shared value, but what is “just” in a
specific situation is determined by the norm of justice. Societal justice norms can
be enforced via self-commitment by actors (type 2), but also by members of
society sanctioning rule breakers (type 3).

Values and norms

Definitions, again

As mentioned earlier, there is no shortage when it comes to definitions of

“institutions.” In this box, I briefly discuss the relationship between the
definition suggested here and other frequently used definitions. North
(1990a) distinguishes between formal and informal institutions, using the
rule component as the criterion, and I thus refer to this distinction as one
between formal and informal rules. Sometimes, however, rules emerge
spontaneously and become ever more formalized over time. It is unclear
how formalized a rule must be before it qualifies as a formal rule. Does it
need to be written down somewhere? Does it need to pass some formal
legislative procedure? The distinction between external and internal
institutions suggested here is based on who does the sanctioning in the
event a rule is violated. If it is the state that sanctions rule breaking, the
enforcement is external to society and is called “external” here; if rule
breaking is sanctioned by members of society, the institution is called
“internal.” One can also think of this as “public” versus “private”
sanctioning.
Acemoglu et al. (2005a) propose distinguishing between economic
and political institutions. Economic institutions “determine the
incentives of and the constraints on economic actors” (Acemoglu et al.,
2005a, 386). Similarly, political institutions “determine the constraints
on and the incentives of the key actors, but this time in the political
sphere” (Acemoglu et al., 2005a, 390). According to Acemoglu et al.,
political institutions allocate de jure political power. Political institutions
determine economic institutions and the authors thus think of these
institutions as hierarchically structured. However, it is not always easy to
precisely differentiate between the political and the economic spheres.
For example, how would one classify institutions constraining state-
owned enterprises? Whereas North (1990a) emphasizes the difference
between formal and informal rules, the distinction between economic
and political institutions uses the kind of interaction as a classification
criterion, and I emphasize the difference between internal and external
sanctioning of rule breakers.
Greif (2006) proposes a very broad definition designed to
encompass many previous definitions, many of which he mentions and
briefly evaluates. He proposes to define institutions as “a system of rules,
 beliefs, norms, and organizations that together generate a regularity of
(social) behavior” (2006, 30, italics in original) and points to some
advantages of his proposal. I prefer not to use Greif’s definition because
it has some disadvantages. His definition does, indeed, encompass both
the rules of the game and the outcome of the game. If there is no
regularity in behavior, no institution exists. Economists are interested in
discovering how institutions influence economic results such as growth
and income. If the definition of an institution is already based on the
outcome, then a cause–effect relationship is difficult to establish. The
conflation of at least four elements – (1) rules, (2) beliefs, (3) norms, and
(4) organizations – in a “system” seems to make exact measurement
almost impossible. Moreover, how exactly are these ingredients
transformed into behavioral regularities?

1.2.2 Interactions between Internal and External Institutions

Institutions come in all sizes and flavors; they differ not only with regard to their
enforcement, but also with regard to the content of the rule component. As the
rule components of institutions have various origins and hence are likely to set
conflicting incentives for behavior, we are interested in the interactions between
institutions of different types. It is easy to imagine that the incentive effects of
some external institution might be corroborated by some internal institution. By
the same token, it is possible that internal institutions counter or neutralize the
effect of external institutions. Interactions like these should play a significant
role in how well an institution is able to reduce uncertainty. Logically, there are
four kinds of interaction between institutions:
 1. Institutions can be characterized by a neutral relationship. This is the
case when the institutions in question involve unrelated domains of human
behavior.

2. Institutions can be complementary when they constrain human behavior

in a similar or equal manner and rule enforcement is organized via the state
as well as by private actors.

3. Institutions can be substitutive. This is the case when they affect human
behavior in the same or similar manner, but rule enforcement is organized
via the state or privately.

4. Institutions can be in conflict when compliance with the internal

institution implies noncompliance with the external institution and vice
versa.

Note that these four kinds of relationships are possible not only between internal
and external institutions, but also within different kinds of internal ones and even
within single types.

Internal and external institutions can mutually reinforce, but also

mutually weaken, their incentive effects

Predictions about human behavior based on the simple model of the homo
economicus have often proven wrong. In the standard behavioral model of
economics, changes in behavior are induced by changes in restrictions, while
preferences are assumed to be constant. Rather than completely abandoning this
approach, it could be worthwhile to investigate the relevant restrictions in more
detail. Institutional economists assert that the quality of behavioral predictions
can be substantially improved when restrictions that are based on internal
institutions – such as habits, traditions, ethical rules, and so on – are accounted
for to a greater extent than in the case under more traditional approaches.

1.3 Research Questions

In the chapters to follow we distinguish between two levels of analysis:
1. On the first level of analysis, institutions will be assumed to be
exogenously given. We then look at how these institutions affect economically
relevant variables. By comparing various types of institutions, we can discover
whether different institutions lead to different outcomes. Indeed, institutional
economists argue that the large variance in observed institutional systems is a
crucial factor in differing growth rates of GDP. The second part of the book
(Chapters 2–5) deals with this level of analysis.

Exogenous variables are variables determined outside the model

Endogenous variables are determined within the model

Definition

Variance measures the spread of a set of numbers. If all numbers have

the same value, the variance is zero

2. On the second level of analysis, institutions are endogenized, allowing

us to investigate the origins of institutions, which is important in light of
the large variance in existing institutions. In the third part of the book
 (Chapters 6–7) we present existing approaches to explaining the origins of
and change in external and internal institutions.

The 2 × 2 matrix of Table 1.2 is based on the typology of external and internal
institutions introduced earlier.

Table 1.2 Identification of research fields

Origins of
Effects of institutions institutions

External institutions 1 3

Internal institutions 2 4

These four research fields are all located within the realm of positive, as
opposed to normative, research. The point is not to discuss which institutions are
optimal and should, hence, be implemented, but to find out how certain
institutions develop (cells 3 and 4) or what effects certain institutions have on
economic outcomes (cells 1 and 2). In the following paragraphs, we utilize this
simple matrix to describe some of the research questions with which institutional
economics is concerned.

Positive vs. normative

Structure of the book

The effects of exogenously given external institutions (cell 1) are

interesting for a number of interaction situations:
 (a) How do institutions affect voluntary exchange of goods between private
actors? Specifically, which goods are exchanged? What is the method of
payment? This is the topic of Chapter 2.

(b) How do institutions affect the way private actors structure repeated
transactions? Chapter 3 deals with such questions.

(c) Chapter 4 looks at how institutions affect the incentives for collective
action. Here, the focus is on the behavior of state representatives, but we
also investigate the possibility of providing certain public goods – for
example, clean air – voluntarily, that is, without recourse to government
action.

(d) Finally, how do institutions affect GDP growth and economic

development? Chapter 5 reviews results from the literature.

Research questions (a)–(c) are at the level of microeconomics, whereas

question (d) involves the macro level. Note that question (d) will be answered
based on insights gained from answering questions (a)–(c).
The questions just posed fit in cell 2 of Table 1.2. The third part of the book
deals with cells 3 and 4. Chapter 6 addresses the question of how we can utilize
the economic approach to explain change in external institutions. The question
of how change in internal institutions can be explained with the economic
approach (cell 4) is investigated in Chapter 7.
If there is more than one course of action open to a policymaker, the
question arises as to which of the possible courses of actions should be chosen.
Answering this question requires a normative theory. Thus, Chapter 8 presents
extant normative approaches. Chapter 9 takes a look at what consequences NIE
has for public choice theory and actual economic policy. The final chapter of the
book, Chapter 10, contains an exploration of potential new pathways in NIE.
 1.4 The Toolkit of Institutional Economists
We now present the tools that can be used to answer the questions just posed.
Broadly speaking, we need tools that help us systematize our thinking and
generate conjectures regarding potential effects of institutions as well as possible
drivers of their change. We here discuss only one such tool because it is
particularly well suited for dealing with strategic interactions, namely, game
theory (1.4.1). No matter how convincing our theories might sound, as
economists, we want to put them to the test, that is, we want to see whether they
truly explain what happens in the real world. In institutional economics,
empirical tests are usually based on comparative institutional analysis (1.4.2).
The central idea here is to see how well different institutions realized in different
countries – or at different times – that essentially serve the same function do in
comparison with each other. There are various ways of doing this. One way is to
use laboratory and field experiments (1.4.3), another way is to draw on case
studies, of which economic history is a particular application (1.4.4). The most
established and most frequently used way is to engage in econometric analyses
(1.4.5). Comparative institutional analysis plays a special role here. Some NIE
scholars argue that since both transaction costs and bounded rationality are now
“mainstream,” NIE’s distinctive feature is comparative institutional analysis.
Viewed like this, laboratory and field experiments, just like econometric
analysis, can be considered as specific ways to implement comparative
institutional analysis. We begin our tour d’horizon of the toolkit with game
theory, which is clearly not exclusive to NIE but can be used very profitably in
NIE.

1.4.1 Game Theory: A Tool for Analyzing Strategic Interaction

Situations
One of institutions’ chief functions is to reduce strategic uncertainty. However,
not every interaction situation is the same: sometimes, actors can achieve higher
payoffs by coordinating (coordination games); sometimes, one actor’s loss is
another actor’s gain (zero-sum games); and some situations involve a mix of
coordination and conflict (mixed-motive games). Game theory reduces a large
variety of interaction situations to their essential components and thus helps
predict the behavior of rational actors in such situations. Although even a short
introduction to general game theory is beyond the scope of this book, game
theory has become an essential element of economic reasoning across the entire
field of economics. Thus, we briefly present two important game types:
coordination and mixed-motive.
A game can be completely described with six components:

1. The players. Here, we distinguish between two-player and multiple-

player games, although most of the focus will be on two-player games.

2. The rules. The rules describe the menu of actions available to each
player at each point of the game. In some games, players choose their
action simultaneously; in others, actions are taken sequentially. Whether
being the first to decide is an advantage or a disadvantage depends on the
game’s structure.3

3. The strategies. A strategy is a complete description of all possible

actions that a player can take in all possible states of the game.

4. The information set. Assuming complete information is equivalent to

assuming that the players know the rules of the game, the strategies
available to all other players, and the payoffs associated with all possible
states of the game. Perfect information implies that a player knows all
relevant actions of the other player up to now.
 5. The payoff functions. These describe how the players value the possible
states of the game.

6. The results. Here, the concept of (Nash) equilibrium is of particular

importance. Such an equilibrium is achieved when, given the other players’
action, none of the players can benefit by unilaterally deviating from that
action.

There are different ways of depicting games. Here, we use a reduced form,
which is a way of depicting a game with all its payoffs depending on the
combination of actions of the players. The first payoff refers to the row player,
the second payoff refers to the column player.

1.4.1.1 A Coordination Game

Picture two cars approaching each other on a narrow street. Let us call the
drivers Laurel and Hardy. When they meet, each can steer either left or right
(Matrix 1.1). It is in both players’ interest to coordinate their behavior with the
respective other because failure to do so will result in a crash, which is not
desirable for either. This type of game has two equilibria in pure strategies: both
players steer left or both players steer right (there is also a mixed-strategy
equilibrium in which both players steer left or right with the same probability).
Simply looking at the structure of the payoff matrix does not provide many clues
as to how the drivers will behave, that is, which equilibrium will result. If the
drivers are able to communicate beforehand, they could promise to both steer
left (or right). Such promises are credible when no player can expect to benefit
by unilaterally deviating. Solutions of this kind are called conventions.
Conventions, in principle, do not require external enforcement, such as by the
state. Conventions as solutions to coordination games fall into the category of
internal (or self-enforcing) institutions of type 1.
Matrix 1.1 The coordination game

Hardy

Left Right

Laurel Left 0 –2

0 –2

Right –2 0

–2 0
Note: The four cells contain the payoffs for all strategy combinations. Within
each cell, the lower left payoff is Laurel’s, the upper right is Hardy’s. Higher
values indicate higher levels of utility. The equilibria are shaded.

Conventions are self-enforcing

1.4.1.2 A Mixed-Motive Game: The Prisoner’s Dilemma

The prisoner’s dilemma is probably the most commonly analyzed game in game
theory. In this game, two criminal suspects – Bonny and Clyde – are arrested and
put in separate cells. The police strongly suspect that Bonny and Clyde have
committed the crime in question but they do not have enough evidence for a
conviction. Bonny and Clyde are interrogated separately. Both are given two
options: testify against the other or remain silent. If neither testifies, they will
both be sentenced to one year in prison on a lesser charge. If they both testify,
each can be sentenced to eight years in prison. If one testifies while the other
remains silent, the one who testifies is sentenced to only three months in prison
while the other is sentenced to ten years. This situation translates into the payoff
situation depicted in Matrix 1.2.

Matrix 1.2 The prisoner’s dilemma 1

Clyde

Silence Testify

Bonny Silence 1 year 3

months

1 year 10 years

Testify 10 years 8 years

3 months 8 years

Obviously, Bonny has an incentive to testify if Clyde remains silent because

three months in prison is preferable to one year of incarceration. The previously
discussed coordination game has two pure strategy equilibria; the prisoner’s
dilemma has only one equilibrium: both players testify against each other. In this
game, testifying is a dominant strategy because it always obtains a higher
payoff than remaining silent, given the other player’s strategy. What makes this
game so interesting is that individually rational behavior leads to a collectively
non-rational result: if neither Bonny nor Clyde testifies, they will both be
sentenced to one year in prison, but in equilibrium, both face a sentence of eight
years.
Matrix 1.3 depicts the prisoner’s dilemma in a more general form, where
the prison sentences have been replaced by ordinal payoffs.

Ordinal scales
 Ordinal scales indicate an order of rank. Interval scales also indicate an
order but additionally indicate the numerical distances between values

Higher values correspond to a higher level of utility. This – or something very

similar – is the most frequently encountered form of the prisoner’s dilemma
game. It is easy to see that individually rational behavior leads to collectively
irrational results: Bonny and Clyde will each end up with a payoff of 2; if they
were able to coordinate, they could each attain a payoff of 3.

Matrix 1.3 The prisoner’s dilemma 2

Clyde

Silence Testify

Bonny Silence 3 4

3 1

Testify 1 2

4 2

At first glance, one would not think economists would be much interested
in this game and yet they find it highly intriguing. Why? Economists argue that
many daily interaction situations have the same structure as the prisoner’s
dilemma. Remember the two strangers who try to exchange goods without being
sure of the goods’ quality? Assume that both could be better off with the
exchange. However, the seller can realize a gain by selling a cheap imitation
instead of the real (and expensive) good. The buyer can realize a gain by paying
with counterfeit money or a bad check. This situation is, in fact, a form of the
prisoner’s dilemma: for both players, cooperation is dominated by defection.
From a societal perspective, cooperation among suspected criminals may not be
desirable but, in many cases, cooperation between parties to an exchange is
definitely desirable. Thus, from a policy standpoint, one of the tasks of NIE is to
propose institutions that transform the prisoner’s dilemma into a game in which
it is rational for both players to keep their ex ante promises.
Use of game theory is sometimes criticized by proponents of NIE. Some of
this criticism revolves around NIE’s distrust of assuming perfect rationality,
which is an underlying assumption for many games. Furthermore, new
institutional economists point out that actors’ strategy sets, that is, their possible
courses of action, are often not exogenously given. Instead, strategy sets often
depend on a specific cultural context or even on an actor’s imagination. Even
payoff functions need not be exogenously given. All of this implies that explicit
integration of transaction costs into games, for example, by subtracting them
from the gross payoffs generally offered, constitutes a tremendous challenge and
might well prove impossible. Despite these criticisms, however, game theory is a
very useful tool for the economic analysis of institutions because institutional
economics is concerned with situations of strategic uncertainty, which is exactly
the realm for which game theory was developed. Using the prisoner’s dilemma
as an example again, the game shows that without institutions – regardless of
whether they are external or internal – a suboptimal equilibrium is likely to be
the outcome. In such a setting, establishing an institution that helps individuals
coordinate on another equilibrium might well increase overall welfare.

1.4.2 Comparative Institutional Analysis

The term “comparative institutional analysis” was coined by Ronald Coase
(1964), and involves identifying and comparing the effects of alternative
institutional arrangements on variables of interest to economists. Comparative
institutional analysis is exclusively concerned with comparing actually realized
institutions with other actually realized institutions. Thus, comparative
institutional analysis is a definite departure from the more traditional sort of
comparative analysis, in which an empirical result is compared with a
theoretically derived optimal result. Typically, the empirical result fares badly in
such comparisons, often resulting in justifications for government intervention.

Institutional economists are interested in feasible institutions

Representatives of NIE are interested in the coordination costs associated

with, and the results caused by, different institutional arrangements. One obvious
way of measuring the quality of an institution is to measure the cost of
implementing that institution or, in other words, transaction costs. Different
institutions are associated with different transaction costs and are evaluated
accordingly.

1.4.3 Experiments in the Laboratory or the Field

The homo economicus behavioral model is a very simple one that allows for
precise predictions. It thus seems logical to test these predictions in the
laboratory, where test conditions can be precisely controlled. Indeed, the
frequency of such tests has increased over the last years, with the not uncommon
result that some behavioral predictions are consistently falsified. Experimental
subjects regularly deviate from theoretically predicted behavior, deviations that
are to some degree systematic, at least on average and over time. These findings
imply that the experimental results can be used to predict behavior in similar
decision situations (for an overview of this rapidly growing field of research, see
Plott and Smith, 2008; Falk and Heckman, 2009). These experiments are
relevant to NIE because many of the behaviors observed in the laboratory can be
explained by internal institutions, for example, socially shared values. Thus,
laboratory experiments can be employed to assess the relevance of internal
institutions. Social norms most likely depend on cultural context. NIE hence
finds it interesting to repeat the same game with experimental subjects from
different cultural backgrounds. By doing so, differences in observed behavior
can be attributed to differences in social norms, that is, internal institutions.

Laboratory experiments allow precisely controlling the conditions under

which choices are being made

Laboratory experiments have been a great success because the conditions in

the lab can be controlled precisely. However, they are also subject to criticism,
chiefly in regard to the possibility that their results are not externally valid, that
is, they might not hold outside the lab. The context in which real choices occur is
often infinitely more complex than any situation created in a lab. This is why
field experiments have gained in popularity over the last couple of years. Some
of these merely replicate in a real-life context games previously played in the lab
and so are, in a sense, artifactual (the term is credited to Harrison and List, 2004,
who distinguish between artifactual, framed, and natural field experiments). On
the other end of the spectrum are natural field experiments where subjects are
not even aware that they are participating in an experiment. This implies that
they are unlikely to modify their behavior as a consequence of being observed.
Whereas field experiments may have higher external validity than laboratory
experiments, they may have less internal validity than laboratory ones because
the factors possibly having an influence on the outcome cannot be completely
controlled for in the field.

Validity

Validity refers to the extent to which a conclusion corresponds with the

real world. A conclusion is internally valid if it is warranted. It is
externally valid if it can be generalized to other situations.

In a way, large-scale social experiments were a precursor of the current wave of

field experiments. Such experiments can be employed as small-scale tests of new
institutional rules that have not yet been implemented. Experimental testing for
the effects of institutional innovation should result in improved predictions
regarding the effects of implementing an institutional innovation on a large scale,
particularly in regard to unintended consequences. One of the first of these was
an experimental study on the negative income tax published as a dissertation in
1970. The experiment set out to test the incentive effects that accompany a
negative income tax, an idea introduced by Nobel laureate Milton Friedman in
1962 (the experiment is described in more detail in Levitt and List, 2009, 5).

1.4.4 Case Studies Including Economic History

Case study research involves analyzing a small number of cases in great detail. A
typical example is to study how specific institutions, perhaps even only one,
emerged during a particular period in a particular country. When such research
refers to past periods, it can also be called economic history. Many NIE scholars
are economic historians, Douglass North certainly the best-known one. Within
NIE, economic historians are interested in the causes that led to the creation of
specific institutions, for example, technological progress or changes in resource
endowment. Economic historians are also interested in the effects brought about
by (changed) institutions. For example, Greif (1992) makes the astounding claim
that the Commercial Revolution, which occurred between the eleventh and
fourteenth centuries, was not due to any substantial change in production
technology or resource endowment, but was a consequence of new (or modified)
institutions.
This tool (i.e., the case study) has the advantage of being able to handle a
great deal of detail; this is also its greatest weakness. It is often unclear if the
explanation attributed to the particular case can be generalized. Based on their
study of economic history, NIE scholars have contributed some important insight
into the role played by institutions. For example, they have demonstrated that
gains from trade can be made without state-secured property rights or even
without the state – in the present sense – existing at all (Milgrom et al., 1990).
They have shown that some institutions that are usually frowned upon (e.g., the
merchant guild) actually perform a welfare increasing function (Greif et al.,
1994), thus illustrating that NIE can discover counterintuitive results.

1.4.5 Econometric Tests

Econometricians test economic models with quantitative data. Therefore, if
institutions can be quantified, both their determinants and their effects can be
tested and compared using econometric methods, which allows testing for the
consequences of external as well as internal institutions. For instance, aggregated
investment stocks or per capita incomes could be regressed on the security of
property rights. Chapter 5 illustrates the use of this method for investigating the
growth effects of institutions.
 At the beginning of this section, I mentioned the special role of comparative
institutional analysis for NIE. In a sense, both experiments and econometric
estimates can be viewed as ways of comparing institutions. Recently, there has
been some talk about “mixed methods,” including the argument that, for
instance, econometric models that focus on rather large numbers could be
usefully complemented by case studies focusing on single cases but adding a
wealth of institutional detail. Only time will tell whether such an approach will
produce useful insight.

1.5 NIE’s Common Ground with and

Differences from Other Research Programs
To date, there is no consensus, even among proponents of NIE themselves, as to
whether NIE is just another branch of traditional economics or whether it is a
new paradigm that stands alone. The first position is taken by those
representatives of NIE who are interested in broadening existing research
questions: that is, instead of assuming institutions to be exogenously given, they
are interested in explicitly analyzing the choice of institutions. Proponents of the
second position argue that this is not sufficient and that there needs to be a clear
and definite step away from traditional economic thought. They argue that
simply modifying an assumption here and there poses a risk of inconsistent
models (Furubotn and Richter, 1998, ch. 10). One of the founders of NIE –
Douglass North – shifted from the first position to the second over time. For
example, his hypothesis on the relevance of intentionality as a result of social
learning and as the foundation of institutional development (North, 2005) is at
odds with the assumptions of neoclassical economics.
 The word “new” in “new institutional economics” implies that there is an
“old” institutional economics. And, indeed, there is. This so-called old
institutional economics blossomed in the first half of the twentieth century and
its most famous practitioners are Thorstein Veblen, John Commons, and Wesley
Mitchell. New institutional economists criticize this research program for being
atheoretical and purely descriptive. While most research programs in economics
developed towards deductive thinking, old institutional economics was
characterized by inductive thinking. In recent years, there has been a certain
renaissance of old institutional economics (for a comparison of old and new
institutional economics, see Hodgson, 1998; Rutherford, 1994).

Precursors of NIE

Definition

Inductive: leading from the specific to the general. Opposite: deductive

Both transaction cost economics as well as property rights theory can be

viewed as precursors to NIE that are now components of it. Transaction cost
economics investigates the consequences of transaction costs for the
organizational structure of firms; its most well-known representative is Oliver E.
Williamson. This research program is looked at in more detail in Chapter 3. The
theory of property rights can also be thought of as ancestor of NIE. Its
representatives look at the economic consequences of differently defined
property rights. They study the idea that economic exchange primarily involves
exchanging property rights. The theory of property rights is covered in Chapter
2.
 Based on the observation that (correct) information is valuable because it
allows actors to make choices resulting in higher payoffs, the subdiscipline of
information economics emerged. The central problem regarding information is
that we are often uncertain whether we can trust a particular piece of information
or not. As the main function of institutions is to reduce uncertainty, and
uncertainty always implies uncertainty of information, the connection between
information economics and NIE is straightforward. Contract theory can be
considered a subfield of information economics as it studies the design of
contracts under asymmetric information. It can also be seen as belonging to the
economic analysis of law which will be mentioned shortly.
Traditionally, constitutional economics analyzed justifications for the
existence of government and governmental action. In recent years, however,
researchers in this field have evinced an interest in applying economic thinking
to (a) the consequences of different constitutional rules and (b) the reasons why
different societies choose different constitutional rules in different situations (for
an overview, see Voigt, 2011). Given this new focus, constitutional economics
can be viewed as part of NIE, in that it analyzes a specific set of institutions, that
is, constitutional rules.
Public choice theory takes an economic approach to analyzing politics.
The difference between public choice and constitutional economics is that in
public choice, institutions are assumed to be exogenously given whereas they are
endogenized in constitutional economics. In the economic analysis of law (or
law & economics), both the determinants and the effects of legislation are
analyzed based on an economic approach. Traditionally, scholars in law &
economics have maintained a closer tie to traditional welfare economics than
have scholars in either NIE or constitutional economics. In the past, informal
rules – which are important in NIE – were either ignored or considered of
secondary importance in the law & economics field, but this began to change
several years ago (see Jolls et al., 1998; Korobkin and Ulen, 2000).
Researchers working with these different approaches to understanding the
links between economics and institutions tend not to communicate much with
each other, preferring to emphasize the differences between the programs instead
of their similarities. We find this unfortunate. So, even though the chief focus of
this book is NIE, when appropriate, we will discuss interesting and important
insights from related research programs. Table 1.3 sums up this discussion of
NIE and related research programs.

Table 1.3 Related research programs

Research
program Central question Relation to NIE

Transaction Consequences of positive Precursor that became a

cost transaction costs (also with component of NIE
economics regard to political processes)

Property Consequences of different Precursor that became a

rights theory property rights arrangements component of NIE

Information Interested in identifying ways In both, uncertainty plays a

economics to deal with situations of central role
uncertainty

Constitutional Legitimation of the state The normative variant is an

economics Consequences of alternative addition to NIE
constitutional rules, The positive variant is a
determinants of constitutional part of NIE
rules

Public choice Economic analysis of politics Analysis of the incentive

 effects of exogenously
given rules

Law & Economic analysis of law Analysis of the incentive

economics effects of exogenously
given rules (primarily
concerning private and
criminal law)

1.6 Open Questions

One of the central assumptions of the behavioral model of economics is that
preferences are given and time invariant. However, humans are not born with a
specific preference for most goods and institutions. Thus, one open question, and
not only in NIE, involves the origins and change of preferences. NIE is
particularly interested in exploring whether the emergence and change of
preferences are dependent on context and culture.
In the context of bounded rationality (and positive transaction costs), it is
posited that it could be rational to maximize utility not over each and every
action, but merely over a sequence of actions with the help of rules (like rules of
thumb; see Heiner, 1983). But if we are merely boundedly rational, is it plausible
that we are rational enough to rationally set utility maximizing rules? Thus, there
is a need for research on the role of learning and the functions of trial-and-error-
processes, and into whether the concept of adaptive behavior might be more
appropriate than that of rational choice (see Vanberg, 1994, ch. 2).

Questions

1. In a famous paper, Milton Friedman (1953) argued that the correspondence

between a model’s assumptions and the conditions found in the real world did
not really matter as long as the predictions produced on the basis of the model
were true. What are the implications of this approach, both positive and
negative?

2. Why is the assumption of positive transaction costs closely related to the

assumption of bounded rationality?

3. What role do transaction costs play in the search for apartments? To what
other situations could you apply the concept and how?

4. Explain the difference between individual decision rules (such as rules of

thumb) and collective rules as institutions. Use examples.

5. Consider the taxonomy of institutions introduced in this chapter. For each type
of institution, name an example and state the rule component as well as the
enforcement mechanism for it.

6. Explain why a private contract is not an institution, and yet the private law it
is based on is.

7. International law consists of rules to which sovereign nation-states have

agreed. Connect international law to the taxonomy of institutions developed in
this chapter.

8. Can the different instruments described in this chapter be reasonably

combined? If so, what are the benefits and drawbacks of using them
simultaneously?

Further Reading
The most important book on institutional economics published in recent decades
is Institutions, Institutional Change and Economic Performance by Douglass
North (1990a). New Institutional Economics: A Guidebook, edited by Eric
Brousseau and Jean-Michel Glachant (2008) contains 21 stand-alone chapters
enabling quick access to particular aspects of NIE.
Daron Acemoglu and James Robinson have been among the most
influential institutional economists of the last 15 years or so. We refer to their
work frequently throughout this book. If you are interested in an easily
accessible and popularized version of some of their findings, Why Nations Fail
(Acemoglu and Robinson, 2012) is a good starting point.
The behavioral model of economics is given a very thorough and concise
treatment in Homo Oeconomicus by Gebhard Kirchgässner (2008).
Ekkehard Schlicht (1990) critically discusses the concept of bounded
rationality. Kreps (1998) discusses the difficulty of incorporating bounded
rationality in formal economic models. The starting point of behavioral
economics is bounded rationality. Some fascinating insights from that research
program are popularized in Daniel Kahneman’s (2011) Thinking, Fast and Slow.
Nudge by Richard Thaler and Cass Sunstein (2008) is similarly popular. The
authors advocate far-reaching policy designs based on findings about how real
people really behave. Their plea for libertarian paternalism is controversial, with
many critics arguing that it is nothing but an oxymoron.
Thinking Strategically is a well-written introductory book on game theory
by US economists Dixit and Nalebuff (1991). The relevance of game theory for
NIE is discussed in Pénard (2008). Examples of how game theory can be used to
study economic development are found in Wydick (2007). Smith (1994) lists
seven prominent reasons why economists conduct experiments and also deals
with the question of what economists have learned from experiments. Greif and
Laitin (2004) deal with institutional change relying on repeated game theory.
Their paper can also be read as an enlightened defense for the use of game
theory in NIE. A website that lists many field experiments is maintained by
Chicago economist John List and can be found at www.fieldexperiments.com/.
The Massachusetts Institute of Technology runs a Poverty Action Lab that has
conducted many so-called randomized field experiments. Their website is at
www.povertyactionlab.org/. Alston (2008) argues in favor of case studies. If you
are interested in a survey summarizing and evaluating the most important
contributions to NIE from economic history, I suggest Nunn (2009).
Finally, quite a few scholars in NIE have been awarded the Nobel prize in
economics. The Prize lecture that is given when they actually receive the prize in
Stockholm is usually an easy-to-comprehend summary of their work as they
speak to a non-specialist audience. In the recommendations at the end of the
chapters, I will therefore frequently refer to these lectures. The website
www.nobelprize.org contains additional information such as videos from the
lectures, the slides shown during the lecture, bibliographical information on the
recipient and more. It is definitely worth a look. Ronald Coase received the prize
for “his discovery and clarification of the significance of transaction costs and
property rights for the institutional structure and functioning of the economy.”
He is clearly a founding father of NIE and his prize lecture (1992) can be read as
an introduction to the whole topic of NIE.

1Behavior and behavioral constraints can also be religiously motivated. The

beach visitor in our example might believe that God would see him leaving
trash on the ground. In such a case, behavior is induced not via self-
commitment, but via the belief that one should act according to the rules of
some supernatural being.

2 This view has to be somewhat relaxed when considering contracts that take
effect beyond the purely private realm, such as labor agreements or contracts
between states.

3 In the mixed-motive game “battle of the sexes,” a boy and his girlfriend want
to spend the evening together. However, their preferences regarding the
location diverge. He prefers to meet at a soccer game, she prefers meeting at a
club. Whoever of the two is faster to commit to a course of action (“I already
bought our tickets to the soccer game, honey”), secures a first-mover
advantage. In contrast, in a game of “rock, paper, scissors” where players
decide sequentially, the one who moves first has a disadvantage.
 2
Simple Transactions
◈

Who exchanges which goods with whom, in what quantity and how often, is
determined by whether a transaction is expected to be profitable for all sides
participating in the transaction. Potential exchange partners must take many
factors into consideration when determining whether a theoretically possible
exchange, once realized, actually benefits all partners. In this chapter, we discuss
several of these factors. Whether buying some good is beneficial for me depends
on what I can do with that good after having purchased it. For example, can I
modify a house without restraint or I am bound by some legal rules (for instance,
laws concerning landmarked buildings)? Am I able to exclude others from the
use of my good (for instance, tourists passing through my property)? Is it
possible for me to legally exclude others from the use of my good, but factually
too costly to do so (for instance, passersby who steal apples from my tree)?
In the following, we deal primarily with simple transactions. We delineate
them as exchanges that are not set out to be repeated frequently. This helps us
distinguish simple transactions from (1) long-term contracts (e.g., contracts
concerning provision of water or electricity), on the one hand, and (2)
transactions within hierarchies on the other hand (e.g., within firms; these will be
dealt with in Chapter 3).
 Chapter Highlights

Learn why property rights are important for transactions.

Understand that internal institutions can also be important for

transactions.

Reflect about how property rights and internal institutions can

reinforce each other – or be mutually exclusive.

Attempt to estimate the development of transaction costs in the long

run.

In the course of this chapter, the concepts of transaction costs – which you
already encountered in Chapter 1 – and property rights play a central role. We
assume that laws (external institutions), as well as norms and customs (internal
institutions), are exogenously given and ask how they channel the behavior of
the actors in question. We proceed as follows: First, we introduce the concept of
property rights and discuss how external institutions impact simple transactions.
Second, we ask how internal institutions, such as norms and customs, might
influence the extent and intensity of simple transactions. Third, we ask how the
interplay between external and internal institutions affects the extent and
intensity of simple transactions. Finally, we present an empirical study that
attempts to estimate the development of economy-wide transaction costs over a
period of 100 years.

What are the incentive effects of property rights?

 2.1 The Relevance of External Institutions
for Simple Transactions
We can think of at least three ways in which laws might influence economic
exchange:

1. With regard to the scope of rights and obligations that are associated with
the exchanged good (design of property rights).

2. With regard to the possibilities and limits of trading goods with others
(design of freedom of contract).

3. With regard to the costs associated with enforcing one’s rights in case of
noncompliance of the exchange partner (design of procedural law).

The concept of property rights

Traditionally, economic exchange is depicted as the physical exchange of goods,

for instance, exchanging a good for money with which one can buy other goods.
A research program emerged in the 1960s that depicts economic exchange as
exchange of property rights, aptly called property rights theory. It states that
the value of a good depends on the specific design of the relevant property
rights. Four components are traditionally identified:

1. The right to use a good (usus).

2. The right to modify a good (abusus).

3. The right to enjoy the fruits from the use of a good (usus fructus).

4. The right to transfer property rights of a good to other persons (venditio).

 Economic exchange as exchange of property rights

Typically, if everything else remains constant, the price for a good will be higher
when the rights attached to that good establish a higher degree of exclusivity.
Frequently, legislation in the form of regulation constrains the freedom of
contract. For instance, the government prohibits exchange of certain goods or
limits exchange on Sundays and holidays. In the USA, for example, there are
still hundreds of “dry counties” that prohibit the sale of alcohol. Whoever
violates such prohibitions and precepts might face sanctions. Whether such
disallowed exchange is still privately beneficial depends on the probability of
detection, the expected profit, and the size of the fine in case of detection.1 By
relying on such regulations, the government intentionally inflates the price of
exchanging certain goods. To stick to the example: finding someone willing to
sell alcohol in “dry counties” will not be as easy as elsewhere as search costs
will be higher. In other words: The transaction costs are increased intentionally.
Common sense tells us that higher transaction costs result in less frequent
economic exchange because the gains from trade are lower.
Finally, whether an exchange is expected to be profitable for all sides
depends on how costly it is to use procedural law to enforce one’s rights in case
of breach of contract. When court proceedings are expected to be very costly and
prolonged, an exchange might appear less attractive ex ante. Likewise, a court
ruling is not very useful if it is not immediately enforceable, thus making a
potential exchange less attractive. As we can imagine, high transaction costs can
have a meaningful impact on the extent of economic exchange. Later in this
chapter, we present empirical estimates of the aggregate level of transaction
costs.
 Costly and prolonged court proceedings can impede economic exchange

Ronald Coase’s essay (1960) on the problem of social cost simultaneously

explores the concepts of property rights and transaction costs and is central to
the development of both NIE and law & economics. When property rights are
well defined in the sense of exactly delimiting who is allowed to do what with a
good and the exchange of goods is free of transaction costs (i.e., they equal
zero), the resulting allocation of goods and rights will be Pareto-optimal,
irrespective of the initial allocation of property rights.

Definition

Pareto-optimality: A Pareto-optimum is defined by the fact that it is not

possible to raise one individual’s utility without decreasing the utility of
another. The concept was developed by the Italian economist and
sociologist Vilfredo Pareto (1848–1923).

Put differently: It is essential that property rights are well defined, but the initial
allocation of property rights is irrelevant for achieving the optimal allocation as
long as transaction costs are zero. This insight has been dubbed the Coase
theorem, based on Coase’s (1960) essay, which is one of the most cited papers
in economics. We will now take a closer look at this theorem.

2.1.1 The Coase Theorem

A producer of burglar alarm systems (P) emits loud noises while testing its alarm
devices. The only resident who lives in the vicinity (R) is very bothered by this,
resulting in a reduced utility of living in his house. R repeatedly asks P to reduce
the noise emissions, but P does not comply, as that would be associated with
additional costs (e.g., the cost of buying noise filters). When the utility of one
actor R is lowered by the actions of another actor P, economists say that the
action of P has an external effect or externality. One can distinguish between
positive and negative external effects. A positive externality is given when we
are able to enjoy the music of a nearby open air concert free of charge. The same
externality can be negative if we are bothered by it.
The firm that produces and tests burglar alarms (P) reduces the utility of
resident R and thus produces a negative externality. In welfare economics, the
standard approach to such problems is to introduce Pigou taxes (named after
British economist Arthur Cecil Pigou, 1877–1959). According to this approach,
the producer of a negative externality pays a tax in the amount of the difference
between the private and social costs of his or her activity. The tax is equivalent
to the damage imposed on others. On the other hand, the producer of a positive
externality receives a subsidy in the amount of the difference between private
and social costs. The expected outcome is that actors will produce fewer
negative externalities, or conversely, actors will produce more positive
externalities. The Pigou tax is thus an intervention which is supposed to improve
the suboptimal outcome that results if market forces remain uncorrected. Even
though we can hardly imagine how to correctly measure the relevant social costs
and benefits, policymakers have time and again attempted to apply the concept
of a Pigou tax. Examples include the protection of emerging industries against
foreign competitors by setting import tariffs and providing subsidies for research
and development.

Definition
 Private vs. social costs: whereas private costs are only those costs borne
by the individuals involved in some economic activity, the social costs
reflect the total costs of that activity. Social costs might be higher than
private costs if some costs, like pollution, are not borne by those
involved in the activity.

Ronald Coase doubts that the existence of externalities requires government

action in the form of taxes or subsidies. Assume that the present value (i.e., the
sum of all future profits discounted to their current value) of the profits that
producer P can attain is €15,000. Let us also assume that before P started its
production the house of R was worth €150,000, now it is worth €120,000. The
production of P is associated with a destruction of social value: The sum of P’s
profit and the reduced value of R’s house (€135,000) is lower than the house’s
value without P’s production (€150,000). Thus, it would be socially optimal if P
stopped its production – at least for this particular location. Finally, let us assume
that there is no regulation prohibiting P to produce and test burglar alarms in this
location. Is there anything R could do? R could try to pay P an amount of money
such that P is at least as well off as if it were still producing. Any amount
between €15,000 and €30,000 is possible. Suppose it is €16,000. This would be
mutually beneficial: P benefits because the compensation payment is higher than
its anticipated profits from production. R benefits because the value of his house
minus the compensation payment (150,000 – 16,000 = €134,000) is higher than
the value of the house if P were producing (€120,000).
Let us alternatively assume that P expects profits to the amount of €50,000,
due to an upward shift in demand for burglar alarms. Now, the sum of the
reduced value of R’s house and the expected profits of P (120,000 + 50,000 =
€170,000) are higher than the undiminished value of the house (€150,000).
Furthermore, there are now legal restrictions regarding noise emissions such that
R could sue P for the emission of noise. In this changed situation, P could now
benefit from paying compensation to R such that R refrains from suing. P can
feasibly pay an amount between €30,000 (the difference between 150,000 and
120,000) and €50,000 (P’s profit). Thus, the punchline of the Coase theorem is
that resources will always be allocated towards their highest valued use,
independent of the initial allocation of property rights, given the assumptions of
zero transaction costs and well-defined property rights. Note that absence of
transaction costs here implies that the various payoffs – under production and
under non-production – are known to all participants (game theorists would say
they are “common knowledge”).
In Figure 2.1, we can see that the Coase theorem is not only applicable to
situations with discrete choices (produce vs. not produce), but also to cases with
continuous choices (produce a little bit more or a little bit less). Figure 2.1
corresponds to the case in which P is not liable for the damage its production
causes (i.e., the decrease in utility of R). We assume that the level of utility loss
for R depends on the level of emitted noise from producer P. The curve
originating in 0 that is upward sloping to the right is the marginal damage R has
to bear. In our example, the damage is equivalent to the loss in the value of R’s
house. The more noise P emits, the greater the damage suffered by R. We also
assume that the costs for lowering noise emissions increase the more P reduces
noise emissions. The first filter P buys leads to a substantial reduction in noise,
the second such filter already has less of an effect and so on. The marginal cost
of noise reduction originates with 100 on the horizontal line since the costs for
not reducing noise are assumed to be 0. If P wants more noise reduction, the
curve gets steeper, because each additional filter has less of an effect.
 Figure 2.1 Bargaining solution when P is not liable.

If P is not liable for the noise emitted, P has no incentive to invest in noise
reduction and we assume P emits noise at level 100. If the level of emissions was
reduced to 75, R could avoid damages in the amount of the shaded area A. It
would cost producer P an amount of B to avoid that much noise. Since the size
of B is only a small fraction of the area A, the benefits of this decrease in noise
clearly outweigh the costs. We have, thus, identified a possibility for both parties
to make themselves better off: R can offer P a sum that is higher than P’s costs of
noise avoidance but lower than the increase in P’s utility gain. Continuing this
line of reasoning, we can easily see that the “optimal” level of noise emissions is
at 40; to the left of this level, the marginal costs of avoiding noise are higher than
the marginal utility loss.
Assuming that R and P are able to bargain and agree upon noise level 40
and that R compensates P with a price E for each unit of avoided noise, then P’s
revenue from this transaction is 60 times E which is equivalent to the shaded
area C. P’s costs for avoiding 60 units of noise are, however, only the area below
the marginal cost curve (denoted as D in the figure) implying that P makes a
profit equivalent to area C–D from the agreement. Based on the two cost curves
displayed in the figure, it is easy to see that a noise emission level of 40 is
optimal. Reducing the noise emissions even further would cost more in terms of
noise reduction than would be gained in terms of the value of the house. Rational
parties would, thus, agree on the noise level 40.
The second case, in which P is liable for the externality, can be solved
analogously. We refrain from showing the corresponding figure here but
encourage you to draw it yourself as an exercise.
If the assumptions of the Coase theorem were fulfilled, there would always
be optimal resource allocations without the need for government intervention.
However, how realistic is it to assume transaction costs to be zero AND property
rights to be well defined?

In the absence of transaction costs, the initial allocation of property

rights is irrelevant for the final outcome However: Transaction costs are
almost always substantial

This seems rather implausible. Even in our original case with merely two
actors we could assume that bargaining might take some time. Furthermore, the
parties would have to spend resources to monitor whether the respective other
party sticks to the agreement. Now imagine that P’s production facilities are
located in a residential area such that 200 residents are bothered by the noise
emissions. Then the 200 households would first need to organize themselves,
which is in itself associated with costs. What if the producer was a Japanese
nuclear power plant that emits contaminated waste which eventually affects
people living in the USA? In this constellation, millions of US Americans would
need to negotiate with millions of Japanese and solutions via private bargaining
seem very unlikely.
But suppose transaction costs were not substantial. The Coase theorem still
might not apply because property rights were not well defined or tradable.
Rights might be, for example, inalienable, that is they cannot be sold or traded.
This is the case for all basic human rights, as well as for the right to vote. And
this is also frequently the case for emission levels, whose regulation is
administered via public law. Public law, in turn, cannot be bypassed by drawing
on private contracts.
The core statement of the Coase theorem is that – given zero transaction
costs and well-defined and tradable rights – bargaining will result in an efficient
allocation of resources, irrespective of the initial allocation of property rights.
Given these assumptions, the specific delineation of property rights is irrelevant.
Why, then, within the NIE do we have a specific theory dealing with the
allocative consequences of alternative delineations of property rights? Because
transaction costs are usually not zero. Since rights are typically not tradable
without costs, their specification is quite important.

Thus: The initial allocation of property rights is very important!

The Coase theorem has become one of the cornerstones not only of NIE but
also of law & economics. As noted earlier, the paper in which Coase first
described his groundbreaking ideas is one of the most-cited papers in economics
of all time. Small wonder then that it has not remained without criticisms. Here,
we mention only two specific criticisms:

1. The Coase theorem neglects strategic behavior. For instance, producer P

could announce ex ante that it will be producing a great deal of noise, in
 order to receive a higher compensation for reducing its emissions. It could
even be profitable to specialize in these kinds of announcements to receive
compensation payments for not following through.

2. Coase emphasizes that the specification of property rights is irrelevant

for the resulting allocation. However, the resulting wealth or income
distribution clearly depends on whether we initially have the right to emit
noise or not. This implies that the Coase theorem is only applicable when
the distributive consequences are not expected to influence the resulting
allocation.

2.2 The Relevance of Internal Institutions

for Simple Transactions
By now, it should be clear that external institutions – such as state-enforced
property rights – influence the extent of economic exchange since their exact
delineation has an impact on the potential gains from trade. The relevance of
internal institutions should also be apparent. For example, when a social group
follows the rule that contracts should be complied with and sanctions rule
breakers by informing all members of the group about the breach, any individual
actor within that group has an incentive to comply with contracts as they would
anticipate not being able to find transaction partners after noncompliance.

How do internal institutions affect the extent of economic exchange?

Norms are not only relevant in explaining whether contracts are concluded,
but also in explaining the content of contracts. We can easily imagine contract
modalities that might be in perfect compliance with the external institutions of a
society, but not in compliance with that society’s internal institutions. Consider,
for example, transactions involving pork or alcohol in a Muslim society
governed by the external institutions of a colonial power. Although legally
possible, such transactions are likely to be frowned upon by one’s fellow
Muslims. Instead of attempting to give a complete and systematic account of
how internal institutions can affect contract modalities, let’s consider two
examples.

2.2.1 Example 1: Norms of Cooperation and the Ultimatum Game

The ultimatum game was introduced by Güth et al. (1982) and has led to intense
discussions about the fundamental behavioral assumptions in economics. In this
game, a metaphoric cake has to be split between two players. The first player has
the right to propose a specific split; the second player can then either accept or
reject the proposal. In case of acceptance, the cake is split according to the
proposal. In case of rejection, both players receive nothing. Compared to a
situation with a payoff of zero, a rational – and selfish – second player would
accept even a minuscule offer. A rational first player would anticipate this and
offer only a minuscule amount to the second player, keeping the rest for himself.
We cannot possibly summarize all the literature that has developed around
this game. Two results are of particular importance for the NIE and are worth
stressing as they show that the traditional homo economicus assumptions are not
met when two people play this game in the laboratory. These results are:

1. Fairly equal splits of the cake often emerge.

2. Proposals that offer a third or less of the cake to the second player are
often rejected.
These results hold even when the payoffs involved are quite substantial. For
instance, Cameron (1999) played the game with Indonesian students for whom
the size of the cake corresponded to the value of three average monthly incomes.

Homo economicus prediction is not confirmed in the ultimatum game

A common but far from universally accepted explanation for these results is
justice and fairness norms of the actors. Let us assume that such behavior can
be explained by societal values and norms, that is, by internal institutions. Such
institutions are far from uniform around the globe. It is, thus, of interest to play
the same game in alternative cultural environments. Ensminger (1998) and
Henrich (2000) were among the first to do just that. When Henrich played the
ultimatum game with subsistence farmers living by the Amazon River, he found
that proposals made there were substantially lower than in developed countries
and that proposals were very seldom rejected. Ensminger (1998) conjectures that
justice and fairness notions are a consequence, not a cause of institutional
development. In Henrich et al. (2001), Henrich and his co-authors – all very
experienced field researchers – played the ultimatum game and other games in
18 small-scale societies that are characterized by great variety in both economic
and cultural conditions. They find considerable differences in the way the game
is played in these societies around the world. One general result is that the more
prevalent market exchange is in a particular society, the higher the level of
cooperation in experimental games. If the prevalence of market exchange is
based on institutions, then these institutions seem to induce higher levels of
cooperation.

2.2.2 Example 2: Fairness Notions and Price Formation

While the above insight is highly interesting, it has the limitation of being based
on experimental evidence. We cannot be sure that the experimental evidence
remains valid beyond the conditions of the experiment. Our second example is,
therefore, based on real-world observations and deals with insights concerning
price formation. Traditionally, we assume that the marginal willingness to pay
for a good corresponds to the marginal utility the consumer expects from it. This
implies that the identity of the seller (a fancy luxury restaurant or a run-down
grocery store) should be irrelevant. It further implies that the profit made by the
seller should also be irrelevant. But there is plenty of evidence that both traits do
matter.
Peak-load pricing is a strategy for suppliers to channel highly volatile
demand levels. Prices are high when demand is high; prices are low when
demand is low. Though economically rational, such a strategy is often
condemned by consumers. For instance, many consumers simply do not accept
higher prices for flowers around a holiday although the quoted price is below
what they are willing to pay (their “reservation price” in more formal
terminology). Some consumers are even willing to accept additional costs to
prevent paying higher prices. When the gas stations of large chains raise their
prices during summer holidays, we can observe very long queues at alternative
gas stations not bound by the price hike of the large chains. Apparently,
consumers are willing to accept high opportunity costs (in terms of lost time) in
order to not pay the additional 2 to 3 cents per liter of gasoline because their
fairness norms are violated. If this is the case, Frank (1988, 167) predicts:
“People will sometimes reject transactions in which the other party gets the
lion’s share of the surplus, even though the price at which the product sells may
compare favorably with their own reservation price” (italics in original; further
examples can be found in Frank (1988) and Kahnemann et al. (1986)).
Both of our examples show that exchange prices and other contract
modalities can be influenced by fairness and justice notions. If we fail to account
for these factors in an analysis of, for example, price formation, the resulting
predictions will probably be less precise. Thus, accounting for internal
institutions can increase the predictive accuracy of economic models.

Accounting for justice and fairness notions can improve predictive

accuracy

2.3 The Relevance of Interplay between

External and Internal Institutions for
Simple Transactions
In Chapter 1, we mentioned four possible ways in which external and internal
institutions might be related:

1. neutral,

2. complementary,

3. substitutive, and

4. in conflict.

In this section, we ask how simple transactions are influenced by the fact that
these simple transactions can be arranged via external as well as internal
institutions.

2.3.1 Conflicting External and Internal Institutions

Internal and external institutions are in conflict when a certain behavior in an
interaction situation is allowed or even encouraged according to the external
(internal) institution, but prohibited according to the internal (external)
institution. If both institutions prescribe a certain behavior, then irrespective of
which institution an actor decides to adhere to, he or she has to anticipate a
sanction. When a colonial power attempts to enforce its “home grown” set of
external institutions in a colony without modifications, conflicting institutions
are very likely. The consequences of conflicting external and internal institutions
with respect to economic development are apparent. Under such circumstances,
it is often beneficial for individual actors to conduct economic exchange in
secrecy. This in turn can have negative consequences for business development.
Optimal firm size cannot be achieved, marketing cannot be exploited, and
external financing is hard to come by and very expensive.

Conflicting institutions can impede economic development

2.3.2 Complementary External and Internal Institutions

We defined external and internal institutions as complementary when they
restrict human behavior in a similar manner implying that rule enforcement is
organized both privately and by the state. Someone who signs a contract with
someone else and then does not stick to the terms of the contract is not only
likely to lose in court but also to see his reputation damaged as soon as it
becomes publicly known how he has acted. Such informal shaming is based on
internal institutions and can significantly increase the “price” of breaking the
law. While the price of losing in court might be a rather modest sum of money,
losing my reputation as a reliable business partner might cost me dozens or even
hundreds of contracts in the future.
If it is true that internal institutions are much less subject to directed change
than external institutions, but both complementarily fulfill the function of
stabilizing expectations, there is very little scope for successfully changing
external institutions. Importantly, the complementarity of internal and external
institutions is a necessary, but not sufficient condition for the economic success
of a society. The reason for this is that complementarity as a formal criterion
leaves open the specific content of institutions. Thus, when internal and external
institutions are complementary, but both encourage behavior that impedes
economic development, the prospects for economic development are low.

Complementary institutions reduce the costs of state sanctions

2.3.3 Substitutive Relationship between External and Internal

Institutions
When institutions are substitutive, they steer human behavior in a similar
fashion, but rule enforcement is organized either by the state or privately. Here,
we only deal with two combinations of internal and external institutions that are
suitable to illustrating this relation, the interaction between external institutions
and internal institutions of type 3 and 4 respectively (customs and formal private
rules respectively. Reminder: you can find our typology of institutions in Table
1.1 on p. 17).
Imagine a situation in which there is a conflict between two actors due to
rule-breaking behavior and there are three possible ways to proceed:
 1. Private conflict resolution between the two parties involved, as a
borderline case of a type 3 internal institution.

2. The involvement of a private arbitration court, thus a type 4 internal

institution.

3. Resorting to a state court (external institution).

An example

Many business people who feel that their contract partners have not lived
up to their contractual obligations face exactly these three choices. Turning to
private arbitration usually implies that the case will not be moved to a state
court, hence the either/or of a substitutive relationship. Many businesses prefer
arbitration over state courts because arbitrators are selected directly by the
conflicting parties. Often, arbitrators are familiar with the conventions of the
industry to which the conflicting parties belong and their decisions are more
likely to be accepted by all parties than those of generalist state judges. Also, the
arbitrator has an incentive to achieve a successful resolution, as her reputation
might suffer from a failed arbitration. Because a solution by arbitration is usually
characterized by some form of compromise, it tends to allow the involved parties
to save face more than in state court proceedings.

Invocation of a private arbitrary court

It might appear that state enforcement is universally less preferable than

private enforcement. This is a deceptive impression, not only because the
invocation of a state court is more appropriate for some cases, but also because
the influences of external institutions extend far beyond the narrow scope of
court proceedings (Galanter, 1981). Although judges only rule in concrete cases,
their decisions provide information that is relevant for private dispute resolution
(Galanter, 1981, 13). Thus, private conflict resolution is influenced by the state if
it invokes a state court ruling. The decisions of private arbitral courts, however,
are often not made publicly available, limiting their ability to fulfill this societal
function. What’s more, the possibility of state court involvement might be what
causes the conflicting parties to look for a resolution outside of court, in order to
avoid the costs of a court procedure. Thus, the relevance of the decisions made
by state courts cannot be disputed even if they consider only a relatively low
number of conflicts.

State dispute resolution

The relationship between state adjudication and private dispute resolution

can also run the other way: Private dispute resolution affects state adjudication
(Galanter, 1981, 24). The interpretation of indeterminate legal concepts
presupposes an understanding of the relevant cultural context. In this manner,
private notions of what is a just resolution to a conflict might have a direct effect
on a state court judge’s rulings.

2.3.4 Empirical Results on the Relationship between External and

Internal Institutions
Having considered several hypothetical examples in an effort to shed light on the
different types of relationships between internal and external institutions, we
proceed to briefly discuss some empirical work in this area. Assume that actors
can choose how to resolve a conflict, either by resorting to formal law (external
institutions) or by invoking customs (internal institutions). By analyzing the
institutional arrangements chosen in specific situations, we can learn a great deal
about the actual relevance of different institutions. Ellickson (1986, 1991)
provides an example of such an empirical study. Ellickson asks whether the
famous example discussed by Coase (1960), in which there is a conflict between
a cattle farmer and a grain grower, possesses empirical relevance. The conflict
arises when stray cattle enter the grounds of the grain grower and destroy part of
his crops. Coase claims that the manner of conflict resolution is determined by
the specific design of the legal framework. Our previous example relied on this
claim to assert that the initial allocation of property rights determines the
resulting level of noise emissions. Ellickson (1994, 97) claims that this
assessment cannot be confirmed for most rural areas in which neighboring farms
are subject to such conflicts. The author empirically investigates how conflicts
between farmers and growers are resolved in Shasta County, California. This
county was chosen because cattle farmers are liable for damages caused by stray
cattle in only a few municipalities. In most municipalities, the grain growers are
responsible for protecting their crops. Ellickson shows that the manner of
conflict resolution is not dependent on the legal rule that is in place in a specific
municipality, i.e., that the design of the legal framework does not affect which
form of dispute resolution is chosen. The result of this study is that internal
institutions can – under certain circumstances (here: repeated interactions) –
crowd out external institutions, even in highly developed regions such as
California.

The form of dispute resolution chosen by neighboring farms is

independent of the specific legal rule in effect
 Many African countries tried to formalize property rights in land by giving
titles to land that was documented in registries. One goal was to reduce the
compartmentalization of customary landownership. From the point of view of
traditional economics, this makes perfect sense. If I hold a formal title to land, I
can use it as collateral with a bank. The bank is more likely to lend me money
which I can invest in agricultural machinery. At the end of the day, agricultural
productivity should be higher. In a fascinating study, Ensminger (1997) shows
that this almost never happened because long-run privatization plans almost
always failed in Africa and, sooner or later, people returned to their customary
rights. She reasons that these attempts failed because the newly passed external
institutions did not fit the customary internal ones. Her observations illustrate
how this rings true. Specifically, the idea to consolidate land into single but
much larger units failed because farmers preferred having smaller plots in
different areas to serve as insurance against one (or more) of their crops failing.
She also observed that for irrigation purposes, it seems important to have family
members as neighbors rather than some other business entities. Farmers simply
ignored that titling was only possible for tracts of land that achieved a minimum
size. The same holds true for the maximum number of heirs established by the
external institutions (which was originally set to five in Kenya, the country that
occupies center stage in Ensminger’s study). De jure, most registered plots were
registered with men. De facto, women play a very important role in agriculture.
Due to the bad fit of external institutions with internal ones, titling never
reflected de facto landownership.
The study of Stone et al. (1996) examines the relevance of external and
internal institutions for business people in two countries: Brazil and Chile. At the
time the study was conducted, Brazil was characterized as being interventionist
with very detailed regulations. Chile, on the other hand, had implemented
systematic reforms to roll back government interventions into markets and
introduce rule-based competition laws (Stone et al., 1996, 100). The authors
examine two situations in which private business people interact with
government representatives (start-up of a firm and regulation of firms) and two
situations in which private business people interact with customers (orders and
sales on credit). They conducted interviews with representatives of 42 textile
firms in the region of São Paulo (Brazil) and the region of Santiago (Chile). The
results are surprising. Even though it is much more difficult to start a firm in
Brazil, the Brazilian textile representatives rarely complained. The explanation
offered by the authors is the development of a specialized professional known as
a despachante that has evolved as a reaction to the complicated legal structures
and overflowing bureaucracy.2 Start-up firms do not attempt to tackle the legal
hurdles of obtaining all permits for their new business by themselves, but rather
delegate this task to a despachante. The total costs for starting up a firm amount
to $640 in Brazil and $739 in Chile. The average time for registering a start-up is
1.6 months in Brazil and 2 months in Chile.

Regulation often causes unintended consequences

These studies offer somewhat surprising results concerning the relevance of

the relationship between external and internal institutions. Ellickson shows that
in some situations internal institutions dominate external institutions, while
Stone and co-authors show that dysfunctional external institutions can in part be
counterbalanced by functioning internal institutions.
We might use a different approach to analyze the relational relevance
between internal and external institutions. Assume that the external (internal)
institutions that different social groups use to structure their interactions are
identical, but there are observable differences in outcomes such as per capita
income, growth, and so on between the groups. In such a case, it would make
sense to ask whether the outcome differences are correlated with differences in
internal (external) institutions between different social groups. An obvious
candidate for an analysis of this type is Italy. While the external institutions – at
least de jure – are identical everywhere, the manner in which interactions are
structured differs widely between regions. In particular, one can observe stark
differences between the north and the south, implying that internal institutions
also differ widely.

Differences in outcomes within a country can be explained by

differences in internal institutions

Putnam (1993) shows that the number of voluntary, non-hierarchical

associations (such as sports clubs, but not the Catholic Church) at the end of the
nineteenth century is an excellent predictor for the quality of local governments
today! Putnam argues that voluntary associations do not represent idealistic
altruism, but rather serve to make practical reciprocity possible, enabling
members to reduce risks in a quickly changing society. He emphasizes the
importance of organizational features for social cohesion and by no means
claims that the south of Italy is apolitical or asocial. However, the south is
characterized by a much lower degree of functioning civil society (“civicness”)
due to the more vertical nature of social structures. A vertical organization is a
sign of dependency and exploitation. Putnam claims that horizontal organization,
such as can be observed in the north of Italy, has helped solidarity to develop.

Italy as an example of a country with heterogeneous internal institutions

 Putnam uses the concept of path dependency to describe the different ways
the two regions of Italy have developed (Putnam, 1993, 177–180). The north is
characterized by a stable social equilibrium with high levels of cooperation,
trust, reciprocity, and so forth. In contrast, the south is characterized by a
likewise stable equilibrium in which defection, distrust, opportunism, and so on
seem to be the dominant strategy. At this point, we abstain from delving deeper
into the concept of path dependency; we will return to it in Chapter 6.

2.4 On the Estimation of Transaction Costs

One obvious indicator of quality for a set of institutions is how much it costs to
conduct transactions. Thus, one can attempt to measure the quality of institutions
in different countries by comparing the transaction costs required to carry out a
transaction. Comparing different levels of transaction costs might then allow us
to comparatively assess the quality of alternative sets of institutions.
For a long time, institutional economists did not even attempt to quantify
transaction costs empirically. Transaction costs were classified as conceptual or
heuristic and the lack of empirical testability was not considered a problem.
More recently, however, estimations of the level of transaction costs have been
published. Before looking at the results, let us discuss a few of the challenges
associated with an empirical measurement of transaction costs. Benham and
Benham (2000) give four reasons why there are only a few empirical studies:

1. There is no universally accepted conceptual definition of transaction

costs.

2. The estimation of transaction costs is difficult, because they often occur

in unison with transformation costs.
 3. When transaction costs are prohibitively high, the transaction is not
carried out, making it impossible to measure them.

4. The “law of one price” is not applicable to transaction costs because they
occur individually. Transaction costs are subject-specific and cannot easily
be operationalized.

A heuristic is a systematic instruction on how to gain new insights

Transformation costs

Transformation costs are costs that are necessary to transform resources

(inputs) into products (outputs). Often, this category of costs is also
called production costs. “Law of one price” describes the tendency of
prices for identical goods, after accounting for transportation costs, to
equalize. When there are unequal prices, there is an incentive for
arbitrage, leading to an equalization of prices.

Wallis and North (1986) are more interested in tracing the development of
transaction costs over time on an aggregate level. They are aware that
transaction costs comprise subjective components. For that reason, they do not
attempt to measure the sum total of transaction costs in an economy, but rather
the size of the transaction sector. Wallis and North attribute to this sector any
activities concerning initiation and execution of economic exchange, such as the
activities of lawyers or real-estate agents. The transaction sector can be
distinguished from the transformation sector, which primarily comprises the
production of goods, and from the transport sector, which can be interpreted as
the spatial dimension of the transformation sector. According to Wallis and
North, there are three main components to the transaction sector:

There seems to be a positive correlation between the transaction sector

and economic development

1. Transaction industries, which are mainly concerned with enabling

transactions. They can also be called intermediaries and include all
resources spent in the fields of finance, insurance, real estate, wholesale and
retail trade.

2. Even within the transformation industries, many workers engage in

procuring input factors, distributing products, processing information and
so on. The labor costs for these employees are also attributed to the
transaction sector. They include firm owners, managers, supervisors, lead
workers, inspectors, lawyers, accountants, judges, notaries, and police and
security personnel.

3. Many of the duties conducted by the public sector are aimed at

protecting private property rights. In this respect, they fundamentally enable
the division of labor. This is why Wallis and North include public budgets
for defense, education, transport, and municipalities.

Wallis and North estimate that the transaction sector of the US economy in 1870
amounted to around 26 percent of gross domestic product (GDP). By 1970, the
size of the transaction sector had more than doubled to 54.7 percent. This
estimate, however, has several critics. Davis (1986), for example, points out that
the result is very sensitive to the exact delineation between production and
transaction activities. At the end of the day, many jobs contain elements of both
production and transaction activities.
The results of this longitudinal study should not be taken to mean that the
quality of the relevant institutions in the USA has steadily declined in the course
of the 100-year period being analyzed. Rather, the analysis shows that a higher
degree of division of labor is associated with a higher portion of the labor force
dealing with the execution of the increasing number of transactions. The fact
that, during the same period, per capita incomes have risen many times implies
that the productivity gains in both the transformation and the transport sector
must also have been substantial. Put quite simply: the cost of single transactions
might be going down, which is expected to lead to more transactions. As a
consequence, the sum of all transactions costs – or, as delineated by Wallis and
North – the size of the transaction sector might go up.

2.4.1 Estimations of the Size of the Informal Sector

The informal sector of an economy includes activities that occur outside
formally regulated activities that are documented in official statistics. Thus,
black market labor falls into this sector. Another term that is often used in this
context is shadow economy. We are now putting forward the hypothesis that the
size of the informal sector is a good indicator for the relative quality of external
institutions. When external institutions create an environment that makes
conducting transactions extremely costly, more transactions will be conducted
through reliance on internal institutions. It is important to keep in mind that this
is a measure for the relative quality of institutions. It does not state anything
about the quality of external or internal institutions per se, merely about their
relation. It is also important to not implicitly assume an exogenously given
number of transactions. If neither external nor internal institutions are suited to
substantially reducing uncertainty, the total number of economic transactions
should be low.
The most influential study in this context is the investigation of three
informal sectors in the Peruvian economy by De Soto (1990): informal housing,
informal trade, and informal transport. De Soto conjectures that the informal
sector is larger when external institutions and internal institutions are less
compatible: “We can say that informal activities burgeon when the legal system
imposes rules which exceed the socially accepted legal framework – does not
honor the expectations, choices, and preferences of those whom it does not admit
within its framework – and when the state does not have sufficient coercive
authority” (De Soto, 1990, 12). In the parlance of this book, De Soto states that
we should expect a flourishing informal sector whenever the government designs
external institutions that are incompatible with the internal institutions of the
relevant actors. The policy recommendation can be made that external
institutions should be, by and large, compatible with a country’s internal
institutions in order to prevent an extensive informal sector.

De Soto: The shadow economy flourishes when external and internal

institutions are incompatible

Even though socially beneficial transactions are conducted within the

informal sector and the sector can be quite orderly, De Soto refrains from
glorifying its achievements. When discussing informal business, he states that
most firms have to forgo the realization of potential economies of scale, as it
would be impossible to remain informal beyond a certain firm size. He also finds
that many firms in the informal sector are at best undercapitalized, that their
capital is not accepted by banks as collateral, that they cannot access certain
markets such as the stock exchange or fairs, that their transactions are associated
with substantial information costs, and that long-term investments are generally
not possible.

Note

Ceteris paribus: All other things being equal or held constant. Common
approach in economic models, often abbreviated “c.p.”

This implies that – ceteris paribus – the rate of investment in the informal sector
should be lower than in the formal sector.

2.5 Open Questions

Many of the results that were obtained using the ultimatum game as a laboratory
experiment are not compatible with the standard rationality postulate that is still
common in economics. It is unclear what conclusions can be drawn with regard
to the modeling of human behavior. Are we merely faced with special cases that
show the need to further generalize the standard behavioral model of economics?
Or could it be that we are faced with such fundamental inconsistencies that a
completely novel behavioral model is required?

Questions

1. Does the result of the Coase theorem change when we account for strategic
behavior of the involved actors?
2. Come up with further examples for the four different interrelationships
between internal and external institutions. How do these relationships affect the
manner and extent of transactions? How can conflicting internal and external
institutions negatively affect societal development?

3. In the first part of the chapter, we dealt in detail with property rights. How
would you classify human rights in this context? What are commonalities with
and differences to material property rights?

4. Give reasons why we could assume that the production of art is only
marginally influenced by the design of the relevant property rights, such as
intellectual property. How would you try to refute such an assumption?

5. The Coase theorem is only valid if the distribution of resources does not affect
the resulting allocation. Try to think of ways in which the distribution of
resources could have an effect on the ensuing allocation.

6. In the description of the Coase theorem, we only explained in detail the case
in which the polluter is not liable for damages from emission. Explain in detail
what happens when the polluter is liable using Figure 2.1.

7. Wallis and North (1986) report that the GDP share of transaction costs in the
USA has more than doubled in the course of 100 years. How can it be that per
capita income has simultaneously multiplied?
8. It is commonly claimed that new developments in modern communication
technology are associated with a decrease in transaction costs. That would
describe a trend opposite to the one observed by Wallis and North (1986).
Discuss.

Further Reading
An early contribution to the theory of property rights is Furubotn and Pejovich
(1972). Alessi (1980) mainly surveys empirical studies. Pejovich (2001) has
compiled two volumes for the “International Library of Critical Writings”
containing some of the most important original contributions.
A well-written introduction to the Coase theorem can be found in Cooter
and Ulen (2012). Over the years, the Coase theorem has been criticized by many
scholars from all sorts of angles. One nicely written example is Deirdre
McCloskey’s piece on “the so-called Coase theorem” (1998). By producing a
small and accessible volume, Coase (1988) not only clarified some of his
original ideas but also answered a number of his critiques. Allen (1998, 108)
claims that by defining transaction costs as “the costs of establishing and
maintaining property rights,” the Coase theorem can be defended against some
standard criticisms.
Oosterbeek et al. (2004) survey the vast literature surrounding the
ultimatum game. A more recent survey is by Güth and Kocher (2014). Henrich
et al. (2005) contains an overview of results for 15 small, non-industrialized
societies. They confirm what we conjectured above: the higher the level of
market integration in a society, the higher the incidence of pro-social behavior.
Schneider and Enste (2007) contemplate alternative possibilities to estimate
the extent of the informal sector. Based on data collected by the World Bank
among firms around the world, Kovač and Spruk (2016) have recently proposed
a new measure for transaction costs. They find that higher transaction costs slow
down economic growth.
Massell (1968) studies the case of several Islamic countries that became
part of the Soviet Union in the 1920s, in which inhabitants started to resolve
conflicts without recourse to the formal legal system when said system was
perceived to be illegitimate.
Voigt and Park (2013) ask whether businesses resort to private dispute
resolution when state dispute resolution is thought to be of poor quality. They
find that state and private dispute resolution are not substitutive but rather
complementary.

1 For a very long time, it was assumed that criminal – and other – offenses
were not amenable to the economic approach. Gary Becker (1968) challenged
that conventional wisdom and laid the foundations for what was to become the
economic analysis of crime. A rational individual is likely to commit an
offense if the expected benefits outweigh the expected costs. Expected costs
are the product of the likelihood of being caught and the severity of the
sanction. This insight is highly relevant for policymakers as it implies that a
low number of policemen can be compensated for by draconian sanctions. Of
course, there might be very good reasons not to make sanctions extremely
draconian.

2Despachar: Spanish for to process, to take care of. Despachantes are

specialized in taking care of the administrative paperwork required by
government authorities.
 3
Repeated and Long-Term
Transactions: On the Choice of
Governance Structures with Given
Institutions
◈

3.1 Introductory Remarks

In Chapter 2, we analyzed how internal and external institutions influence simple
transactions. In this chapter, we consider the effects of given institutions for
transactions that are repeated and intended to be long-term. We speak of “given”
institutions to indicate that they are not created by the actors directly involved in
the transactions, but that they have been “given” to them by others, most likely
lawmakers.
In 1937, Ronald Coase asked why firms exist at all when other economists
posited that markets are efficient. You know the answer already: markets cannot
be used without costs. In many cases, hierarchies are able to manage transactions
at a lower cost than horizontally structured markets, thereby reducing positive
transaction costs. However, coordination via hierarchies, such as firms, is also
characterized by costs, so-called organization costs. These comprise the costs
for procuring inputs as well as those spent on managing and monitoring
personnel. This simple observation already allows for a prediction regarding
firm size: A firm will stop expanding when the additional transaction cost
savings are lower than the additional required organization costs.

Optimal firm size depends on the ratio between organization costs and
transaction costs

When two friends pool resources in order to jointly produce and sell
something, a long-term contract might be required. Frequently, it is
extraordinarily difficult to determine the value of different individual inputs that
go into the production of a good. Accordingly, it can be very difficult to observe
whether both friends are putting an appropriate amount of effort into joint
production or whether one of the two is trying to free-ride on the other’s effort.
One could also envision a situation in which a buyer places an order for a large
amount of the produced good. In order for the producer to confirm the order, the
firm needs to extend its production capacities requiring a significant investment.
But what if, before the investment has fully amortized, the purchaser decides to
switch to a different supplier?

Chapter Highlights

Understand some of the incentives of people making up a firm.

Hear about the various problems caused by asymmetric information.

Get acquainted with the view of the firm as a team – as well as a

collection of assets.
 Learn about the connection between transaction characteristics and
governance structures.

Think about the relevance of internal institutions for firms.

In this chapter, the new institutional economics of the firm are discussed. The
main issue revolves around the incentives that drive the behavior of actors within
the firm (owners, managers, employees). If these are understood, it might be
possible to set up governance structures that help to increase the overall
performance of the firm. Firms themselves are not institutions, they are
organizations. North (1990a) refers to organizations as the players of the game –
as opposed to institutions that define the rules of the game. According to him,
firms – just as other organizations – are “made up of groups of individuals
bound together by some common purpose to achieve certain objectives” (North,
1994, 361). But firms are based on external institutions, e.g., the corporate law
of a country. At the same time, firms usually create their own (internal)
institutions that are used to coordinate behavior of people within the firm. The
external institutions on which a firm is built impact its running costs. For
instance, whether a firm is a limited liability company or an unlimited liability
corporation is relevant for the costs of borrowed capital. If I am liable for a loan
with my entire wealth – including my private wealth entirely unrelated to the
firm I own – banks might grant me better conditions for a loan than in the case in
which I am only liable up to a specified amount, say €30,000. Thus, while firms
are not institutions, they are constrained by institutions.

Firms are organizations, not institutions

 In Chapter 1 we distinguished organizations from institutions without
defining organizations. Following North (1990a, 4), we define organizations as
groups of individuals that are united in the pursuit of a common objective. While
institutions can be called the rules of the game, organizations can be called the
(collective) players of the game.1 The founding of organizations is influenced by
the constraints and possibilities that a game offers for potential members of an
organization to increase their (individual) utility. In firms, resources – i.e.,
property rights – are pooled among their owners and behavior is frequently
coordinated by a mix of rules and commands.
In reality, we observe (a) a large variety of given institutions on which
organizations can be based and (b) a great diversity of organizational forms
within a given institutional framework. It therefore seems straightforward to
assume that optimal organizational forms will differ depending on the concrete
circumstances the organization is facing.
Traditional microeconomics differentiates between household theory
(supply of input factors and demand for goods) and the theory of the firm
(demand for input factors and supply of processed goods). Usually, the firm is
depicted as a production function, that is, a functional relationship between input
factors and outputs. Topics that are not addressed by the traditional theory of the
firm include processes within firms, incentives of alternative salary schemes, and
information problems associated with increasing division of labor. Thus, it seems
a bit pretentious to talk of a “theory” of the firm. Critics often refer to the firm
as a black box: in the black box, input factors are transformed into output goods,
but traditional microeconomics tells us very little about how exactly this
transformation occurs.

The firm as production function?

 Transaction cost economics is a subdiscipline of the NIE that deals with
exactly these topics. Business administration also deals with these kinds of
topics, and rightly so. Indeed, many institutional economists consider the usual
distinction between economics and business administration to be artificial. After
all, representatives of both disciplines draw on the toolkit of modern economics
described in Chapter 1.
The remainder of this chapter is divided into six sections. In Sections 3.2 to
3.5, we consider different aspects of how institutional economics addresses a
theory of the firm. In Section 3.6, we deal with the relevance of internal
institutions for repeated and long-term transactions. In Section 3.7, we formulate
open questions.

3.2 From a Black Box to the Firm as a Team

In their groundbreaking essay from 1972, Armen Alchian and Harold Demsetz
describe the firm as a team, shifting the theory of the firm away from the
traditional view as a production function towards a view of the firm as an
organizational structure. In the framework of Alchian and Demsetz, owners of
resources pool their resources because the output from joint production is larger
than the sum of outputs from individual production. In essence, when owners
pool their resources, they create a team. All such teams are characterized by one
common problem; as soon as joint production starts, it is difficult to measure the
(marginal) contribution of each team member to the joint output. The
consequence is that each team member has an incentive to exert less than
optimal effort with respect to the joint objective, hoping that the remaining team
members will carry the burden. In other words: Each team member tries to free-
ride. This incentive exists for all team members. A careful reader will see that
the underlying interaction situation is that of a prisoner’s dilemma.

Incentive problems in teams …

In this case, the game is not played between two actors, but between one
team member and the rest of the team. In order to keep the notation simple, we
will utilize a common trick. By assuming that all other actors have the exact
same range of options available, we can depict them as a single actor (see Matrix
3.1). The rows represent the available actions of the single team member, while
the columns represent the possible actions for the rest of the team.

Matrix 3.1 The prisoner’s dilemma within a team

Rest of the team

Exert no
Exert effort effort

Single team member Exert effort 3 4

3 1

Exert no effort 1 2

4 2

The highest possible payoff for the single team member is achieved when
he exerts no effort, while the rest of the team does (lower left cell). But when the
rest of the team also exerts no effort, free-riding will not be associated with a
high payoff (lower right cell). From this matrix, it can be inferred that because
all team members are subject to the same incentive structure, no one will exert
effort. On balance, individually rational behavior leads to socially suboptimal
results. Thus, each team member would be better off if the team were able to
implement a mechanism that brings all team members to exert effort, or in the
language of game theory, to cooperate instead of defecting.
Alchian and Demsetz (1972) suggest a solution to this problem. Team
members assign one person to coordinate their activities. This person is not only
authorized to monitor all team members, but also to hire new team members and
fire existing team members. This would solve the incentive problem of the team.
However, there might be an incentive for the coordinator to exert no effort,
which would imply that free-riding would still be the outcome of the game.
Thus, an additional mechanism is required to create the right incentives for the
coordinator: The coordinator is given the right to appropriate the residual
income – that is, the profit – from joint production. Because a high firm profit
correlates with a high payoff for the coordinator, there is an incentive for the
coordinator to coordinate the team’s activities optimally.

… and a possible solution

Definition

The residual income is what remains from a firm’s revenues after

paying off all contractual obligations, such as wages

Two factors stand out when considering the firm as a nexus of contracts:
 1. The coordinator – we could also call him entrepreneur – enters into
bilateral contracts with all team members as a group. In this manner, he can
economize on negotiation costs. If for any reason there is a breach of
contract, or a change in team composition, and the entrepreneur had to
renegotiate with each team member individually, the resulting costs would
be high.2

2. The better durable capital goods belonging to the firm and used to
produce the goods the firm intends to sell are taken care of, the longer their
lifespan and the higher the return on investment. Because the entrepreneur
is endowed with control rights, he has an incentive to invest in the
maintenance of capital goods. If the entrepreneur contributes a large part of
the firm’s real capital, it makes sense that he should also be given the
control rights for the capital goods, as this leads to the proper incentives.

The theory of the firm proposed by Alchian and Demsetz was criticized, but also
further developed, by a host of authors, including both Demsetz and in particular
Alchian (see Alchian, 1984; Alchian and Woodward, 1988). Barzel (1987)
proposes the measurement cost approach, which emphasizes that there are
high costs associated with the entrepreneur measuring his own inputs. Barzel’s
conclusion is that the person whose contribution to team production is the
hardest to determine is the entrepreneur.
Having discussed the origins of the institutionally founded theory of the
firm, we turn to a problem that is prevalent not only in many firms, but also
other relationships: asymmetric information between a supervisor (more general:
a principal) and his or her employee (more general: an agent).

3.3 Problems Associated with Asymmetric

 Information: The Principal–Agent Theory
In their 1976 paper, Michael Jensen and William Meckling introduced what
would later be referred to as principal–agent theory. At its core, principal–agent
theory is concerned with the consequences of asymmetric information between
partners to a contract. The principal assigns a certain task to an agent. However,
the principal cannot perfectly (or costlessly) observe the agent’s actions, nor can
the principal evaluate the performance of the agent’s contractual task in complex
situations. Thus, the agent possesses some degree of discretion that she can use
to maximize her own utility – which may not be congruent with the principal’s
utility. The main research interest of principal–agent theory is the optimal design
of contracts given the assumption of asymmetric information. In its applications,
the contribution of Jensen and Meckling is not limited to the theory of the firm.
Many other relationships can be analyzed using this theory. This includes the
relationship between voters and politicians, between department head and
department staff, between creditors and debtors, and so on.
The classic example is the incorporated company. The shareholders – the
principals – have at their disposal a different level of information than the
managers – the agents. Shareholders have an interest in signing contracts with
managers that lead to the maximization of their expected profits. Two crucial
preconditions for such contracts have been identified, namely:

1. The agent is at least as well off by entering into the contract as she would
be if she didn’t (this is called “participation constraint” in contract theory).

2. The agent takes actions that maximize her own expected utility within
the respective contract (this is called “incentive compatibility constraint” in
contract theory).
The costs that arise from asymmetric information are called agency costs. These
include all costs borne by the principal in order to restrict agent behavior that is
not in the principal’s interest.
By assumption, information is asymmetrically distributed between principal
and agent. To keep measurement costs low, the principal will resort to easily
observable variables when trying to evaluate the productivity of agents.
Productivity, however, is only imperfectly observable, e.g., when hiring new
employees. Because there is discrepancy between the attributes the principal
would like to observe and the attributes the principal can observe, certain
problems can arise. Two of these problems are adverse selection and moral
hazard. Let us look at these in a little more detail.

Asymmetric information can occur ex ante and ex post

In general, adverse selection implies that a buyer cannot distinguish

between high quality and low quality products before buying a good. The
inability on the buyer’s side to distinguish between high and low quality implies
that her willingness to pay will be rather low. Formulated differently: were she
able to distinguish between low and high quality goods, she would be ready to
pay more for the high quality good. The inability to distinguish between different
qualities means that average prices will be rather low. This, in turn, implies that
the potential sellers of high quality goods might prefer not to sell at all. In
extreme cases, this process can lead to a complete stop of any exchange in such
markets. This story was first told by George Akerlof (1970) with reference to
used cars. Here, the inability to distinguish between various qualities on the side
of the buyer leads to adverse selection in the sense that the average quality
offered on such markets is likely to decrease over time.
 Adverse selection is also a problem if a firm wants to hire agents with high
productivity. The principal might simply be unable to ascertain the quality or
productivity of the agent. This situation is often referred to as hidden
characteristics. Hidden characteristics refer to stable attributes of an agent that
cannot be observed by the principal ex ante (i.e., before a contract is concluded)
but will be revealed ex post (i.e., after the contract has been concluded). An
agent may be a hard worker, but not very skilled at completing a task. Thus, the
problem is relevant before entering into a contract with a potential agent. For
firms, this problem occurs primarily in the process of hiring. While potential
new employees might have a good idea about their own productivity, firms try to
measure productivity either by using costly methods (also referred to as
screening) or by resorting to other ways of obtaining information that might
correlate with productivity (signaling where the potential agent tries to credibly
signal his qualities). It is crucial that signals are hard to fake, i.e., that only those
with the desired attributes can send them. In economic parlance: signals must be
costly. One example for the latter is a college degree with good grades. Although
a good college degree does not directly measure productivity, a highly
productive individual is more likely to complete college with a good degree.
Some business consultants hire people with a degree in the natural sciences.
Knowledge in biology or chemistry is often only marginally useful in consulting.
It seems that these graduates are hired because their degrees signal their ability
to perform well in a demanding environment.

Ex ante …

In general, moral hazard refers to a situation in which one person takes a

high risk because he does not have to bear all of the consequences of the
behavior. Moral hazard, hence, involves a negative externality. The problem of
moral hazard is present when the principal is able to observe the agent’s
productivity (no information asymmetry here), but cannot ascertain to what
degree the resulting outcome is due to the agent’s actions or due to exogenous
factors. Thus, while the problem of adverse selection occurs before entering into
the contract, the problem of moral hazard occurs after entering into the contract.
For instance, shareholders (the principals) have a hard time determining whether
their firm’s decreasing profits are due to bad management decisions or to
unanticipated exogenous shocks that might have counteracted the otherwise
good work of management.

… and ex post

Exogenous shocks

Exogenous shocks are unanticipated events that are beyond reach, hence
exogenous. The event of a natural disaster could be such a shock. By
destroying the better part of a crop, it causes prices to increase.

Naturally, agents are aware of these problems and have an incentive to blame
poor firm performance on exogenous shocks. Moral hazard is often
differentiated into hidden information and hidden action. Hidden information
describes a situation in which the principal does not possess the expertise to
adequately evaluate the agent’s actions. Hidden action describes a situation in
which the principal simply cannot observe the agent’s actions. Both types of
information asymmetries are associated with moral hazard problems.
 In Section 3.4, we discuss several approaches for mitigating problems
caused by information asymmetries.

3.4 Transaction Cost Economics

As a student of Ronald Coase, Oliver E. Williamson continued to explore
Coase’s inquiry into why firms exist and developed a unique approach to
transaction cost economics. In Williamson’s approach, the question is not merely
why some transactions are carried out via markets and others via hierarchies (his
1975 anthology is entitled Markets and Hierarchies), but also which type of
transaction is carried out using so called hybrid governance. Hybrid
governance refers to forms of governance somewhere between the two “pure”
forms of governance, namely markets and hierarchies. Joint ventures and
franchising are just two examples of such hybrids. More specifically, Williamson
investigates how the optimal type of contract (or governance) is affected by
various characteristics of a transaction (behavioral assumptions, specificity of
investment, transaction frequency, and so on).

Individuals are assumed to be boundedly rational and opportunistic

Williamson assumes that the actions of individuals are characterized by

bounded rationality. He also assumes that individuals are opportunistic, that
is, they will proceed with an action that makes them better off, even if that action
has a negative effect on another individual. If potential transaction partners are
not able to utilize or develop institutional mechanisms that prevent opportunism,
then many transactions that otherwise might be mutually beneficial will not be
realized. Again, we can see that an adequate institutional framework is important
for the number and the value of transactions in a market economy. Opportunistic
behavior is particularly prevalent when a specific ex ante investment by one
party is required in order for a transaction to be realized. As soon as that
investment is made, however, the value of the next best use for that investment
good is much lower than the value that can be obtained within the contract.
Suppose the investment is a factory for producing smart phones. If, all of a
sudden, no smart phones are to be produced there but notebooks, the return to
the investment is likely to be lower. Williamson refers to this phenomenon as
asset specificity or specific investment. Note that specificity can refer not only
to real capital and human capital, but also to the location of a firm. It is
important to realize that the incentives before entering a contract (ex ante) are
very different from the incentives after having agreed on a contract (ex post).
Before making specific investments, a supplier is not tied to a particular buyer.
After having made that specific investment, the situation is that of a bilateral
monopoly. For Williamson, this change in incentives is so important that he also
talks of it as the “fundamental transformation.”
Imagine a railroad network installed according to the specific requirements
of the buyer, e.g., a railroad company. If for some reason the railroad is no longer
used, one could uninstall the rail tracks, install them elsewhere, or simply melt
them to regain the steel. Re-dedicating the use of the railroad network is
associated with significant costs. The part of these costs that cannot be recovered
– for instance by selling off remaining parts and materials – is called sunk costs.
Once costs have been sunk, contracting partners are locked to each other, as
switching partners would imply writing off the sunk part of the investment. This
is called lock-in. The difference between the value of the first best use and the
second best use of a good is called quasi rent. A buyer tries to recoup as much
of the quasi rent as possible.3 Despite the assumed bounded rationality, many
suppliers will anticipate this, such that many potentially beneficial transactions
will not be realized. Think back to the example we introduced at the beginning
of this chapter: A buyer orders a large quantity of a good. The supplier is only
able to supply this large quantity after investing in additional capacity. However,
after this investment, the buyer has an incentive to try to renegotiate the price. If
the supplier anticipates this, he might not carry out the required investment in the
first place. One possible solution to this problem is for buyer and supplier to
merge into a single firm since under joint profit maximization, the problem of
opportunism does not arise.
Williamson shows how variations in the assumptions regarding bounded
rationality, opportunism, and specific investment affect the optimal type of
contract (1985, 31).
When perfect rationality, opportunism, and specific investment are given,
actors can use their perfect rationality to anticipate all relevant eventualities and
deal with them in respective contract clauses. In other words, contracts are
complete in the sense that all possible events (even events with an extremely low
probability of occurring) are explicitly dealt with in the contract, and there is
never scope for an ex post dispute regarding their correct interpretation. The type
of contract under these assumptions is referred to as “planning” or “mechanism
design” by Williamson.

Planning

When we assume bounded rationality and specific investments, but actors

are not opportunistic, contracts cannot be complete because the consequence of
bounded rationality is that we cannot possibly foresee all future states of the
world. Promises to pursue a common goal, however, would be credible and thus
sufficient. In the absence of opportunism, such a contract is self-enforcing, such
that third-party enforcement is not required. The optimal type of contract under
these assumptions is called “promise” by Williamson.

Promise

If we assume that actors are boundedly rational and opportunistic, but

specific investments are absent, goods can be re-dedicated at any time without
significant loss. Under this assumption, markets function as they should
according to neoclassical theory: Competition will lead to efficient results and
Williamson refers to the implicit type of contract here as “competition.”

Competition

Governance

Finally, let us assume that all three assumptions are given. Then, the
contracting parties will not resort to any of the previously mentioned contract
types, but rather create a governance structure of their own. This could, for
instance, have the form of a joint venture. There are two further alternatives in
the presence of bounded rationality, opportunism, and asset specificity: First, the
transaction is not realized at all. Second, the transaction is realized, not via the
market, but within an organization. In our example, that would imply a merger
between the buyer and the supplier. The creation of a governance structure is
associated with the need for contractual safeguards against opportunistic
behavior.
Let us posit for now that it makes sense to assume bounded rationality,
opportunism, and asset specificity. A consequence of operating under all three
assumptions is the prediction that actors will try to create a specific governance
structure in order to realize mutually beneficial transactions. The logical
corollary question is: Which factors determine which specific governance
structure is optimal for a given type of transaction? We now discuss this question
in detail.

Factors that are relevant for the choice of a governance structure

Williamson distinguishes three characteristics of transactions:

the degree of asset specificity,

the degree of uncertainty, and

the frequency with which a transaction is repeated.

Regarding asset-specificity Williamson proposes to distinguish between (1) non-

specific assets, (2) assets of an intermediate degree of specificity, and (3)
idiosyncratic specificity. Regarding the frequency with which transactions are
repeated, he makes a distinction between “occasionally” on the one hand and
“regularly” on the other. If we were to combine these two dimensions by
drawing a table we would thus get a table with six cells.
The distinction between transactions that are carried out occasionally and
ones that are carried out regularly is probably self-explanatory although it might
not always be crystal-clear how to group a specific transaction. With regard to
the characteristics of the investment good, that is, the extent of asset specificity,
some explanation might be required. If the investment is non-specific in
character, the value of its second best use is nearly as high as the value of its first
best use. Hence, sunk costs are hardly relevant here. At the other end of the
spectrum, there are idiosyncratic assets. By this, Williamson means an
investment good with unique characteristics. Such goods require a high degree
of specific investment.
Williamson now argues that different transaction characteristics lead to
different optimal governance structures. To characterize these governance
structures, he goes back to a 1974 essay by Ian Macneil. According to Macneil,
classical contracts are characterized by a strong reliance on external institutions
and formal documents. Because bounded rationality prevents actors from
anticipating all possible future contingencies and including them in the contract,
the effort to take care of all eventualities that might occur in the future leads to a
quick escalation in negotiation costs for long-term contracts. “Classical
contracts” are governed by relying on markets. This type of governance is best
suited for goods that are non-specific, no matter whether exchanged regularly or
only occasionally.
Neoclassical contracts can be interpreted as a middle ground between
attempting to anticipate all possible contingencies on the one hand and accepting
the fact that contracts are necessarily incomplete on the other. In this
constellation, the solution involves the establishment of arbitration mechanisms
and resorting to external arbitrators that are respected and trusted by all parties
involved. Therefore, the governance structure underlying neoclassical contracts
is also referred to as “trilateral governance” and it is most appropriate for goods
with an intermediate degree of specificity that are exchanged only occasionally.
Finally, the concept of relational contracts views individual transactions as
part of an ongoing business relationship that is made up of a large number of
such transactions, the extent and frequency of which is impossible to anticipate
ex ante. Given such a conception of contracts, it is not necessary that the mutual
account is in balance after every single transaction. Under such contracts, it is
not uncommon for one party to advance funds in the expectation that this will be
compensated for in the long-term business relationship. When the goods to be
exchanged are idiosyncratic and this occurs regularly, a unified governance
structure (such as a single firm) is expected to be most appropriate.
Transaction cost economics can have far-reaching consequences for
competition policy. Here is just one example: In traditional economics, vertical
mergers (that is, mergers between firms at different levels of the value chain) are
seen rather critically. However, given the insights of transaction cost economics,
a re-evaluation might be in order. What if the (expected) transaction cost savings
of such a vertical merger are higher than the (expected) additional organization
costs? Then, prohibiting such a merger would prevent a more efficient
organizational structure. This is why transaction cost economists take a stance on
antitrust policy that is markedly different from more traditional approaches.

Policy consequences

3.5 The Firm as a Collection of Assets

During the second half of the 1980s, a group of economists began to think more
deeply about the effects that vertical integration, i.e., unified governance, would
have on the incentives of all the affected actors. In order to develop a theory of
the firm that is able to say something meaningful about the boundaries of the
firm, the extent to which a firm is vertically integrated is crucial. Sanford
Grossman, Oliver Hart, John Moore, and Jean Tirole were among the economists
thinking about these issues. Since their conceptualization of the firm relied
heavily on property rights, it is also called the property rights approach to the
firm. More generally, their approach is known as incomplete contract theory and
they view the firm as a collection of assets.
Suppose there is a contract between a buyer and a seller that specifies many
– but not all – contingencies. Contracts cannot be complete because some
information is observable (to the contracting parties) but not verifiable (in front
of a neutral third party, such as a court). Ownership of assets now implies that
the owners possess residual rights of control over the respective assets.
According to property rights theory as introduced in Chapter 2, ownership
implies the right to transfer the rights to use or modify an asset. But when
contracts are incomplete, not all potentially valued rights can be perfectly
transferred. The term “residual right” refers to the right of an owner to proceed
with her asset as she sees fit as long as no particular contract or general law
stands in her way.
This view of the firm includes all kinds of nonhuman assets (from
machines and inventories, buildings and client lists to patents and copyrights).
Human assets are explicitly excluded because they can neither be bought nor
sold. In essence, the theory claims that the identity of the asset owner matters for
how assets are used, for the relative bargaining power of the contractual partners
vis-à-vis each other, for how they divide a potential surplus, and, at the end of
the day, for how much investment will take place.
These assumptions are then used to identify the boundaries of the firm. Hart
(1989, 1770) summarizes the main findings:

Highly complementary assets should be owned in common; a minimum

size of the firm is the likely consequence.

As the firm grows, the value created by some activities at the periphery is
unlikely to be specific to the assets at the center; at that stage, a spinoff is
in order to reduce the danger of hold-up of the periphery by the center.
 In the absence of significant lock-in effects, nonintegration is always
better than integration; coined differently, in the absence of lock-in,
relying on markets is better than relying on firms.

Transfer of ownership of physical assets has incentive effects for the

owners of human assets; quite simply, it is in my self-interest to cater to
the interests of the new asset owner as that will improve my bargaining
position in relation to her.

The property rights approach of the firm has had a huge impact. Some
shortcomings that have been criticized are that the propositions are nearly
untestable (Whinston, 2003) and that it is a theory of the firm without managers
(Gibbons, 2005). Another critique might be considered the cornerstone for yet
another theory of the firm. As pointed out, the theory confines itself to
nonhuman assets. An alternative theory of the firm focuses explicitly on human
assets and emphasizes that firms, as governance structures, have advantages in
the creation of firm-specific knowledge. In explicit contradistinction to
Williamson, organization costs decrease with human asset specificity. This view
of the firm has been developed by Richard Nelson and Sydney Winter (1982).
In this chapter we have retraced various steps in the development towards
an “institutional theory of the firm” including principal–agent theory as well as
transaction cost economics. Given the observation that different legal forms of
firms are prevalent (thus entrepreneurs do not always opt for the same legal
form), we can conjecture that some institutional arrangements are more suited
for certain business objectives than others. Within the scope of this text, we can
only discuss this matter very briefly. A short discussion of the advantages and
disadvantages of different legal forms from the perspective of institutional
economics can be found in Eggertsson (1990, 177–188). A more detailed
discussion, albeit without institutional focus, can be found in any introductory
textbook on business administration (such as Schermerhorn, 2012).
The choice of legal form depends significantly on the respective feasible
production techniques on the one hand, and tax implications on the other hand.
Capital intensive production with a high degree of fixed costs is usually not
feasible in sole proprietorship.
The basic differences between sole proprietorship (the sole proprietor is
liable fully and solely) and other legal forms of partnership (nontrading
partnership, general partnership, limited partnership) and a joint stock company
(incorporation, closed corporation) are probably known to you. For certain
objectives, the legal forms of cooperative society or foundation might be
optimal. These various legal forms differ significantly with respect to their
liability consequences. Liability, in turn, impacts possibilities for and costs of
funding.
We would like to stress here that different legal forms are associated with
different incentives for employees. This applies not only to the incentives to
exert effort, but also to the incentives to invest in one’s own human capital and
specialize. The problem of ex post opportunism is relevant here too. A firm
might need a worker who is highly specialized. However, if the value of the
second best use for his specialized human capital is much lower outside his
current workplace, there is an incentive for his employer to lower his salary as a
consequence of his specialization! Anticipating this, the worker will refrain from
making productivity enhancing investments into his human capital absent an
institutional solution that gives the employer an incentive to raise the worker’s
salary after such a specific investment in human capital. On the other hand, an
employer might make a considerable investment in training a new employee,
which increases the trainee’s market value considerably. To prevent a highly
qualified trainee from simply being headhunted away after finishing his training,
many trainee contracts include a clause requiring the trainee to stay with the
company for a minimum number of years.

Legal form influences employee incentives

3.6 The Relevance of Internal Institutions

In Chapter 2, we saw how internal institutions might restrict the way in which
simple transactions are carried out. Here, we discuss how and in what situations
they can have an impact on repeated and long-term transactions. Again, we do
not aim for a full discussion, but rather discuss two examples of how internal
institutions can affect such transactions.

3.6.1 Example 1: Corporate Culture: On the Coordination of

Interaction Situations within Firms
Employees interact with each other in many different ways within a firm. Similar
to the example of Laurel and Hardy in Chapter 1, employees prefer to coordinate
their behavior. The sum of conventions used by employees to coordinate their
behavior has been coined corporate culture by Kreps (1990). “This is how we
do it,” is an instruction often given to new employees that are not yet familiar
with a firm’s corporate culture. Corporate culture is not necessarily limited to a
set of conventions (that is, type 1 institutions), but can also include other
institutions. For instance, employees who break a certain rule could be scolded
by their colleagues (based on custom, i.e., a type 3 institution). This can involve
the spontaneous formation of behavioral rules which can be very costly for, or
even impossible to change by top management. Entrepreneurs are also interested
in cultivating certain aspects of corporate culture. For example, if there are
corporate norms that lead employees to informally sanction colleagues who try
to steal office supplies, the control costs of preventing such theft will be lower
for management. Conversely, entrepreneurs will want to abolish corporate norms
that use social exclusion as a sanctioning mechanism for “over-eager”
colleagues.
The difficulties in realizing theoretically possible synergies after two
companies have merged are commonly known by now. An explanation that
suggests itself is that incompatible corporate cultures can be a major
impediment. A number of empirical studies on this topic are available with
somewhat contradictory findings. In mergers taking place within countries,
different organizational cultures reduce the profitability of mergers, as expected.
In cross-country mergers, however, different national cultures tend to have the
opposite effect. Any insight that can be gained from the study of merging firms
promises to be relevant for other areas too: When different administrative bodies
within an international organization have to cooperate, different (corporate)
cultures can clash. As such, there might be some coordination failures at the EU
in Brussels due to national administrative cultures. This notion can also be
applied to the “fusion” of societies or states.

3.6.2 Example 2: On the Relevance of Reciprocity in Labor Relations

Quite a few experimentalists started their careers as labor economists. As a
result, their primary interest was employee–employer relationships. Small
wonder, then, that some of the early experiments dealt with exactly this
relationship. One example is the study by Fehr et al. (1997) which examines an
“experimental labor market.” Participants were either employers or employees.
For an employer, the ideal employee puts a lot of effort into her work but does
not demand a high wage. For an employee, the ideal job is not very demanding
in terms of necessary effort but highly paid. In the experiment, the employer
offers a labor contract that specifies a certain wage combined with a desired
effort level and a contract is made with the first employee who accepts the offer.
The employee receives the agreed upon wage no matter how much effort she has
put into her work. There is no way for the employer to punish the employee if
she puts in less than adequate effort.
In theory, this game has a straightforward solution: the employee would put
in a minimum level of effort. The employer, anticipating this, would only offer a
wage level sufficient to provide him with an employee. In actual plays of the
game, however, employers often offered high wages combined with high levels
of effort. The employees, rather than taking advantage of this by answering with
a low level of effort, often reciprocated with high effort levels. As a
consequence, both employers and employees were often better off than
suggested by the theoretical solution.
Now, if the experiment ended here, we could conclude that employees are
strong reciprocators. But we could not say anything about employers, after all,
their generous offers meant higher profits for them, so their behavior could be
rational profit-maximizing. To learn more about the behavior of employers, Fehr
and his co-authors extended the experiment and gave employers the possibility
to reward or punish employees, but at a cost. The game was not repeated, so the
actors did not have the opportunity to develop a reputation as “tough” or “effort
rewarding” or whatever else. In theory, no employer would spend a single cent
on punishing or rewarding any employee since he would not reap any benefits
by such behavior. In the experiment, however, employees were often punished or
rewarded depending on their level of effort. These findings have been confirmed
in other experiments (see, for instance, Fehr et al., 2009 or Gächter et al., 2011).
If these findings also hold outside of the lab, they would prove that internal
institutions that sanction employees who do not reciprocate play an important
role in employer–employee relationships.

3.7 Open Questions

In this chapter, we have formulated multiple hypotheses that have not yet been
thoroughly investigated empirically. Even the implications of the Internet for
governance structures cannot be fathomed. In a similar vein, the agency and
measurement costs that occur in virtual societies also remain unexplored.

Questions

1. Think back to the definition of institutions. Could (a) shareholder agreements,

(b) labor contracts, and (c) corporate and labor law be thought of as institutions?

2. In the view of Alchian and Demsetz (1972), what is the solution to the
incentive problem of “simple” team members and the coordinator (the
entrepreneur)?

3. Explain the problem of moral hazard using the example of fire insurance.

4. Illustrate the problem of adverse selection using the example of an insurance

company that sells automobile insurance by determining the premium based on
the actuarial value.

5. Discuss incentive problems pertaining to collectively organized cooperatives,

taking into particular consideration the view of the firm as a nexus of contracts.
6. Discuss to what degree outsourcing decisions can be explained with
Williamson’s approach.

7. In Section 3.4, I use many words to describe things that can be easily depicted
as tables. Go back to that section and try to produce a table regarding optimal
contracts and another one showing optimal governance structures taking into
account both the degree of asset specificity as well as the frequency in which
transactions occur. I would have liked to reprint the tables from Williamson
(1985) but the copyright holder set a prohibitive price, which is why the tables
are not included here. Instead, you can compare your tables with those that are
on pages 31 and 79 respectively in Williamson (1985).

8. What category of contract would be appropriate if neither bounded rationality,

nor opportunism, nor asset specificity is assumed to be present?

9. Try to come up with yet another example for the relevance of internal
institutions in employer–employee relationships considering possible
implications for the design of labor contracts.

10. Use incomplete contract theory to explain why mergers and spinoffs are
often part of the lifecycle of the firm.

Further Reading
Paul Milgrom and John Roberts (1992) have written a very good textbook on the
theory of the firm from an institutional economics point of view. Williamson
received the Nobel Prize in economics for “his analysis of economic
governance, especially the boundaries of the firm.” In his prize lecture (2010),
he gives an account of how transaction cost economics progressed over time.
Friedman (1991) gives a short introduction into the life and research of
Ronald Coase. An evaluation of his impact on economics is Shirley et al. (2014).
An overview of contract theory can be found in Bolton and Dewatripont
(2005). An introduction to principal–agent theory can be found in Sappington
(1991).
One of the crucial contributions to the theory of adverse selection is “The
Market for Lemons” by George Akerlof (1970) in which he shows that
asymmetric information can even lead to the complete collapse of the market for
a good. Incidentally, lemon does not refer to the fruit but rather to cars of low
quality. The argument of Akerlof can be applied to all goods for which potential
buyers cannot immediately ascertain the quality. This contribution is one of the
reasons why Akerlof received the Nobel Prize for economics in 2001.
Baker et al. (2002) give an introduction to the concept of relational
contracts.
Hart (1989) provides a very accessible description of the development of
the theory of the firm putting major emphasis on the collection-of-assets view.
Williamson (2002) offers his take on the theory, including a concise criticism of
the shortcomings of the collection-of-assets view. Garrouste and Saussier (2008)
explicitly acknowledge the ingenuity of Coase’s early (1937) contribution but
also mention weaknesses of his early take and compare his theory to more recent
theories of the firm. Aghion and Holden (2011) survey the relevant theoretical
literature on incomplete contracts in a very accessible way.
Shelanski and Klein (1999) is an overview that surveys the literature on
empirical estimates of transaction costs in firms. The essay by Macher and
Richman (2008) is not only more recent, but also wider in its applications, as it
also includes transaction cost estimates for areas such as legislation, health
policy, and agricultural policy.
The effects that differences in corporate governance across countries can
have on the gains of cross-border mergers have been analyzed by Martynova and
Renneboog (2008). If the bidder originates from a country with good corporate
governance (regarding, for instance, the protection of minority shareholders or
creditors) and the target company with worse governance, then the merger is
likely to result in a positive spillover effect, implying that governance structures
will improve in the country of the target company.
Kreps (1996) has written an introduction on the topic of corporate culture
from the viewpoint of economics. The empirical findings regarding the influence
of both organizational and national culture on a merger’s success are surveyed
by Teerikangas and Very (2006). They also inquire into the reasons for the
conflicting findings in the literature to date. Ahern et al. (2015) find strong
evidence that three important dimensions of national culture have significant
effects on both the number of mergers as well as their realized synergies. These
are the degree to which people trust each other, the degree to which hierarchies
are commonly accepted, and the degree of individualism. Countries with similar
national cultures not only realize more mergers, the mergers also experience
higher synergies.

1 Organizations, as such, cannot act. Strictly speaking – and in line with the
concept of methodological individualism that we introduced in Chapter 1 – it
is, hence, not organizations that act, but rather the individuals who are part of
an organization.

2One reason for the inefficiency of worker governed firms and many
cooperatives is that many decisions are made jointly, which is associated with
high decision-making costs.

3This strategic situation is called hold-up. The buyer figuratively attempts to

“hold up” the supplier for a part of the quasi rent.
 4
Institutions and Collective Action
◈

4.1 Introductory Remarks

We have repeatedly asked why firms exist when the common conception is that
goods and factors find their most efficient use through “quasi-automatic”
allocation via markets. We have seen that the use of markets is not without costs,
and that the choice between using the market (horizontal coordination) and the
firm (vertical coordination) depends on the costs associated with the respective
type of coordination. In this chapter, we ask a broader question: If markets (and
the firms within them) function so efficiently, why do we need states? The
traditional answer in economics is quite simple. We need states because the
private provision of certain goods is not possible due to the specific
characteristics of those goods, even though the consumption of these goods is
beneficial to most (or even all) citizens. Economists call such goods public
goods. One of their characteristics is that as soon as they have been provided no
one can be excluded from their consumption without prohibitive costs given the
available technology. This is called non-excludability. Another characteristic of
public goods is that one individual can consume them without reducing their
utility for other consumers. This is called non-rivalry. Consider a dam that
protects all farms behind it from flood damage irrespective of whether all
farmers in question contribute to the costs. Non-rivalry means that the level of
protection for farmer B is not reduced by the fact that farmer A is also protected
by the dam. Once again, we can illustrate the underlying structural problem of
public good provision by referring to the prisoner’s dilemma.

Why do we need states?

The characteristics of public goods

In Chapter 3, we used a simple trick to facilitate the illustration of a multi-

person prisoner’s dilemma. We again assume that all actors are endowed with
the same range of options, which allows us to create one category of “all other
actors,” and another category of “one actor.” The row player is one actor; all
other actors are represented by the column player (see Matrix 4.1).

Matrix 4.1 The prisoner’s dilemma as N-person game

All other actors

Cooperate (C) Defect (D)

One actor Cooperate (C) 3 4

3 1

Defect (D) 1 2

4 2
 To “cooperate” here means to contribute to the provision of the public
good, for instance the construction of the dam. To “defect” here means not to
contribute to the provision of the public good. Those who do not contribute hope
that all other actors provide the public good (thus cooperate), making it possible
for the defector to benefit from the public good without incurring any costs. The
problem with such a “solution” is that all actors have the same incentives in
determining whether to contribute to the provision of the public good.
Rationally, we have to expect that all actors will defect and the dam will never
be constructed based on voluntary contributions. At the same time, we know that
all farmers would be better off if the dam were to be constructed. The classical
solution to this problem is for the government to provide public goods such that
the outcome of the game is not the individually rational equilibrium (D, D), but
rather (C, C). The government is able to provide public goods because it has the
power to tax citizens.
From Chapter 3, you remember the problems associated with team
production. We saw that in order for team production to be (economically)
successful it is not sufficient to assign one team member to monitor the rest of
the team. The monitoring agent needs to be provided with incentives to ensure
he or she monitors the team properly. While there are many differences between
the problems faced by economic organizations (firms) and political organizations
(governments), these organizations share a number of structural similarities. Let
us define citizens as members of “team society” who assign a few among them
with the task of providing certain goods and services. Again, we need to
consider carefully the incentives of the chosen agents, who we now call
government instead of entrepreneurs. As soon as we endow some agents with
special competencies – in particular the monopoly to use force – the danger
arises that those actors might abuse these competencies.
 Chapter Highlights

Understand how politicians behave under given institutions.

Familiarize yourself with the dilemma of the strong state.

Get acquainted with the public goods game – and how it is played in
the laboratory.

Learn about possibilities – and pitfalls – to manage common pool

resources.

The main goal of this chapter is to explain the behavior of agents who are
assigned the task of providing public goods and who are subject to certain
institutional constraints. Even when we assume that the average politician is
interested in maximizing his or her utility, we still see that there is a wide variety
in the behavior of politicians in different countries. Institutional economists
propose that an explanation for this variety of political behaviors is differences
in institutional constraints, not differences in objective functions.

Politicians’ behavior can also be explained via institutions

In the remainder of this chapter, we assume the state – and its constitution –
to be given because we want to analyze how the incentives of different
constitutions impact the behavior of politicians and other actors. In a
subdiscipline of institutional economics – constitutional economics – it is
common practice to distinguish between a constitutional and a post-
constitutional level. With respect to the state, the constitutional level
corresponds to the constitution of a country, while the post-constitutional level
corresponds to legislation that is passed based on that constitution. Thus, one
potential approach is to consider a state’s constitution as a given institutional
structure and then to ask what incentives politicians have to pass different laws,
given those structures. As always, we define an institution as having a rule and a
sanction component. The question here is how politicians are sanctioned when
they are noncompliant with the rules governing their behavior.

4.2 Explaining Politicians’ Behavior Under

Given Institutions
4.2.1 Preliminary Remarks
During the last few decades, representatives of public choice theory have dealt
with several questions that we are interested in here. Giving a comprehensive
overview of public choice theory is beyond the scope of this book (Holcombe,
2016 is a brief introduction). We restrict ourselves to naming just a few of the
research questions that public choice theorists have been concerned with. These
include:

1. What is the effect of different decision rules (i.e., unanimity rule or

different forms of majority rule) on the expected outcomes?

2. What is the influence of the electoral system on the number of political

parties?

3. What determines the propensity to form coalitions and their stability?

4. Does it matter whether a state is organized federally or centrally?

5. What is the effect of direct democracy on politicians’ behavior?

 6. How can the behavior of bureaucrats be explained?

To illustrate the general logic of public choice theory, let us consider an example
of how different institutional arrangements can lead to different political
behavior. Imagine a country A, in which legislation can be passed by a simple
parliamentary majority and contrast this with country B, in which legislation can
only be passed with the majority of votes from the Lower House, a majority in
the Upper House, and a signature of the president (similar to the US system). As
soon as different parties control the two Houses, it becomes much more difficult,
that is, more costly, to achieve the majorities required for passing legislation.
Ceteris paribus, we expect a lower number of new laws passed in country B than
in country A.
The restrictions in place can also induce political behavior that is not
concerned with the provision of socially beneficial public goods, but rather with
the maximization of a politician’s utility while harming the rest of society. We
look at two examples of such behavior: (1) rent seeking and (2) political
business cycles.

Examples of harmful political behavior

4.2.2 Example 1: Rent Seeking

The term “rent seeking” was coined by Anne Krueger (1974). The notion itself
goes back to Gordon Tullock (1967). It has nothing to do with payments for a
leased good, but can be thought of as that part of a price that is above its
production costs. Rent seeking describes activities by lobby groups aimed at
using the political process to secure special benefits, such as protection from
import competition or simply subsidies. It implies that some actors are privileged
and others – in turn – are discriminated against. Politicians who hand out rents
thus behave in a way that is not compatible with the rule of law. Although the
process of rent seeking wastes resources (any resources that flow into rent
seeking cannot be utilized for productive purposes), private agents will spend
resources on rent seeking as long as the expected net utility of this behavior is
positive. Politicians – the agents of interest here – will grant special privileges
when they expect to be better off because they receive something in return like
political donations, campaign support, or even bribe money. The demand for and
the supply of special privileges should be determined by the institutional
structure of a country. If an institution’s sanction for accepting bribery implies
the end of one’s political career, we would expect less bribery than if there is no
sanction for bribery. If there are sanctions for supplying special privileges, we
would expect a lower demand for such privileges by interest groups, as the
probability of gaining special privileges would be rather low. If the expected
utility of rent seeking is low, interest groups will invest fewer resources to gain
special privileges.

The potential for and the limitations of rent seeking are closely related to
the institutions in place

Olson (1982) believes that extensive rent seeking by interest groups is one
reason for the economic decline of nations. Becker (1983) emphasizes that as the
number of interest groups increases, it is more likely that their ensuing
competition will neutralize demands for special privileges. In the latter view, rent
seeking is not necessarily associated with economic decline. Buchanan and
Congleton (1998) discuss whether it is possible to reduce the extent of
discriminatory privileges (which are consequences of rent seeking) utilizing
adequate institutional (in this case constitutional) structures. Their answer boils
down to the principles of the rule of law. The more general a rule, the lower the
potential for it to be abused for rent seeking.

4.2.3 Example 2: Political Business Cycles

Economists believe that one of the principal functions of government is the
stabilization of business cycles. Some economists, however, question whether
governments are ever able to stabilize business cycles, even when they are
assumed to be benevolent. Rather than argue this point, we continue to
investigate the incentives of political agents. This investigation leads to a
surprising result: Rational politicians cause business cycles. Thus, politicians
might not be the solution, but rather the cause of the problem.

Politicians are part of the problem

Let us assume that the probability of a government’s re-election depends

decisively on the level of unemployment shortly before the elections. Further, we
assume that fiscal measures can lower unemployment in the short run, while
leading to inflation in the long run. High inflation rates, however, are viewed
very critically by the electorate, lowering the chances of re-election. Given these
assumptions, a rational government has an incentive to use fiscal measures such
that the decrease in unemployment (which increases the chance of re-election)
occurs just before elections, while the increase in inflation (which decreases the
chance of re-election) optimally occurs only after elections. One final
assumption is required in order to produce such political business cycles,
namely that the electorate places a higher value on utility gained today than on
utility gained tomorrow. Put differently, with regard to the outcome of today’s
election, current political success of the government is more important than
failures of the past.
Different models of political business cycles have been tested and
confirmed empirically again and again for various countries (Mueller, 2003,
430–436, provides an overview of the empirical research). Institutional
economists are interested in whether the observed differences in the extent of
political business cycles can be explained via the constraints institutions place on
politicians. For instance, whether the use of short-term fiscal measures is more
limited in some countries than in others. Or whether the degree to which central
banks in different countries are free of political influences plays a role in
moderating political business cycles. And yes, under certain circumstances,
institutionalized constraints on budget deficits can limit the size of political
budget cycles. One such example is a constitution with explicitly spells out
budget limits. But even with clear constitutional constraints, highly transparent
processes for the creation and implementation of the budget are necessary to
guarantee that the constraints are honored.

4.2.4 The Dilemma of the Strong State

In Chapters 2 and 3, we looked at ways in which individuals might secure
transactions that are beneficial. We saw that external institutions can play a
crucial role in this. For example, contracts can be structured allowing for
recourse to external institutions or the visible hand of the state. In this chapter,
we are dealing with the incentives that representatives of the state encounter.
Think of the state as a unitary actor (for instance a dictator who represents all
functions of the state). Further, think of a private citizen who considers entering
into a voluntary transaction in which the state is a contracting party. There are
many examples of this. For instance, when a private citizen works for the state,
when a private company supplies the state with goods such as tables or chairs for
a ministry, or when citizens lend money to the state. Now suppose that the
private citizen on the one hand and the state on the other interpret their contract
differently and the private citizen would like to seek redress in front of a state
court, i.e., rely on external institutions. There, he will encounter the state in two
functions: not only as the defendant against whom the private citizen is airing a
grievance, but also as the judge who will provide the ultimate decision. Using a
sports metaphor, we can formulate the problem thus: The state faces the problem
of being both player and referee at the same time. Given this situation, few
private actors will be willing to participate in a transaction with the state.

Problem: The state is a player as well as the referee

In market economies, one function of the state is to protect private property

rights and voluntary transfers thereof. Effective protection requires a strong
state. However, as illustrated above, the strength required to protect private
property rights can also be a significant problem. As Weingast (1993) suggests, a
strong state has the discretion to disregard private property rights entirely. We
are faced with this dilemma: On the one hand, a strong state is required for a
market economy to function well; on the other hand, a strong state can impede
the economic development of a market economy. We propose to call this the
dilemma of the strong state. If representatives of the state are able to credibly
promise to respect private property in the future, private actors are likely to
invest more and thus contribute to higher economic growth. Governments and
representatives of the state can expect higher tax revenues and lower interest
rates, allowing for a greater scope of action and easier access to financing for
their expenditures. This problem is similar to the problem of moral hazard we
discussed in Chapter 3. Here, the citizens are the principal and state
representatives are their agents. After having entered into the (social) contract,
the agents might choose actions that exert significant negative externalities on
their citizens (the principal).

Rational governments want to be able to credibly commit …

Governments could, of course, promise to respect private property in the

future in order to induce more private investment. Then, as soon as those
investments are made, representatives of the state can attempt to nationalize
them or attenuate their value. Private actors know that the government has an
incentive to make promises ex ante but renege on them ex post. Acting on this
knowledge, rational private actors will, thus, refrain from private investment.
In order for a government to induce private actors to invest in the market, it
must be able to convince private actors that it will not renege on its promises.
Private actors may resort to several self-binding mechanisms, described by
Schelling (1960), to convince others that they will keep their promises. Many of
these self-binding mechanisms require the presence of an independent third party
to sanction breach of contract. The ability of the state to self-bind, however, is
limited. If representatives of the state attempt to tie their own hands, there is
rarely a third party available to sanction breach of contract.

… but have a hard time making credible promises

The concept of functional separation of powers suggested by

Montesquieu is an attempt to mitigate the dilemma of the strong state. Laws
passed by representatives of the state (the legislators) are more credible if they
are implemented by a separate office (the executive) and if a third office (the
judiciary) decides how these laws conform to existing contracts (the state’s
constitution). We can infer that representatives of the state who accept a
separation of powers recognize that a voluntary and credible limitation of their
competencies can, indeed, strengthen their position. This is an “as if
explanation” of the functional separation of powers. It does not claim to
correctly describe historical developments, because, in reality, the separation of
powers has often been the result of intense struggle rather than the action of
enlightened rulers. Federalist structures are sometimes referred to as vertical
separation of powers. These structures can also help to mitigate the dilemma of
the strong state as they guarantee a minimum amount of autonomy to the
constituting states.

Separation of powers as one possibility to increase the credibility of

promises

One means to mitigate the dilemma of the strong state

The traditional idea of the separation of powers implies separating the

functions of legislating, executing, and judicial decision-making from
each other. If legislators promise potential investors (by way of general
legislation) that their investments are safe and that they can set prices at
their will, can freely transfer profits, will not be taxed very highly, and so
on, this may sound attractive to potential investors. Still, they will
wonder if such promises are credible. And if they do not believe them to
be credible, they will not invest. If, however, there is a judiciary that is
 independent from the legislature (and the executive), an investor who
feels that her property rights have been infringed can turn to the judiciary
and have it decide whether government has kept its promises.
A judiciary that is actually independent from government is thus
one way to mitigate the dilemma of the strong state. If a country
manages to establish an independent judiciary, it is expected to attract
more investment and experience faster growth. This is, indeed, the case
as shown by Feld and Voigt (2003) and more recently by Voigt et al.
(2015).

We have just described a potentially inverse relationship between the

powers that politicians have at their disposal and their resulting level of utility.
This insight can also be applied to monetary policy. If, for example, the
government is endowed with monetary policy competencies, it has an incentive
to promise price stability, in order to induce moderate (nominal) wage increase
demands by trade unions. After the conclusion of collective agreements,
however, the government has an incentive to expand money supply, in order to
lower the (real) cost of labor and increase employment rates. As trade unions
will rationally anticipate this, their expectations that inflation will increase in
future will already be accounted for in the negotiated collective agreement
(inflationary bias). High inflation increases everyone’s costs as relative prices
are likely to be affected and consumers will incur costs simply to ascertain the
current prices of goods they are interested in. Thus, monetary policy under such
an institutional frame causes social costs (in the form of increased inflation),
while not being able to induce any social benefit (Kydland and Prescott, 1977;
Barro and Gordon, 1983). Even a utility maximizing government could be
interested in solving its time-inconsistency problem by transferring monetary
competencies to an independent central bank. Given this, it appears that all
members of society – including politicians – would favor the foundation of an
independent central bank whose sole mandate is to maintain price stability. And
indeed, over the last couple of decades more and more central banks have
become independent, at least on paper.

Independent organizations as another mechanism to mitigate the

dilemma

Definition

A decision-maker is subject to time-inconsistent preferences when she

prefers one policy in advance but a different policy when the time to
implement has come. In the example, government has time-inconsistent
preferences because it has incentives to announce a tight monetary policy
ex ante but once the time to implement has come, it has incentives to
implement an expansionary policy.

We have mentioned two instruments that representatives of the state might use in
order to reduce the problem of self-binding:

1. Traditional functional separation of powers.

2. Delegation of competencies, which is also a separation of powers in a

broader sense.

A third, related, possibility is to submit to the rules of international

organizations. If the rules of an international organization are endowed with a
sanction, we call them “international institutions” here. An example of such
institutions is the World Trade Organization (WTO) rule stating that tariffs
cannot be increased unilaterally – except in specific circumstances. If a
government breaches its commitment to comply with the rules of the WTO, the
country aggrieved by this behavior can initiate highly formalized proceedings
against the noncomplying government. The Dispute Settlement Body of the
WTO is an international body comparable to a state court in the national setting.
It has proven to be a well-functioning body.

Membership in international organizations as third possibility

A nice illustration of the dilemma of the strong state is offered by Levy and
Spiller (1994) using the privatization of telecommunication networks as their
point of reference. Politicians (particularly in less developed countries) have an
incentive to attract foreign investors to their country. As soon as foreign
investors have created the networks, however, domestic politicians have strong
incentives to expropriate them. Anticipating this, many foreign investors are
unwilling to participate in attractive investment opportunities unless
governments are able to demonstrate their promises are credible. All involved
actors (government, investors, and the population) are better off when
governments are able to commit credibly. Levy and Spiller show that optimal
regulation depends on (exogenously given) institutions. In their analysis, they
explicitly account for informal restrictions (internal institutions in our
terminology). They suggest that governments that are not able to demonstrate a
credible commitment fall back on international organizations as funding sources
(such as the World Bank). Another possible scenario is to privatize networks so
that the shareholders come from a broad spectrum of the domestic population. In
this scenario, a government trying to expropriate the rightful owners would
expect heavy domestic opposition, making expropriation a very costly option.
Drawing on a particularly interesting case, Voigt et al. (2007) analyze
whether membership in international organizations can indeed be beneficial for a
country. After attaining independence, several of the former British colonies
continued to accept the Judicial Committee of the Privy Council in London as
their highest court of appeal, while others switched fully to a judiciary of their
own. Even after controlling for miscellaneous differences (for instance,
geographical or ideological distance to Great Britain), those countries that kept
the Judicial Committee as their highest court of appeal have attracted more
foreign investment, have paid lower interest rates on their sovereign bonds, and
are characterized by higher economic growth. More recently, Dreher et al.
(2015) have shown that governments are able to “buy” credibility by joining
international organizations. They find that the theoretical conjecture of Levy and
Spiller (1994) can be confirmed and that governments that voluntarily have their
discretion curbed by membership in multiple international organizations attract
more foreign direct investment. There is, thus, some evidence that the credibility
problem of governments can be alleviated not only by domestic institutions, but
also by international institutions that are administered within the realm of
international organizations.

4.3 Explaining Collective Action Using

Internal Institutions
4.3.1 From Non-Repeated to Repeated Games
We referred to the prisoner’s dilemma game to illustrate the problems associated
with the provision of public goods and the possibilities of collective action. The
only Nash equilibrium of this dilemma we have encountered is (D, D). Our
conclusion is that the voluntary provision of public goods is not individually
rational and that the existence of a state, which provides public goods, can make
every individual better off. We then demonstrated that the variance in political
behavior with respect to the provision of public goods is due to varying
institutional constraints, assuming the institutional constraints (i.e., the
constitution) to be exogenously given.
For ease of exposition, however, we intentionally oversimplified the
argument and confined it to non-repeated games. But in the real world, many
relevant interactions do occur repeatedly. Once we allow for the game to be
repeated, an entire universe of additional equilibria beyond (D, D) or (2, 2)
becomes feasible (the so-called Folk theorem1). In Figure 4.1, the gray area
depicts all possible equilibrium payoff combinations of a repeated prisoner’s
dilemma. The figure also shows that the strategy combination (C, C) is a
possible equilibrium, albeit only one of many. What we need now is some type
of mechanism that helps us predict what equilibrium is likely to be selected.
Game theorists have been working on this for a long time. However, it seems fair
to say that until now, they have been rather unsuccessful in spelling out
mechanisms that would help people to bring about any specific equilibrium.
Here, we refrain from surveying that literature in any detail and instead focus on
the possibility that internal institutions might affect the ultimately realized
equilibrium.
 Figure 4.1 A graphic depiction of the prisoner’s dilemma
The payoff for player 1 is on the horizontal axis, the payoff for player 2 on the
vertical axis. The corner points of the gray area represent the possible payoff
combinations that you remember from the non-repeated game. In the iterated
game, other (average) payoff combinations within the gray area are possible
too. A player who defects in each round can secure at least two payoff units.
Thus, payoffs below that are not part of the equilibrium area. The areas below
the dashed lines and to the left therefore do not belong to the area of possible
equilibria.

When considering the provision of public goods, the existence of equilibria

to the northeast of (D, D) implies that provision of public goods without recourse
to the state might be possible. Internal institutions might be one key explanation
for this outcome. There is a host of real-world examples in which voluntary
provision of public goods occurs. For example, when citizens voluntarily serve
as jury members or lay assessors, or join the fire-fighters or any other non-
governmental organization providing public goods. Even when people contribute
to Wikipedia either by writing contributions or by donating money, a public
good is provided that can be used by anyone. We first present some of the
laboratory evidence concerning the voluntary provision of public goods and then
discuss several internal institutions that might facilitate voluntary provision.

4.3.2 Evidence from the Laboratory

Based on the framework of game theory, we can conjecture that rational actors
will not voluntarily provide public goods in a non-repeated prisoner’s dilemma,
thus contributing zero. Results from experiments refute this conjecture. Even in
non-repeated games, participants contribute an amount significantly larger than
zero. There is ample evidence from so-called linear public goods experiments.
In these games, all participants are given an equal amount of resources, usually
in the form of tokens. They then must decide whether or not to contribute (and,
if so, how much) to the provision of a collective good. Tokens put into the
common pot multiply by a factor larger than one. The common pot can be
thought of as the public good. Consequently, the pot is divided among all
participants of the game no matter how much they contributed. The group’s total
payoff will be maximized if all players put all of their tokens into the common
pot.

A numerical example of the public goods game

Here is a numerical example of the public goods game: Suppose each

member of a group of five is given $10 at the beginning of the game.
Each member now decides how much of the money to keep (privately)
and how much to transfer into a public account. At the end of the game,
each participant receives the sum of what is in the public account (it is
supposed to mimic a public good, thus nobody can be excluded from its
consumption, even those who did not participate in its provision). The
 “investments” transferred into the public good are, however, multiplied
by a coefficient of, say, 0.4 before being paid out.
With these numbers, the sum of individual payoffs would be
maximized if each participant transferred the entire $10 into the public
account. In that case, $50 would end up there. After multiplication by
0.4, each participant would receive $20, i.e., twice the original
endowment. If all five participants chose to invest their entire
endowment, the sum of all payoffs would, thus, amount to $100.
However, if I kept the $10 for myself and all of the other participants
transfer their original endowment into the public account, I would still be
better off. In that case, I would receive 10 + 0.4(40) = 26. All others
would then receive only $16 and the sum total would be $90. If
everybody tries to free-ride on the others, then no money would end up
in the public account and no public good would be provided at all.

However, contributing is not individually rational. Instead, a rational individual

will contribute zero. Again, we are confronted with a situation in which
individually rational behavior leads to collectively suboptimal results. This game
has been played hundreds of times in laboratories all over the world. The most
noteworthy outcome is that – contrary to theoretical predictions – many players
do contribute significant parts of their original endowment.

Individually rational behavior leads to socially suboptimal results in

public goods games

While Davis and Holt (1993), Ledyard (1995), and Chaudhuri (2011)
present more comprehensive overviews, Ostrom (2000) offers a seven-point
summary of the results found in the laboratory:

1. In non-repeated games, participants contribute between 40 percent and

60 percent of their initial endowment for the provision of the collective
good. This also holds for the first round of finitely repeated games.2

2. In the rounds following the first, the contributions decrease, but still
remain clearly above the predicted zero percent.

3. Participants who expect other participants to contribute will likewise

contribute with greater than average probability.

4. The amount a player contributes decreases with a falling rate the more
often the game is played. Ostrom concludes from this that players who have
gained a better understanding of the game cooperate more, not less, as was
commonly believed for a long time.

5. Allowing direct communication between players increases the

contribution rate in all rounds of the game. Thus, non-binding
commitments, commonly referred to as cheap talk, might not be so “cheap”
after all.

6. If allowed, players are willing to use some of their own resources in

order to sanction other players who contribute less than average.

7. The contribution rate also depends on contextual factors. These include,

for instance, the way in which the game is described (i.e., “framing”).

A standard criticism of laboratory results is that they stem from the laboratory,
not from real-world interactions. The external validity of laboratory results
would, therefore, be questionable. Despite possible challenges to laboratory
results, the sheer amount of evidence is impressive. What is of interest to us is an
examination of the role played by internal institutions in producing these results.
 For a clearer overview, let us return to the table we introduced in Chapter 1,
expanding it with relevant examples (Table 4.1).

Limitations of laboratory results

Table 4.1 Internal institutions and individual contribution to collective action

Type of
Rule Form of enforcement institution Example

1. Convention Self-enforcement Internal type Traffic rules

1

2. Ethical rule Self-commitment Internal type Fairness norms,

2 Justice norms,
Secondary virtues

3. Custom Spontaneous informal Internal type Norms of

societal enforcement 3 reciprocity, norms
of solidarity

4. Formal Organized private Internal type Churches

private rule enforcement 4

Conventions are institutions. A convention is the stable equilibrium of a

game with two or more stable equilibria (in the traffic example introduced in
Chapter 1, two in pure strategies, namely everyone steers left, everyone steers
right, and one in a mixed strategy like drive on the left with probability one
half). The non-repeated prisoner’s dilemma, however, has only one stable
equilibrium, (D, D). In the repeated prisoner’s dilemma, (C, C) is also a possible
equilibrium. Political scientist Robert Axelrod (1984) showed that there is one
strategy which trumps all other strategies, both on average and over time. That
strategy is called tit-for-tat. It is a very simple strategy: One cooperates in the
first round, but in all subsequent rounds, one mirrors the other player’s strategy
of the respective previous round. As long as the other player cooperates, (C, C)
results. A criticism expressed by some game theorists is that accidental defection
(or cooperation that is mistaken for defection) leads to an infinite sequence of
non-cooperative strategy combinations. They propose strategies with a higher
tolerance threshold, for instance defection might only be chosen after two
defections in a row.

Tit-for-tat as a particular strategy to play the prisoner’s dilemma

Axelrod shows that there are certain conditions that facilitate the viability
of tit-for-tat as a strategy. These include: (1) a low preference for the present (a
high preference would imply that payoffs in this round might be valued higher
than the loss in payoffs in future rounds) and, (2) the probability of meeting
again with the same player, which for its part should be negatively correlated
with group size. It is the latter factor that makes it questionable whether tit-for-
tat realistically qualifies as a viable convention for an n-person prisoner’s
dilemma. It is only when the relevant group is sufficiently small, or there is some
“natural” division into smaller groups, that the strategy described by Axelrod is
viable. The tit-for-tat strategy has little relevance for us, because here we are
interested in solutions for very large groups.

Requirements for tit-for-tat to work

 When examining how large groups provide public goods, it is much easier
to develop arguments from the perspective of ethical rules. For instance, if
certain justice or fairness norms have been part of an individual’s upbringing,
one could well imagine that individual utility is reduced by not contributing a
“fair” or “just” amount to the public good. If members of a social group can ex
ante promise each other to contribute a certain amount to the public good, there
is even more scope for ethical rules to apply, for instance the rule to stick to
one’s promises. Such rules are often referred to as secondary virtues.

Relevance of ethical rules

Customs enforced by third parties

Customs, the noncompliance of which is sanctioned by third parties, are

particularly relevant in our context. Contributing less than what is commonly
perceived as fair or less than was promised, could be sanctioned by ostracism, or
public airing, leading to loss of reputation. In general, the very sanctioning of
non-cooperative behavior carries associated costs. Let us assume there is a norm
of cooperation that benefits all members of a social group. This implies that all
members of that social group have an interest in upholding that norm and
protecting its continued existence. If sanctioning is associated with costs, all
group members are interested in not only sanctioning rule breakers, but also in
letting other group members carry out the sanction. In other words: The act of
sanctioning is in itself a collective good, the provision of which is not
guaranteed. Guaranteeing the provision of adequate sanctions is more likely, the
more precisely the task of sanctioning is allocated to certain group members.
Many experiments have been conducted to analyze the conditions under which
participants are willing to incur costs to punish those who do not contribute what
is perceived as their fair share for the provision of the public good.

Free-rider problem

Definition

Ostracism as practiced in ancient Athens is the practice of excluding

someone from the group. In Athens, it was often used to expel people
who were considered potential tyrants. To this day, ostracism is practiced
by many groups.

Perverse punishment

Many experiments have shown that people are willing to punish free-
riders, i.e., those who do not pay their share for the provision of a public
good (Chaudhuri, 2011 gives a nice overview). But the story does not
end there. Benedikt Herrmann, Christian Thöni, and Simon Gächter
(2008) conducted a fascinating experiment in 15 very different locations
ranging from Boston and Melbourne to Samara, Riyadh, and Muscat.
These locations were chosen to find out whether cultural differences had
a significant impact on how the game was played. The surprising finding
of this experiment was that high contributors were frequently punished.
How can we make sense of this seemingly perverse punishment? It is
possible that this punishment directed at the high contributors is simply
 an act of retaliation, because the punishers suspect the high contributors
are the ones who previously punished them (the game was repeated ten
times). Herrmann et al. term this behavior “antisocial punishment.”
Consequently, societies that punish the pro-social behavior of those who
contribute a lot to the provision of public goods are expected to have
substantial difficulties in providing public goods. Interestingly, the
lowest amount of antisocial behavior was recorded in Boston and
Melbourne, whereas the most was found in Samara (Russia), Riyadh
(Saudi Arabia), Athens (Greece), and Muscat (Oman).

Finally, one could also argue that sanctions administered by private

organizations might be relevant. Let us interpret the voluntary donations of
members of a religious group as contributions to the provision of a collective
good. There might be a rule that a certain percentage (e.g., the tithe in
Christianity or the zakat in Islam) of one’s income should be donated to the
religious group. Sanctions for noncompliance with that rule could range from
simple informal reminders by representatives of the religious group to meet the
required contribution, to more formal sanctions that might include expulsion
from the group.

Formal sanctions by private organizations

4.4 The Interplay between External and

Internal Institutions and its Relevance for
Collective Action
In a previously mentioned essay, Elinor Ostrom (2000, 147) writes this
concerning the interplay between external and internal institutions:

The worst of all worlds may be one where external authorities

impose rules but are only able to achieve weak monitoring and
sanctioning. In a world of strong external monitoring and
sanctioning, cooperation is enforced without any need for internal
norms to develop. In a world of no external rules or monitoring,
norms can evolve to support cooperation. But in an in-between case,
the mild degree of external monitoring discourages the formation of
social norms, while also making it attractive for some players to
deceive and defect and take the relatively low risk of being caught.

Certainly, this is a very striking conclusion. So let us spend some time to see
how Ostrom arrived at it.
Common pool resources and public goods share the characteristic of non-
excludability. Common pool resources differ from public goods in that their
consumption is rival in the sense that one unit consumed by a particular member
of the community cannot be consumed by anybody else. If no clear rules
regarding the use of the goods exist, the threat of depletion looms large. Here is
an example: Assume a lake with many fish. It is individually rational for every
fisherman to fish as long as his personal benefits from an additional catch are at
least as large as his personal costs. Usually, this implies overfishing, and fishing
would soon come to depletion if no institutions regulating fishing are established
and enforced. This problem was described by Garrett Hardin (1968) as the
tragedy of the commons. Besides the lake just used as an example, there are
many other common pools in the world; the oceans, the woods, meadows,
(clean) air, and so on.

To prevent the depletion of common pool resources, institutions are

necessary

Quite often, state ownership has been recommended as a solution. In fact,

considerable amounts of development aid have been paid to governments of
developing countries to develop and manage their common pools, e.g., water
systems on which farmers depend. Alternatively, private ownership with
property rights enforced by the state has been recommended. Ostrom (1990, 14)
points out that these recommendations share a common assumption that some
external institutions must be imposed from above on the individuals affected.
Ostrom begs to differ. She points out that those directly affected – such as
herders using a particular meadow year after year – might have the most
accurate information regarding “their” common pool. Out of self-interest, they
might also have the strongest incentives to monitor the compliance with any
rules regarding the use of the common pool.
There are, in fact, examples of small-scale communities that have
successfully managed their common pool resources over hundreds of years.
Examples that Ostrom mentions refer to communal tenure in high mountain
meadows and forests in Switzerland and Japan, and to irrigation systems in
Spain and the Philippines. But there are also many – probably more – examples
in which the communities have not been able to deal with their commons
properly. Ostrom sets out to identify the factors that help communities to be
successful in dealing with their common pool resources. She suspects that the
capacity to communicate within the group and the ability to develop trust are
important aspects helping groups in successfully managing their own commons.
In her comparative analysis of many communities, she utilizes the framework of
the comparative institutional analysis we introduced in Chapter 1.
The commitment problem discussed at length above also plays a central
role here: At the time the rules are agreed upon, every user will promise only to
take so much water out of the canal but when his or her harvest is in danger at
some later time, the incentive not to behave as promised is present. Ostrom
argues that commitment is never credible without monitoring. She suggests a
commitment can be credible only if there is some systematic monitoring of how
much water every farmer takes out of the canal. In her field studies, Ostrom was
particularly interested in learning how communities deal with the commitment
and monitoring problem. In Governing the Commons, she produced a list of
seven design principles that characterize all institutions that helped their
communities manage their common pool resources successfully (1990, 90ff.).
There needs to be:

1. Clearly defined limits regarding the right to withdraw resource units from
the common pool resource; this refers to the precision regarding the rule
part of institutions as defined in this book.

2. Congruence between rules defining how much a user can take out of the
common pool (so-called appropriation rules) and how much the user is
obliged to put in (for monitoring, cleaning, repairing, and so on; so-called
provision rules).

3. Ways to modify the collective-choice arrangements. To increase the

probability of compliance, it is important that most individuals affected by
operational rules can participate in their modification if necessary.
 4. Accountability of the monitors to the appropriators; one straightforward
way to set up monitoring is to have appropriators do it.

5. Graduated sanctions, implying that during times of severe crises

tolerance for rule infractions might be higher than in normal times.

6. Conflict-resolution mechanisms to resolve conflicts on the exact

interpretation of the valid rules.

7. Minimal recognition of the right to organize. This brings us back directly

to the issue of the relationship between external and internal institutions: if
governmental officials insist on their monopoly to define rules, enforcement
by locals might be impossible.

Design principles for the successful management of common pool

resources

Numerous lessons can be drawn from Ostrom’s observations. Perhaps most

important, ownership or management of common pool resources should not be
reduced to either state or private ownership but communal ownership as
extensively described by Ostrom should be considered as a possible alternative.
Societies that rely primarily on internal institutions for the management of
common pool resources are better able to recognize and utilize the existing local
knowledge about these resources.
Of course, reliance on internal institutions will only work if government
does not insist on monopolizing the creation and enforcement of institutions. In
other words, when there is no conflict between external and internal institutions.
Why is this so important? It is not only important to explain why some
traditional societies have been successful in dealing with their commons while
other traditional societies have not. It is also important because global climate
can be thought of as a common pool resource with literally billions of
appropriators and – at least potentially – billions of providers. How much the
world climate will change depends on how much CO2 and other greenhouse
gases are emitted into the atmosphere as a consequence of billions of individual
choices. Scientists from two Max Planck Institutes in Germany asked whether
there are ways to encourage contributions to the global public goods and
developed a game that added a number of unusual features to the standard game
already described above (Milinski et al., 2006). The unusual feature of interest
here is the possibility to contribute to the common good – climate protection –
publicly. Public-mindedness can, thus, be observed. This, in turn, enables others
to reward those who have been behaving public-mindedly and, at the end of the
day, such behavior may even turn out to be personally profitable. The authors
conclude by stressing the hope that we might be able to design strategies to
improve reputational gains from behaving public-mindedly as an important
device to reduce climate change.
Ostrom’s observations, analyses, and conclusions offer us one way to think
about these things. Bruno Frey (1997) has also dealt with the relationship
between external and internal institutions. He builds on David Hume’s
statement: “In contriving any system of government, and fixing the several
checks and controls of the constitution, each man ought to be supposed a knave,
and to have no other end, in all his actions, than private interest” (Hume, 1987
[1777], 42). Frey argues that the apparently required strong distrust between
principal and agent can lead to a crowding out of intrinsic motivation. The term
crowding out is more commonly used with respect to governmental borrowing:
A credit-financed expansion of governmental demand can lead to a higher
interest rate and thus a crowding out of private demand. Frey, however, uses the
term to emphasize that an expansion of governmental control might crowd out
the private willingness to contribute to public goods, for instance, to voluntarily
pay taxes.
If we use the vernacular of principal–agent theory, we notice some
interesting asymmetries. Politicians can be agents as well as principals (this is
valid for citizens too). Politicians are principals when facing citizens who are
supposed to pay taxes. Politicians cannot readily observe before-tax income of
citizens, causing an information asymmetry. Politicians are agents when they are
providing the bundle of public goods desired by citizens. But here again an
information asymmetry exists because citizens cannot readily observe whether
politicians are taking adequate action in order to provide the public goods. In
another possible scenario, if politicians do not trust citizens to pay taxes and
express this distrust by hiring additional tax collectors, some citizens who are
intrinsically motivated to pay taxes (“There is a price to good infrastructure; it is
only fair that I contribute my share to its financing.”), might decide to evade
taxes.

Politicians as principals …

… and as agents.

Frey argues that crowding out might also work conversely. If citizens
express their distrust by an overly detailed constitution with very precise
restrictions, a decrease in the intrinsic motivation in politicians might be the
consequence. The general conclusion is clear: There are interdependencies
between external and internal institutions. If these interdependencies are not
sufficiently accounted for in the design of external institutions, even a well-
intended change in external institutions can induce unintended changes in
internal institutions, leading to a possible net loss in social welfare.

4.5 Open Questions

While reading Sections 4.3 and 4.4, you might have noticed that our ability to
explain the impact of internal institutions on collective action is limited. It is also
difficult to describe the interdependencies between external and internal
institutions. We are better able, however, to describe the impact of external
institutions on collective action. There are many reasons for this status quo. One
reason is our inability to be specific with terms. For example, “public good” can
describe a variety of goods; “collective action” can refer to a variety of actions.
Future research should be very clear and explicit about this.
Evidence from behavioral economics suggests that there is a significant
difference between decisions concerning the controlled use of a public good that
already exists (such as meadows, fishing stocks, forests), and a collective good
that must first be created (such as dikes) through the contributions of group
members (Brewer and Kramer, 1986). A reduced usage of common pool
resources is often seen as social loss, the utility gained by providing a public
good as social gain. One key result of behavioral economics is that utility
reductions induced by loss are valued higher than utility increases induced by
gains. This could imply that it is easier to manage a reduction in the usage of a
common pool resource than ensuring the provision of a (yet non-existent)
collective good.
So far, we have assumed that a constitution is exogenously given and de
facto enforced. As we can observe in many parts of the world, this assumption is
rather naïve. One can thus ask what determines whether or not constitutional
rules are actually enforced. A possible answer might be that it is not only the
design of external institutions that matters (remember the separation of powers),
but also internal institutions. A rational government will only break
constitutional rules if it expects to gain from it. If government members expect
broad opposition to such rule breaking, they might refrain from it altogether. The
provision of opposition is equivalent to the spontaneous provision of a public
good: If it is effective, all citizens benefit from it. However, contributing to the
provision of opposition is associated with costs. Thus, the spontaneous
production of the public good opposition seems more likely if there are
appropriate internal institutions. In addition, if such internal institutions are in
place, the chance that the de facto constitution is in line with the de jure
constitution is higher than if they are not (a more detailed discussion can be
found in Voigt, 1999a). In Chapter 6, we address this matter again.

Questions

1. In Section 4.2.1, we formulate a number of questions that public choice

scholars are concerned with. Think about possible answers. Hints on the answers
are provided in the Further Reading section.

2. Describe the dilemma of the strong state and discuss institutional

arrangements that might be able to mitigate it.

3. Think of additional examples of the voluntary provision of public goods and

discuss which internal institutions might be relevant in enabling their voluntary
provision.
4. Think of additional examples for a crowding out of intrinsic motivation of (a)
politicians and (b) citizens due to a very strictly formulated principal–agent
contract.

6. Why will private firms underprovide public goods?

7. Which factors make cooperative outcomes in public good games more likely?

Further Reading
A number of decision rules and their effects are dealt with in chapters 7 and 8 of
Mueller (2003).
It has been argued by Maurice Duverger (1954) that electoral systems
relying on majority rule (often also called first-past-the-post) lead to two-party
systems whereas those relying on proportional representation lead to multiple
party systems. Since the evidence on this argument is very strong, this
relationship is also known as Duverger’s Law. Mueller (2003, 271–276)
summarizes the empirical evidence.
Coalitions are often formed quite trivially to reach parliamentary majorities.
It is said that as soon as the necessary parliamentary votes are reached in a
coalition, additional parties are unlikely to be admitted to the coalition because
the members of the coalition would then have to share the spoils of governing
with more parties. This notion is called minimum-winning coalition. But the
idea that any combination of parties, no how matter how far apart ideologically,
could form a coalition seems unrealistic. A modified version has been called
minimum-connected-winning coalition. It is based on the idea that
ideologically neighboring parties are more likely to enter into coalition
agreements. Somewhat counterintuitively, coalitions with sizable majorities
seem less stable than those securing a bare parliamentary majority (Mueller
2003, 281–284).
The economics of federalism is an important branch within public choice.
One of the eminent scholars of federalism within public choice, William Riker,
wrote this (1975: 155): “Nothing happens in a federation because of the federal
constitutional arrangements that could not happen otherwise in fundamentally
the same way.” While some scholars doubt that being constituted as a federation
– rather than as a unitary state – has important consequences, there is lots of
evidence that this does matter. Weingast (2014) is a recent survey of the relevant
literature.
Direct democratic institutions can make the agents – the politicians – more
accountable to their principals – the citizens – because direct democratic
institutions allow the citizens to express their preferences on single issues and
politicians do not like to be corrected by their citizens. This is why direct
democracy increases politicians’ incentives to listen to citizens. Matsusaka
(2005) is a good survey of the literature. Blume et al. (2009) is the first cross-
country study inquiring into various effects of direct democracy institutions.
William Niskanen (1971) was one of the first to analyze the behavior of
bureaucrats from a public choice perspective. Although his model is highly
stylized and many assumptions have been criticized, it is still very readable. The
subsequent discussion is neatly summarized in Mueller (2003, chapter 16).
The literature on rent seeking has turned into a veritable cottage industry. A
two-volume set, edited by Roger Congleton, Arye Hillman, and Kai Konrad
(2008), contains the most important contributions to this field over a 40-year
period. In a recent contribution, Toke Aidt (2016) deals with the commonalities
and differences between rent seeking and corruption. Mueller (2003, chapter 15)
summarizes the literature on rent seeking.
More on the application of principal–agent theory to the relationship
between citizens and governments can be found in Moe (1990).
The argument that a strong distrust between citizens and politicians might
lead to a crowding out of intrinsic motivation is at the core of a monograph by
Brennan and Hamlin (2000).
Ostrom (1990) deals in detail with mechanisms that social groups utilize in
order to secure the use of common pool resources or provide new public goods.
She was awarded the Nobel Prize in 2009 “for her analysis of economic
governance, especially the commons.” Her prize lecture (2010) nicely
summarizes her thinking about how to govern the commons.
Voigt et al. (2015) show that higher levels of de facto judicial independence
are robustly correlated with higher levels of economic growth.
Hayo and Voigt (2008) connect two of the topics of this chapter, namely the
separation of powers and central bank independence. They show that higher
levels of de facto independence of the judiciary from the other government
branches are associated with lower inflation levels.

1The name stems from the fact that this result used to be commonly known
among game theorists. Fudenberg and Maskin (1986) derived it formally.

2 In theory, finitely repeated games should lead to the same results as non-
repeated games: In the ex ante known last round, the repeated game is
equivalent to the non-repeated game. We would thus expect (D, D) in that
round. By extension, the same should hold for the second to last round, and so
on. In game theory, this approach is called backward induction. It is not
without critique (Elster, 1989a, 4–8, provides a concise summary; Kreps et al.,
1982 show that cooperation can be rational even in the finitely repeated
prisoner’s dilemma).
 5
The Relevance of Institutions for
Growth and Development
◈

5.1 Introductory Remarks

In Chapters 2, 3, and 4, we discussed the consequences of institutions for
individual action. We considered simple and complex transactions, the
interrelationships between different types of institutions, and the incentives to act
as part of a social group. In this chapter, we look at the consequences of these
individual-level actions for the macro level. More specifically, we are asking
what the consequences of institutions are for aggregate measures such as
economic growth. At the most basic level, we have one conjecture: The cheaper
it is to carry out mutually beneficial transactions, the more frequently such
transactions will be carried out, the faster a society’s economy will grow, and
the higher the resulting income and welfare level of society will be.
You might think that economists are obsessed with growth. Or you might
think that they are boring because in the end, their discussions always revolve
around a single topic, growth. I would prefer to call the concern with growth a
clear priority rather than an obsession. Why? Depending on how one counts,
there are at least one billion people on the planet suffering from poverty. This
has terrible implications: insufficient nutrition, inadequate shelter, poor health,
lack of education, and so on. The only way to improve the lot of the poor, and
for that of most people as well, is economic growth. Economic growth implies
that more goods and services are produced and can, hence, also be consumed.

Definition

Economic growth: The gross domestic product (GDP) measures the

value of all goods and services produced in one country over a certain
period of time (usually one year). Economic growth is the increase of
GDP from one period to the next. It is usually measured on a per capita
base and thus indicates the change in average individual income between
two periods. Current income can be thought of as growth that
accumulates over a long period of time.

Now, you might wonder why redistributing wealth from the (few) rich to the
(many) poor is not a solution? The simple answer is incentives. The rich whose
income is reduced by transferring it to the poor have fewer incentives to keep on
producing as much in the future. The poor, who can consume a little more as a
consequence of receiving transfers, have fewer incentives to increase their own
efforts to get out of poverty. So, at the end of the day, everyone might be worse
off. On top of this, administering a global redistribution scheme would eat up an
enormous amount of resources. Taking money from the rich will be met by some
resistance and will, therefore, be costly. For administering large welfare
programs, many bureaucrats are needed. In sum: Redistribution has negative
incentive effects for both the rich and the poor and its implementation will eat up
a substantial part of the resources.
 You might know that traditional growth economics explains growth rates
based on input factors, particularly labor and capital.

Note

Growth economists attempt to identify the determinants of growth in per

capita income.

The so-called new or endogenous growth theory further accounts for the fact
that the factor labor is neither homogeneous nor exogenously given. In other
words, people have different skills and can invest in their skills by attending
university or following training programs. Institutions, as we understand them,
are not considered in endogenous growth theory. If the basic conjecture that we
just formulated is supported empirically, a rethinking of growth economics
towards an institution-based theory is in order.

Chapter Highlights

Discuss potential determinants of economic growth.

Ask how institutions can be measured.

Discuss one early measurement attempt in detail.

Summarize the most important findings regarding the influence of

institutions on economic growth.

As in the previous chapters, we deal both with external as well as internal

institutions. In Section 5.2, we not only reiterate the central theoretical
conjecture that is the foundation of the NIE – namely, that high quality
institutions are conducive to growth – but we also discuss briefly two competing
explanations. One explanation posits that it is primarily geographical factors that
determine income and growth, another one points at the overwhelming relevance
of culture. Section 5.3 deals with the question of whether differences in external
institutions cause differences in growth rates. To answer that question, reliable
measures for institutions are needed. Some attempts to make institutions
measurable are presented and discussed. We then summarize the available
evidence regarding the effect of institutions on growth. In Section 5.4, we report
some evidence on the effects of internal institutions on growth and economic
development. In Section 5.5, the relationship between external and internal
institutions and the implications of that relationship for economic development
are explored.

5.2 Determinants of Economic Growth:

Institutions, Geography, Culture?
5.2.1 Institutions
If we look at the year 1750, differences in income levels across countries were
fairly small. In other words, no matter where you lived you had to get along with
little money and few goods. Around 250 years ago, this situation of fairly equal
income levels began to change. A number of European countries started to
experience substantial growth rates and some of the (former) settler colonies like
the USA and Australia soon followed suit (Figure 5.1). This situation was not a
global phenomenon; most other countries did not experience substantial change
in growth rates. This difference in the growth paths of countries has led to vastly
unequal income levels today. There are still a number of African countries such
as Burundi or Malawi where the average income is less than US$1 a day. Just
pause for a second and think what that means. This number does not refer to the
poorest 10 or 20 percent of the population, it is the average over the entire
population. On the other side of the spectrum, there are a number of countries
with an average income of above US$50,000 a year. Besides British influenced
countries (Australia, Canada, and the USA), this is also the case in most
Scandinavian countries (Denmark, Norway, Sweden, and Iceland). This means
that the average person in one of the richer countries is 150 times richer than the
average person in one of the poorest countries.

Figure 5.1 The evolution of income in the USA, the UK, Spain, Brazil, China,
India, and Ghana between 1820 and 2000.

Source: Acemoglu (2008, 14)

Conjecture: Economic growth is determined by institutions

 Institutional economists argue that the main reason for some countries
“taking off” is that they improved their institutions. The Glorious Revolution of
1688 is considered by many scholars to be one of the important moments in
history, because it constrained the discretionary power of the king and made
government behavior more predictable (e.g., North and Weingast, 1989). Other
countries followed suit, like France in 1789. Reliable institutions that protected
property rights were a precondition for technological innovation to occur and
spread quickly. When thinking about these stylized facts, at least two questions
come immediately to mind: How can we know it is really institutions that led to
these radically different development paths? And, if European countries
managed to set up growth-enhancing institutions 200 or more years ago, why
didn’t every other country simply copy them? This chapter deals primarily with
the first question. The second question will be dealt with in Chapter 6.
One illustrative example for the enormously important role of institutions is
the economic development of Germany. The main power in Imperial Germany
(i.e., before 1918) was Prussia which extended over large areas of both the
eastern and western parts of the country. Geographical conditions were fairly
similar across the entire country and the population was fairly homogeneous in
terms of language, religion, culture, and other aspects. Up to World War II, rapid
industrialization took place in both the eastern and the western part of the
country. After World War II, the country was separated into East (socialist)
Germany and West (market oriented) Germany. In the West, private property
rights were re-established, a hard currency was introduced, and the country soon
began to experience high growth rates after the devastation of the war. East
Germany was under the influence of the Soviet Union and private property rights
were mostly limited to personal belongings. The consequence was that there
were few incentives to be creative and entrepreneurial in the East. Productive
technology in the East soon lagged behind the West. Since the country did not
produce many goods that could be exported, it did not acquire any foreign
currency and its citizens could not even consume simple imported products such
as bananas or coffee.
All this clearly shows up in the diverging income levels between the two
countries. In 1960, the net disposable income of an East German household was
around two-thirds (67 percent) of an equivalent West German household. Over
the ensuing decades, that share fell continuously. In the early 1980s, it was only
45 percent of the West. In the late 1980s, it fell to less than 40 percent of the
West, and in the end the system simply collapsed. But the story does not end
there. In 1990, the countries were reunited and the institutions that had been in
place in the West were essentially implemented in the East. Just as the West had
experienced after World War II in the 1950s, the East now experienced its own
Wirtschaftswunder (economic miracle). Between 1991 and 1997, per capita GDP
grew by around 60 percent, roughly the same number the West had experienced
between 1950 and 1956. Today, disposable incomes in the East are 85 percent of
the Western level. If we take into account that consumer prices are still lower in
the Eastern part of the country, disposable income in the East is 90 percent of
that in the West. The divergent developments that have taken place in North and
South Korea after World War II tell a similar story (e.g., Acemoglu et al.,
2005a). The German example, however, is even more revealing as it not only
shows that different institutions can cause vastly different developments (pre-
reunification), but also that substituting high quality institutions for low quality
ones can even reverse the previous development (post-reunification).
It is unlikely that other competing theoretical frameworks (namely,
geography and culture) can adequately explain the differences in growth rates
that occurred in East and West Germany. After all, the East and the West
developed more or less in tandem until the end of World War II. Then, the
institutions of West Germany were heavily influenced by France, the UK, and
the USA, whereas those in the East were created and implemented under the
direct influence of the Soviet Union. In other words, the German case is a good
example for the relevance of external institutions. But one or even two examples
(Germany and Korea) could be exceptions to the rule. This is why we look into
this issue more systematically later in this chapter.
Pointing towards the growth-inhibiting and growth-enhancing traits of
institutions to explain the vast differences in per capita income levels across
countries has convinced most, but not all, people. That is why we are sketching
two competing explanations here, namely geography and culture.

5.2.2 Geography
The French philosopher Montesquieu, who is perhaps best known for his
writings on the separation of powers, conjectured that climate has an important
effect on how people behave and how productive they are (Montesquieu, 1989
[1748]). Consider this straightforward example of how the climate could have a
direct impact on economically relevant behavior. In very mild and temperate
areas where nature offers abundant produce regardless of the time of the year,
delaying consumption now to be able to consume in the future is of little value.
But developing the habit of delaying current consumption so that it is possible to
consume in the future is saving, saving is a precondition for investing, and
investing is a precondition for economic growth. This is one very simple
example of how the environment might shape people’s behavior, their attitudes,
and their productivity.

Competing conjecture 1: Economic growth is determined by geography

 Webster’s Dictionary defines geography as “a science that deals with the
earth and its life” and mentions in particular “the description of land, sea, air and
the distribution of plant and animal life including man and his industries with
reference to the mutual relations of these diverse elements.” When “geography”
is named as a potential determinant for incomes around the world today, the term
is used to synthesize a lot of quite diverse aspects. We began our discussion of
geography by looking at temperature, one of many possible aspects of climate.
Climate is closely related to the characteristics of the soil, the ruggedness of the
terrain, and so forth. How rugged the terrain is will determine how difficult it is
to connect the various parts of the country with streets. The soil, in turn, can be
home to a huge variety of natural resources that might also impact upon
economic development. If a country is landlocked, both exporting and importing
will be relatively more difficult than if it has at least one port. But the climate
together with the soil and the ruggedness of a country also determine its disease
environment and so on. As this is an introductory text into institutional
economics – and not into the economics of geography – we do not aspire to give
a fully-fledged summary of all the aspects of geography that could impact on
economic development. Instead, we mention a limited number of aspects of
“geography” to exemplify the type of argument based on it. We propose to
separate arguments making the point that “geography” has a very direct impact
upon income levels from those that argue that the impact of “geography” is
mediated via institutions. At the end of the section, objections of institutional
economists regarding the relevance of “geography” are briefly summarized.
Let us begin by having a quick look at the simplest – and probably also the
most important – conceivable geographical variable, namely latitude. Latitude
measures how far away a particular country is from the Equator. Being located
on or close to the Equator implies an unfavorable disease environment and low
productivity due to the combination of high temperatures and humidity. The
farther away a country is from the Equator implies lower temperatures and
humidity and, hence, a higher expected income. In Figure 5.2, the absolute
latitude of a country (i.e., its distance from the Equator) has been plotted against
its 1995 per capita income in a logarithmic scale. The straight line minimizes the
squared distances between the latitude–income combinations of 180 countries
and the line itself. Its positive slope indicates that, as expected, more distance
from the Equator is correlated with higher per capita income. As you can see, a
couple of countries are far away from the line, these are commonly referred to as
outliers. Singapore (depicted as SGP in Figure 5.2) is one of them. Based on its
distance from the Equator, we would expect it to have an income a lot lower than
that actually realized. This certainly means that there are other variables that
influence current income levels. These could be other geographical traits (in the
case of Singapore, for example, having access to the sea), cultural norms (if, for
example, people believe that success in life is mostly determined by their own
efforts, and not merely by luck), or institutional factors.

Figure 5.2 Relationship between latitude (measured as the distance of a

 country’s capital from the Equator) and income per capita in 1995.

Source: Acemoglu (2008, 125)

The distance from the Equator is easy to measure. However, it is little more
than a black box. We can see that there is a close correlation between this
distance and current income levels, but the exact channel through which a
particular aspect of geography (in this case proximity to the Equator) causes
growth to be high or low still needs to be unveiled. In fact, it might be any one of
the many aspects mentioned above.
The most coherent argument placing geography at center stage is raised by
US American scientist Jared Diamond in a number of popular books, most
notably in Guns, Germs, and Steel (1998). During the Neolithic revolution (i.e.,
at the time when hunter-gatherer economies transformed themselves into
pastoral production) the inhabitants of Eurasia in general, and in particular those
inhabiting the area often referred to as the Fertile Crescent, enjoyed a number of
advantages compared to people elsewhere. Among these were the high number
of edible plants and domesticable mammals. The East–West orientation of the
continent (i.e., small variation of latitudes) also allowed for rapid diffusion of
agricultural innovations, because there are likely to be similar climatic
conditions across the continent. Contrast that to a North–South orientation (i.e.,
large variation of latitudes) where one encounters a different climate fairly often,
and the diffusion of innovations is correspondingly less likely.

Definition

The Fertile Crescent is the area encompassing the Nile riverbed in the
west, spanning across to Mesopotamia in the east. It is fertile in terms of
 agricultural output, and is often considered to be the birthplace of
agriculture, urbanization, writing, trade, and science.

These advantages enabled this region (covering parts of modern-day Egypt,

Israel, Jordan, Lebanon, Syria, and Iraq) to prosper more than other regions, to
feed a growing population, and to experience an early wave of technological
innovations. People from this region enjoyed a head start. Their immunity
against many diseases (germs), combined with their technological advances
(guns and steel) enabled them to dominate people from other regions (most
notably in Latin America) who had not enjoyed a similar geography-based head
start. Olsson and Hibbs (2005) tested Diamond’s hypotheses empirically and
found that the direct effects of geographical conditions on current income levels
are remarkably strong. They show that the impact of geography, while perhaps
mediated via institutions, is quite direct.
There are other studies that show that geography can impact income levels
by affecting the prevalent institutions. Jeffrey Sachs is probably the best-known
economist who argues that the disease environment of a country is one of the
central factors determining its growth prospects. He focuses on malaria and
shows that wherever malaria is prevalent, poverty is high and economic growth
is low. He shows that malaria impedes development through a number of
obvious channels, e.g., increased medical costs, premature mortality,
absenteeism, and lower worker productivity, but also via less obvious channels
such as its effect on fertility, population growth, and savings and investment
behavior, to name a few.

Malaria – and the disease environment in general – as an important

aspect of “geography”

Institutions a function of geography?

A region’s climate and general geography are also key determinants for the
crops that are cultivated. In the northern parts of the USA, wheat and potatoes
are appropriate crops, whereas in the south, cotton is more prevalent. If we go
even further south, say into Latin America, the climate and geographical features
may be more conducive to growing coffee. The regionality of crops determines
the factors of production. Crops grown in the north use small-scale farming,
whereas southern crops rely on plantations and need lots of input from cheap
labor. Economic historians Stanley Engerman and Kenneth Sokoloff (2000)
argue that it was not a historical accident that slaveholding was much more
important in the south than in the north, rather it was a direct consequence of the
prevalent geographical conditions or the relevant resource endowment. They
establish, in other words, a direct link between geography and institutions.
Slavery is here considered an institution because it establishes that human beings
can be held as property. Slaves can be bought, owned, and sold according to the
relevant property law, which is a set of institutions.
More recently, Alberto Alesina and two co-authors advanced the
observation that the degree to which societies relied on the plough in traditional
agriculture is a good predictor for today’s role of women in society (Alesina et
al., 2013). The argument that specific agricultural practices could have an
important influence on gender role differences was first advanced by Ester
Boserup (1970) and is straightforward: Cultivation of the soil relying on the
plough requires a lot of body strength to either pull the plough or control the
animal that pulls it, giving men an advantage over women. Agriculture that relies
more on the hoe and the digging stick requires less strength and is more labor
intensive allowing women to actively participate in farm work. Work with these
tools can easily be interrupted and resumed again, a fact that is compatible with
child caring, a task performed by women almost everywhere. Relying on
information about whether or not the use of a plough is suitable for a particular
area (i.e., geography), Alesina and his co-authors show that norms and beliefs
about the appropriate role of women in society and participation of women in the
workplace can be predicted based on geography. Here, geography has also had a
lasting impact on culture by way of influencing the norms and beliefs regarding
the proper role of women in society.
It certainly appears that geography has both a direct and an indirect effect
on income levels today. Examining only a limited number of geographical
factors (the East–West orientation of the continent, the simple latitude variable,
or agricultural variables), we can see high correlations between geographical
aspects and income levels. It seems that there is little room or even need for an
explanation based on institutions. Acemoglu, Johnson, and Robinson (2002),
however, stress a number of facts not compatible with this simple view. They ask
a simple question – what countries were the richest in the world around the year
1500? (i.e., before the onset of colonization) – and observe that the Mughals (in
India), and the Aztecs and Incas (in what is today known as Latin America) were
among the richest. Since no income statistics are available for so many years
back, they use two proxies for income. They look at urbanization rates and
population density based on the assumption that densely populated urban centers
could only emerge if agriculture was sufficiently productive to feed a large
population of people who were not active in agricultural production. In addition,
they look at population density based on the assumption that more densely
populated areas were only possible if agricultural productivity was sufficiently
high. So what do they find?

When favorable geographic conditions do not lead to high income: the

reversal of fortune

If one plots the regional or national income circa 1500 against the regional
or national income today, a negative correlation results (the plot is shown as
Figure 5.3). In other words, countries that were rich 500 years ago tend to be
poor today and countries that were poor circa 1500 tend to be rich today.
Acemoglu et al. (2002) coin this occurrence the reversal of fortune. It took
quite some time for this reversal to happen. Acemoglu and his co-authors
suggest it occurred between 1800 and 1850. So this is a blow against any simple
geography-based explanation and the authors go on to show that it was the
differences in the quality of institutions that caused the reversal to occur.
Possible explanations for just why institutions developed so differently in
different parts of the world will be discussed in Chapter 6. So if you were
wondering above, how come the countries in the Fertile Crescent are not among
the richest in the world today, here you have one possible answer.

Figure 5.3 Population density in 1500 and income per capita in 1995 among
former European colonies.

Source: Acemoglu (2008, 131)

There is evidence that a variety of factors often synthesized into the single
term “geography” do have an impact on economic growth and income levels
(Figure 5.4). And very few scholars quarrel with that insight. The main issue that
separates people like Jeffrey Sachs and Jared Diamond, on the one hand, from
scholars like Daron Acemoglu and James Robinson, on the other, is the channels
through which these aspects of geography impact growth.
 Figure 5.4 Direct and indirect effects of geography on income.

Fairly early in the debate, Bill Easterly and Ross Levine (2003) were
interested in empirically estimating the relative influence of these two channels,
i.e., in ascertaining the relative importance of geography compared to the
relative importance of institutions. They used a handful of variables to represent
geography, and another handful to represent the quality of institutions. They find
that latitude, disease environment, and cultivatable crops affect development via
institutions. They do not find that latitude, the disease environment, and crops
have a direct effect above and beyond the effect already captured via institutions.
It thus seems that explanations drawing on geography but omitting geography’s
effects on institutions are utterly incomplete.

Competing conjecture 2: Economic growth is determined by culture

5.2.3 Culture
There is no uniform position within the NIE that deals with the notion of culture.
Some scholars consider aspects of culture – just as geography – to be an
explanation that competes with explanations based on institutions. In their view,
one must choose to focus separately on either institutions or culture. Others take
a broader view and consider cultural explanations to be part of institutional
explanations. In our view, type 2 internal institutions do, in fact, overlap with
culture.
Many proposals have been put forward in an effort to define culture. The
Italian economists Luigi Guiso, Paola Sapienza, and Luigi Zingales have
published many important papers on the relationship between culture and
economic outcomes over the last decade. They propose to define culture as:
“Those customary beliefs and values that ethnic, religious and social groups
transmit fairly unchanged from generation to generation” (Guiso et al., 2006,
23). We agree that beliefs and preferences are key when defining culture but
propose to be more specific regarding the way in which they are transmitted. We
propose the following definition: Culture is the sum of rules, beliefs, preferences,
and values shared by others that are neither self-enforcing nor enforced by third
parties. According to this proposal, culture does not cover self-enforcing
institutions (type 1 institutions), nor rules whose noncompliance is sanctioned by
others (type 3 and 4 institutions). But we can think of type 2 institutions as part
of culture. This proposal suggests that there is an overlap between institutions
and culture. But it also suggests that some institutions are not culture and some
aspects of culture do not have the quality of an institution.
Figure 5.5 shows that type 2 internal institutions are special because they
can also be thought of as part of culture. Note that our definition of culture is
more restrictive than many other definitions. We use this restricted delineation of
culture to be able to clearly demonstrate that type 2 internal institutions arise out
of culture, while type 1, 3, and 4 internal institutions do not. In this section, only
one aspect of culture will be highlighted, namely religion.
 Figure 5.5 The relationship between culture and institutions.

Religion is an important part of culture because it is one of the most

important ways in which norms are transmitted across generations. There is a
well-known theory claiming that religious beliefs have an important effect on
economic development. The theory we have in mind was advanced by the
German sociologist Max Weber early in the twentieth century. Weber believed
that the rise of Protestantism (particularly Calvinism) brought about the
internalization by its adherents of a number of secondary virtues that proved
very favorable for the development of modern capitalism (Weber, 1993 [1920]).
This is frequently summarized as the Protestant Ethic.
The doctrine of predestination holds that God has already chosen those
whose souls will be saved. This somewhat fatalistic approach seems an unlikely
start for a theory in which personal incentives are to play a major role. But
Weber argues that those who are chosen by God are already better off during
their lives on this earth. The religious stance goes something like this: To reduce
my uncertainty as to whether I have been chosen – and to show my neighbors
that I am a chosen one – I do two interrelated things: I will live an ascetic life,
wasting neither time nor resources, and I will try to be productive as this is likely
to make me well-off. Both of these actions will show my neighbors that I am a
chosen one of God. Weber argues that the consequences of these two lifestyle
choices not only led to the so-called Protestant work ethic, but also established
secondary virtues such as punctuality and honesty, and a continued emphasis on
the role of education.
The belief that working hard pleases God is assumed to have made
believers work harder. Investing in one’s children’s education is assumed to
increase their productivity. Secondary virtues such as punctuality and honesty
imply that fewer transaction costs will arise in exchange. If my employees are on
time, I need fewer resources to monitor them. If my contracting partners are
honest, there will be fewer conflicts and so on. If time is precious, I will be less
inclined to bargain all the time. This is Weber’s explanation for fixed – and non-
negotiable – prices in most of the Protestant world.
From the very beginning, this theory has polarized scholars. To this day,
scholars question the accuracy of Weber’s ideas. Martin Luther demanded that
all Christians ought to be able to read the Bible. As a result, many Protestant
churches put a lot of emphasis on education. Instituting a weekly Sunday school
as part of a child’s education is just one example. Becker and Woessmann (2009)
try to disentangle the effect of the Protestant Ethic from the emphasis on
education. They show that most of the differences in economic outcomes can be
explained by the latter. According to them, the secondary virtues frequently
stressed in discussions regarding Weber’s argument can only claim to be of
secondary relevance. More recently, Cantoni (2015) used the religious
heterogeneity of the German countries between 1300 and 1900 to test Weber’s
conjecture empirically, and finds no effects of Protestantism on economic
growth.
 5.3 The Relevance of External Institutions
for Economic Growth and Development
In Section 5.2, we briefly laid out the chief conjecture of the NIE, namely that
the quality of institutions is the main determinant of economic growth. Over the
course of the first four chapters of this book, many arguments that make this
conjecture plausible have been presented. These arguments could also be called
our theoretical foundation. But to avoid sounding pretentious, we will continue
to refer to our key expectation – that institutions are crucial for growth – as a
conjecture and not a fact.
We also critically discussed competing conjectures, namely that economic
growth is primarily driven by geography or culture. Obviously, the conjecture
that institutions are the main determinants of economic growth might be
supported by the facts – or refuted by them. To be able to empirically test our
conjecture, we need to make institutions measurable. Being able to create a
measuring rod allows us to compare institutions across countries and we could
then put our conjecture to an empirical test. In this section, we will spend quite a
bit of time discussing one of the first indicators developed to make institutional
quality comparable across countries. Since the indicator is theory-based, its
presentation also enables us to complement our theoretical considerations here
and there. At the end of the section, we offer a brief overview of other
commonly used indicators.

Measures of institutions a necessity

The following questions are at the core of this section:

1. How can the quality of institutions be measured and compared?

 2. Are good institutions closely connected with fast growth and high
income levels?

3. Can an improvement in the quality of institutions induce higher

economic growth?

5.3.1 How to Measure External Institutions

Surprisingly, the issue of how best to measure institutions played a rather minor
role in the NIE for a long time. This is surprising because the claim that
“institutions matter” can only be supported or refuted if institutions can be
measured. Before attempting to measure institutions, however, a clear and
concise conception of the specific institution is necessary. Trying to measure
“democracy” or “the rule of law” does not seem to be a promising start. Both
are made up of hundreds of different institutions. On the other hand, if we can
identify and measure the various single components of, say, the rule of law, it
does not seem inconceivable to then add them up and establish an overall
measure. But if one is interested in discovering “actionable indicators” (i.e.,
indicators that can be used to improve the situation in a country), then an
aggregate indicator that is the sum of single components will be of little use
because we would not know where to begin looking for the “actionable
indicator.”
The presumed effects of institutions arise from both the rule and
sanctioning components. This implies that both the rule and the sanctioning
component should be explicitly taken into account when measuring institutions.
In addition, the effects of institutions will crucially depend on the degree to
which noncompliance is actually sanctioned. When we speak of sanctioning, it is
critical to determine the probability of noncompliance being detected, and the
severity of the ensuing sanction. Rules that exist just “in the books” are unlikely
to have important effects on how real people really behave. Two institutions that
are formally identical, but are implemented in different ways, are likely to lead
to very different behaviors. An obvious implication seems to follow: One must
not only analyze and compare institutions as they are written down in some
government gazette, but try to take into account the manner in which they are
actually implemented.
If one is interested in the effects of a certain institution on specific
outcomes, one needs to carefully isolate the institution from the possible effect.
Sounds self-evident? Well, it should be – but it is not. Many of the available
indicators rely on expert surveys. Suppose the conjecture to be tested is “secure
property rights are conducive to economic growth.” When answering a question
on the security of property rights in a specific country, the experts are likely to
make their evaluation knowing the growth rates that that country has achieved
over the last couple of years. If that is the case, finding a significant correlation
between the two variables is extremely likely – but not very helpful in
determining the true relevance of institutions. The general implication from this
reflection is that objective data are more suitable than subjective evaluations.
Objectivity in measurement implies that anybody repeating the identical
measurement exercise should end up with exactly the same results. This is,
however, only possible if the criteria, the coding rules, the various components
of a measure, are all disclosed. Unfortunately, some of the most frequently used
institutional measures are not that transparent.
Equipped with these simple criteria regarding the measurement of
institutions, we now proceed to present a few early attempts to measure external
institutions. After that, we present and discuss one indicator in considerable
detail.
 5.3.2 Early Attempts to Measure External Institutions
Clague et al. (1999) have devised a simple indicator to measure the security of
property rights. They measure how much cash – as opposed to bank holdings –
an individual holds. They assume that private actors prefer to hold cash when
they fear that banks might renege on their contracts or simply fold. Simply put,
this indicator examines the (subjective) expectations of economic subjects with
regard to one relevant aspect of the economy, and objectively measures how
those expectations affect behavior. When individuals perceive property rights to
be more secure, they are willing to hold more so-called contract-intensive
money (CIM) (i.e., money that will only be available if contracts are likely to be
complied with). This includes money that is used to fulfill contractual
obligations to third parties. Clague et al. (1999) operationalize their concept as
M2−C/M2(M2 − C)/M2.

Definition

CC is currency outside of banks and M2M2 is a very broad concept of

monetary supply.

The authors show that this indicator correlates (statistically) significantly

and (economically) meaningfully with investment, even after accounting for
inflation, real interest rate, and other common determinants of investment. An
important advantage of this indicator is that the underlying data are available for
a great number of countries and years. This distinguishes CIM from other, more
elaborate indicators that are almost impossible to reconstruct for past years.
Further, the indicator is based on objective data.
 Henisz (2000) investigates the capability of governments to credibly
commit to their own rules. The basic idea for his indicator is simple:
Unanticipated rule changes are less likely, the larger the number of (political)
actors required to agree to a rule change. Even if there is a large number of veto
players or chambers, rule change is possible, as long as the members of those
chambers are characterized by similar preferences. Henisz accounts for this fact
by including the actual distribution of preferences. Thus, this indicator
incorporates both institutional and non-institutional (policy) aspects: On the one
hand, the formal institutional structure of a separation of power, and on the other
hand, the non-institutional political majorities within the respective chambers.
The conjectured transmission mechanism is as follows: The higher the number
of veto players, the higher the level of legal security, the greater the investment,
the faster the economy grows. Henisz finds that his indicator exhibits a positive
effect on economic growth that is both statistically significant and economically
meaningful.

Number of veto players as indicator

A possible criticism of this indicator is that Henisz has to assume that each
political actor that is a de jure veto player is also a de facto veto player. It goes
without saying that many courts and central banks are formally, but not de facto
independent. Furthermore, this indicator does not tell us anything about the
concrete design of institutions. Governmental credibility is probably a necessary
but not sufficient condition for economic growth. In a political system with a
large number of veto players but with low quality institutions, change for the
better is hard to implement precisely because of the large number of veto
players. Implicitly, Henisz has to assume that existing institutions are socially
beneficial.
Let us move on to studies that utilize subjective data. Knack and Keefer
(1995) employ information that potential foreign investors use. They are
interested in gauging the risk associated with investing in a specific country and
comparing this risk across potential investment locations. Such data are collected
in the International Country Risk Guide (ICRG) and sold by its producer the
PRS Group. The ICRG contains several dimensions regarding the security of
property rights, such as the strength of the rule of law, the risk of expropriation,
the probability of the government disregarding private contracts, the extent of
corruption within the government, the quality of the bureaucracy and so on.
Knack and Keefer (1995) show that the ICRG index exhibits a statistically
significant correlation with economic growth.

Subjective indicators

Brunetti et al. (1998) argue that subjective indicators of uncertainty can be

superior to objective indicators. Contrasting with a number of other indicators,
they prefer surveying local entrepreneurs rather than foreign investors, because
the behavior of local entrepreneurs decisively influences the economic
development of a country. The authors interviewed more than 2,500
entrepreneurs in low-income countries and around 200 entrepreneurs in OECD
member states. Overall, they collected data from 58 countries. The sub-
indicators security of persons and property and predictability of rule making are
most strongly correlated with economic growth, while the sub-indicators
corruption, subjective perception of political instability, and predictability of
judicial enforcement are more strongly correlated with investment rates.
 Having discussed several studies that seem to support the notion that the
content of institutions and/or their credibility must be considered when trying to
explain economic growth, we have to admit that a multitude of open questions
remains. A central question is concerned with causality: Do good institutions
really cause growth? It might be the other way around: Only countries that
experience economic growth and have achieved a high standard of living are
able to “afford” good institutions. In fact, a debate has been raging around this
question ever since the publication of Lipset (1959). Acemoglu et al. (2005b and
2014) are at pains to show that the causal effect is from democracy to income
(institutions to growth), and not the other way around.

5.3.3 One Measurement Attempt in Detail

5.3.3.1 Preliminary Remarks

The main concern of this section is to get acquainted with one indicator in more
detail. What are its various dimensions, where does the underlying information
come from, what drives particular coding choices and so on? The indicator we
will look at in more detail is the Economic Freedom Index. The reason we have
chosen this indicator is because it was created by relying on the advice of several
very clever economists, a few of them Nobel laureates. It is also one of the first
very broad indicators and, not least importantly, it has had an important impact
in that it has been used in hundreds of studies.

5.3.3.2 The Economic Freedom Index

Beginning in the mid-1980s, the Canadian Fraser Institute gathered together a
group of researchers to attempt to operationalize the concept of economic
freedom and make it comparable across the world (Walker, 1988; Block, 1991;
Easton and Walker, 1992). Their combined efforts resulted in the publication of
the Economic Freedom Index (Gwartney et al., 1996; extended and updated in
Gwartney et al., 2017). The first Index was published in 1996. Figure 5.6, taken
directly from the 2017 edition of the Index, lists the 5 categories and 24
components of the Economic Freedom Index. In the following, we briefly
present all 24 components of this Index. We will touch upon the theoretical
arguments that led to including each respective component.

Figure 5.6 Overview of the components of the Economic Freedom Index.

 Size of Government
This category is concerned with determining whether resources and goods are
allocated by the government or by individuals. The first variable used in this
group measures government expenditures as share of total consumption. The
higher the government share of consumption, the less free individuals are in the
marketplace with regard to production and consumption decisions.
Another indicator for government influence is the share of transfer
payments and subsidies of the entire GDP. When the value of this variable is
high, representatives of the state will redistribute resources according to their
notions rather than paying attention to private property rights and the rules of a
decentralized market. If outcomes resulting from decentralized and voluntary
market exchange are not accepted, but rather corrected in a discriminatory
fashion based on the whim of the state, an imbalance occurs making some better
off to the detriment of others.
The third variable is concerned with the role of state-owned enterprises.
The theoretical argument here is that privately owned firms can only survive in
the market if their products correspond to consumer preferences. This is different
for state-owned firms. If consumers do not pay a price that covers at least the
production costs of their products, these firms are often subsidized, implying that
consumers are forced – via taxes – to share in the production costs.
The last variable of this group is based on the premise that the incentives
for efficient market production depend in part on the level of taxation. The
higher the marginal tax rate for productive citizens, the lower their economic
freedom.
Notice that none of the four components reflect – or even measure –
institutions as such. Instead, all of them are results of policy choices made by
government. The Economic Freedom Index is, hence, subject to a critique voiced
by Glaeser et al. (2004) that many indicators purporting to measure institutions
really only reflect policies. Their critique will be taken up in more detail below.

Legal System and Property Rights

In Chapter 2, we argued that the definition of private property rights, the contract
law in place, and the procedural law of a country are crucial determinants of
economic activity. The Economic Freedom Index builds on this idea in several
ways. This group of variables consists of nine components. The components are
named individually in Figure 5.6.

Sound Money
The basic conjecture is that a low rate of inflation (or a stable currency) protects
the economic freedom of individuals by enabling them to conserve value and
also to enter into predictable long-term transactions. A clear link to institutional
economics is already established: the reduction of uncertainty. This group of
variables consists of four indicators.
The first indicator measures the average growth rate of money supply.
The reason for employing this indicator is because when the supply of money
grows at a faster rate than GDP, undesirable inflation is the result. Inflation
reduces the monetary wealth of individuals and is referred to by the publishers of
the index as “wrongful seizure of property” (Gwartney et al., 1996, 3). The
second indicator measures the spread of the annual inflation rates over the
previous five years (in terms of the standard deviation).

Definition

Standard deviation: Statistical measure for the variation of a variable

around its mean.
Price instability makes it more difficult for individuals to form stable
expectations. Thus, a wider spread of price variations is valued negatively. The
third indicator in this group measures the current inflation rate. The final
indicator is concerned with whether citizens are allowed to keep bank accounts
in foreign currencies and whether citizens can legally keep bank accounts in
other countries. The ability to do these two things is valued positively because
citizens are then able to substitute the domestic currency for foreign currency in
order to compensate (at least partially) for any instabilities (and the associated
negative effects) of the domestic currency.
These four measures are neither institutions nor policies but consequences
of monetary policy. Of course, they can have substantial impacts on how people
behave, but they are certainly not measures of institutions.

Freedom to Trade Internationally

This group has four variables. The basic premise here is that there is no reason to
impede citizens from making profits through economic exchange or to disallow
international transactions simply because a national border needs to be crossed.
The first variable in this group compares the revenue from taxes levied on
international trade as a share of total trade. The higher the level of such taxes,
the more difficult it is to realize gains from trade across borders which thus
lowers economic freedom. The second variable consists of two components. The
first component measures how strongly non-tariff barriers impede cross-border
trade. The second component measures the cost of adhering to import and
export regulations. The third component indicates whether there are black
market exchange rates. If there are currency regulations, it is usually difficult
for domestic agents who are interested in international trade to obtain the
required foreign currencies. The higher the black market premium for a unit of
foreign currency, the more restrictive currency regulations are, resulting in more
restricted economic freedom. The final indicator measures whether the mobility
of both capital and people is restricted.

Extent of Regulation in Banking, Labor, and Business

The three components in this group measure the extent individuals are able to
pursue their own choices without governmental intervention. This refers to both
the production of goods as well as consumption choices. The question boils
down to whether individuals, as market participants, decide for themselves or
whether state representatives dictate these decisions.
With regard to the regulation of banking, three aspects are measured: Who
owns banks, is credit supplied to the private sector and if so, to what extent is
there governmental regulation of interest rates? With regard to the regulation of
labor, potential restrictions of economic freedom are seen in the existence of
minimum wages, regulation of hiring and firing, and whether there is mandatory
military service.
The last component assesses the strength of governmental influence
towards the management of businesses. This includes variables that indicate
how expensive it is to establish a new firm and whether businesses can freely set
their prices. Furthermore, this component uses variables that indicate whether
bribe payments are necessary to operate businesses and how complicated it is to
fulfill tax regulations.

Method of Evaluation
The Economic Freedom Index includes data from more than 150 countries for
the 24 indicators. The highest possible rating of an aspect is 10, the worst is 0.
The authors of the study emphasize that it is important to rely on as few value
judgments as possible. Thus, they use (when available) variables that can be
operationalized and are objectively measurable. Whenever that is not possible,
they use ratings of other studies (such as the Global Competitiveness Report or
the International Country Risk Guide).
Figure 5.7 is taken from the 2017 edition of the Index. It shows the 2015
country ratings for economic freedom. The subsequent figures show correlations
between the Index and various measures of wealth, such as income or income
growth, but also the income share of the poorest. The results are surprisingly
clear: More economic freedom is strongly correlated with better economic
outcomes.

Note

Breaking down a distribution into equally sized groups results in

quantiles. Four equal groups are called quartiles, five are called quintiles,
ten are called deciles, and one hundred equal groups are called
percentiles.
 Figure 5.7 The country ranking of the Index for 2015.

In Figure 5.8, the distribution of countries was grouped into four quartiles.
We can see that there is a clear correlation between the extent of economic
freedom and per capita income. Figure 5.9 shows that the relationship between
economic freedom and growth of per capita income is not as clear.

Figure 5.8 Economic freedom and per capita income.

 Figure 5.9 Economic freedom and per capita income growth.

Non-economists might interject that the importance of income and income

growth is exaggerated and that other indicators such as the income share of the
poorest 10 percent of the population are much more important. Figures 5.10 and
5.11 show that more economic freedom is not correlated with a lower income
share of the poor. Formulated differently, extensive economic freedom and fast
growth are essentially uncorrelated with income inequality.

Figure 5.10 Economic freedom and the income share of the poorest 10%.
 Figure 5.11 Economic freedom and the income earned by the poorest 10%.

The authors of this study assume that the results depict not mere
correlations, but rather unambiguous causality.1 Countries that increased their
level of economic freedom exhibited increased growth rates only several years
afterward. It is, therefore, assumed that the improvement of economic freedom
caused the higher growth rates. Academics are much more critical and skeptical
about buying into these conclusions. Economic freedom is, as repeatedly pointed
out above, a policy choice and, hence, endogenous. It could be that only rich
countries are able to afford good institutions. If this is the case, the causality
would run from income to economic freedom and not the other way round.

5.3.3.3 Criticisms of the Economic Freedom Index

Let us now consider some critical issues regarding the design of the Economic
Freedom Index. These issues are, in fact, important for the construction of all
indices.

1. The weighting issue: As mentioned above, the Economic Freedom Index

consists of 24 different indicators. The underlying idea is to aggregate
various important aspects into a single number. But according to what
aggregation rule? Are all 24 indicators equally important? As just
 described, the authors of the Economic Freedom Index group their 24
indicators into five different areas. Should all five areas be attributed equal
weight? And if not, how should the weights be determined? Are there
convincing arguments that all areas are necessary for citizens to enjoy
economic freedom? If that is the case, it might make sense to multiply the
values of the areas with each other. If, however, low scores in one area can
be compensated by high ones in another area, adding up the various scores
makes more sense.

2. Institutions have been defined as rules endowed with a sanctioning

mechanism. Policies can be thought of as choices made by politicians under
given institutions. And outcomes are the consequences of policy choices.
The Economic Freedom Index consists of all three types of indicators. As
an index for the quality of institutions, it is, therefore, not entirely adequate.

3. Above, it was argued that objective indicators enjoy the advantage of

being replicable by any scholar interested in replicating them over
subjective indicators that measure the perceptions and evaluations of
individuals. Some of the indicators used here rely, however, on subjective
measures.

The Economic Freedom Index is only one among quite a few measures that have
been produced over the last ten or fifteen years. We cannot give all of them the
same detailed discussion we gave to the Economic Freedom Index, but the
following box summarizes the basic purposes of many of them.

A short summary of several indicators

1. The non-governmental organization Freedom House annually

publishes the report Freedom in the World, which includes two
indicators: one concerning political rights and one concerning civil
liberties. The 195 countries included in the study are rated on a
scale of 1 (free) to 7 (not free). Freedom House has made these
indicators available since 1973. Freedom House also publishes an
indicator on press freedom.

2. A group of researchers are responsible for the Polity IV

indicators, which aim to capture the extent of democracy as
actually realized across countries and years. Countries that are
completely autocratic are coded –10, while perfect democracies are
coded +10. The indicator codes countries all the way back to 1800.
This makes it a very valuable source of data for studies interested in
the long run.

3. Polity IV does have its critics. One frequently raised point claims
that democracy and dictatorship are categorical concepts where you
either are democratic or not. A continuous scale would, hence, not
make much sense. On the basis of this idea, Cheibub et al. (2010)
propose a Democracy–Dictator indicator which is available for
199 countries on an annual basis between 1946 and 2009.

4. The first couple of indicators deal with broadly conceived civil

and political rights; we now turn to indicators interested in
reflecting economic institutions. The indicator that is conceptually
very similar to the Economic Freedom Index is the Index of
Economic Freedom which is published by the conservative
Heritage Foundation jointly with the Wall Street Journal. It is
published annually and covers up to 186 countries for the period
from 1995 until today.
5. The World Economic Forum, which is best known for its annual
convention in Davos, publishes the annual Global Competitiveness
Report, which tries to quantify a nation’s competitiveness based on
twelve dimensions. To a large degree the indicator relies on the
evaluations of experts, mostly business people. In its current
construction, it has been available since 2004. It is produced on a
yearly basis for 137 countries.

6. A similar report, the World Competitiveness Yearbook, is

published by the Business School IMD in Lausanne. It also relies on
a mixture of survey and expert data and also has its primary focus
on competitiveness. Its advantage over the Global Competitiveness
Report is that its data go back to 1989; its disadvantage is that it
only covers 60 countries.

7. The last three indicators briefly portrayed cover a country’s

environment for private business in a fairly general manner. This is
different for the next two indicators to be presented. They are for
profit indicators that cater to (potential) foreign investors who are
interested in the particular risks they might be subject to in their
destination country. The Political Risk Services Group (located in
Syracuse, New York) publishes the International Country Risk
Guide, which is used by potential foreign investors to gauge the
security of investing in countries all over the world. It has been
published since 1980 on a monthly basis.

8. A very similar analysis called Business Risk Service is published

by Business Environment Risk Intelligence. The company has been
around since the 1960s and it produces risk assessments for 50
countries three times a year. Almost needless to say, the indicator is
based on expert evaluations.

9. Transparency International is a globally active non-governmental

organization whose main goal is to fight corruption. Since 1995, it
annually publishes the Corruption Perceptions Index (CPI),
which assesses the perceived level of corruption in up to 176
countries. Objective data are very hard to get regarding corruption.
The CPI is based on a variety of different surveys. This is why it has
also been called a survey of surveys.

10. Since 2003, the Bertelsmann Foundation has been publishing

the Bertelsmann Transformation Index (BTI), which tries to
document the institutional development of up to 129 less developed
countries. Its premise is that sustainable development will only be
achieved with an adequate change in both political and economic
institutions and is divided into political transformation, economic
transformation, and an index of “transformation management”
which tries to evaluate the quality of transformation management by
the respective governments. The BTI is produced on the basis of
expert evaluations.

11. Since 2008, the World Justice Project has published its Rule of
Law Index. It measures the rule of law according to 47 indicators
grouped around 8 themes. It is composed of two surveys, namely a
general population survey as well as an expert survey and has been
carried out in 113 countries.

12. The Worldwide Governance Indicators, published by the

World Bank since 1996, consist of six composite indicators that are
 compiled on the basis of a multitude of available data from other
organizations. It has been heavily criticized for various reasons, the
most basic one that it lacks a clear theoretical foundation.

5.3.4 Results of Empirical Studies

Figures 5.8–5.11 are a graphic representation of the bivariate relationship

between the Economic Freedom Index and one other variable (namely per capita
income, income growth, and income share of the poorest 10 percent). Bivariate
(based on two variables) relationships are easy to depict graphically. However,
we should not draw any premature conclusions based on bivariate relationships.
For instance, it could well be that economic growth is influenced by a number of
other factors, including the rate of investment, population growth, the rate of
inflation, and global market integration, just to name a few. Further, the direction
of causality is unclear. And further still, the two variables might only be
correlated, and determined by yet another variable. In order to arrive at reliable
results, we need to employ multivariate methods that account for this multitude
of influences. Over the last 15 years, quite a few studies have tried to determine
the effects that institutions have on economic growth. Rather than a systematic
survey, we will only highlight the main findings of several studies that set the
path for many subsequent papers.
We now know that the Economic Freedom Index contains 24 indicators. Let
us assume the objective of a politician is to increase the rate of economic
growth. Turning to the Economic Freedom Index as a source of information that
might help in achieving this objective will probably not be very useful. In all
likelihood, not all indicators have a significant effect on growth. Starting from
this possibility, several authors have attempted to discover which areas covered
by the Index are significantly correlated with growth – and which are not.
According to one study (Carlsson and Lundström, 2002), the only variables that
survive all robustness tests relate to legal structure and the security of private
property rights. The variable concerning the freedom to use foreign currency
comes close, while all other indicators failed robustness checks.

Estimations are considered to be robust if moderate modifications of the

model do not significantly change their qualitative results

Now, empirical confirmation that the security of private property is key

accords well with theoretical priors. In fact, quite a few studies interested in a
simple measure for the quality of institutions rely on the security of private
property rights.
Earlier in this chapter, we mentioned that some economists believe
geography is the single most important determinant of economic growth and
income. We presented the results of a study by Easterly and Levine (2003). They
show that if one explicitly controls for the effects of geography mediated via
institutions, the direct effects of geography are of secondary importance. The
outcome of a study by Rodrik et al. (2004) is unambiguously summarized in its
title, namely Institutions Rule. The authors of this study run a “horse race”
between three competing explanations, namely geography, institutions, and
international trade. By now, you are very familiar with the first two approaches.
The third one argues that growth will pick up considerably when a country is
closely connected with the rest of the world via international trade. The Rodrik
et al. study is broader than that by Easterly and Levine because it takes
international trade explicitly into account. But the main results are very similar
as Rodrik et al. also find that institutions are crucial for economic development.
Geography is important in the sense that it has an effect on institutions. The
direct channel from geography to growth again appears to be rather negligible.
A significant paper by Acemoglu and Johnson (2005) adds another aspect
to the discussion. They propose to separate (“unbundle”) property rights
institutions from contracting institutions. The idea is that secure private property
rights primarily imply protection from government intervention. The
government cannot simply take property away from you without adequate
compensation. Contracting institutions basically enable people to enter into
contracts voluntarily. If private firms want to enter into contractual relations with
each other, they can often also do so without relying on the state. If private firms
are not comfortable with contracting institutions provided by the state, they
might turn to privately provided ones (e.g., those offered by private arbitration
organizations). Sidestepping the government with regard to property rights
institutions is, however, impossible. Based on this argument, Acemoglu and
Johnson expect the security of private property rights to be relatively more
important for economic growth than contracting institutions. Their hypothesis is
supported by their empirical analysis.
In sum, there is strong evidence that institutions affect economic outcomes
significantly. This not only holds for bivariate correlations (on which we spent
some time because they can easily be depicted in figures) but also for analyses
based on multivariate models.2

5.3.5 Institutions or Policies?

The first attempts to empirically estimate the relevance of institutions for the
growth of economies are relatively recent. Comparable data for the quality of
institutions across countries have become widely available only since the mid-
1990s. In these early investigations, the question of whether or not such data are
suitable to measure the quality of institutions was not widely considered. Glaeser
et al. (2004) are an exception. They put forward a general critique of these
estimations, arguing that many studies did not measure the effects of institutions,
but rather the effects of policies. They further suggest that institutions have to be
relatively stable over time in order to constrain political behavior. This is not
compatible with the observation that many institutional indicators vary
significantly over short time periods. Glaeser et al. (2004) conclude that such
studies measure – at least partially – the effects of short-term policies instead of
long-term institutions. Although this critique is overstated in many regards, the
conclusion that empirical indicators for institutions should be assessed for their
quality is surely justified.
The studies we have discussed so far are concerned with the analysis of
external institutions and their enforcement. In the following, we will consider the
potential relevance of internal institutions for economic growth and societal
development.

Don’t mistake policies for institutions

5.4 The Relevance of Internal Institutions

for Economic Growth and Development
Only recently did the relationship between internal institutions and economic
development attract the interest of economists. Before 2000, there were almost
no empirical studies analyzing this relationship. Since then, quite a few studies
have inquired into the effects of different concepts such as trust and culture on
economic development. Before turning to some empirical results, we present a
few theoretical arguments connecting both beliefs and internal institutions with
economic development. Remember that institutions come with a sanctioning
mechanism whereas beliefs do not. Putting aside the interrelationship between
internal and external institutions, the primary question is which internal
institutions are conducive for economic growth and development.
The following individual beliefs and internal institutions have been argued
to be conducive to economic growth (Voigt, 1993):

Individual beliefs and economic growth

1. The individual is responsible for setting his/her own objectives, for the
choice of means to reach them, and the degree to which they are actually
reached. If a large proportion of actors are convinced that individual effort
is irrelevant for their achievements and that fate or God or some other
external factor determines their success, it is hard to picture a prosperous
economy with many entrepreneurs and high rates of economic growth. It is
equally difficult to imagine a functioning system of private property rights,
given that property rights represent a link between individual efforts and the
fruits of those efforts. Private property rights not only give the rights
holders the right to use and sell a good, but also imply a certain
responsibility for their property (such as a cattle herd trampling a
neighbor’s crops).

2. Economically successful individuals are considered to be role models

rather being frowned upon. This implies that perceived inequality resulting
from differences in (legitimately attained) economic success is accepted to
some degree. Furthermore, envy can be associated with positive effects if it
induces incentives to imitate the envied.
3. Actors are socially and geographically mobile. Geographical mobility is
advantageous as it enables the efficient combination of mobile input factors
with immobile input factors. This attitude should be shared even by
immobile societal members. If immobile actors share an aversion for the
unknown – for instance, because they fear increased competition and
resulting wage decreases – an inefficiently low factor mobility might result,
leaving unrealized growth potential on the sidewalk. Social mobility
implies that individuals can climb as well as descend the social ladder. If
individuals that have climbed the social ladder are thought of as role
models, higher growth could result through imitation. Optimally,
individuals that have descended in their social status should not be
stigmatized to prevent higher risk aversion and decreased
entrepreneurship.3

4. A certain portion of society behaves innovatively. Innovative behavior is

not only limited to production decisions, but can also refer to consumption
choices. The latter, the so-called consumption pioneers, are crucial with
regard to the diffusion of new products.

5. Large parts of society share a certain level of tolerance. There is a broad

acceptance that other people are different and that this difference is a good
thing. It is important that a society does not exhibit a militant aversion
against the unknown. This relates to foreign investors and foreign workers,
but also to foreign products.

6. Large sections of society are willing to accept that some individuals will
attain great prosperity with seemingly unproductive activities, such as
financial services.
 7. Large parts of society share certain secondary virtues, such as honesty,
punctuality, and so on. If, for a simple transaction, one can reasonably
expect not to be cheated, the resulting transaction costs will be lower.

Naturally, many individuals who do not share the above listed beliefs reside in
countries with a high per capita income or high growth rates. Thus, the mere
pervasiveness of such individual beliefs and internal institutions cannot be a
necessary condition for high economic growth. At the same time, individuals
who exhibit the beliefs listed above should not be impeded in behaving
according to these beliefs. Put differently, although it might not be necessary that
appropriate institutions support the beliefs listed above, existing institutions
should not punish individuals who base their behavior on these beliefs. These are
just tentative arguments on this topic which need to be expanded. For instance,
one could ask whether there is a threshold share of the population that should
hold the listed attitudes in order to ensure sustainable economic growth.
To be able to test these conjectures empirically, measures for beliefs and
trust are needed. The following box briefly summarizes some of the sources that
economists have used to make beliefs and trust comparable across countries or
regions.

How to measure beliefs and trust?

A number of indicators have been presented that are often used as

proxies for external institutions. Here is a short overview of sources
often used to generate indicators for trust and beliefs. Unfortunately, a
list of indicators measuring internal institutions proper cannot be offered
as measurement of internal institutions clearly lags behind the
measurement of external institutions. Measurement of internal
institutions is a serious challenge for scholars within the NIE.
1. Geert Hofstede is a social psychologist and former IBM manager
who proposed four basic dimensions to identify the effects of
culture on values. These are power distance, individualism,
uncertainty avoidance, and masculinity. Hofstede conducted several
IBM employee surveys; the largest survey polled 117,000
employees. This was the first broad survey-based cross-country
study. Since these employees share many characteristics and
attitudes, the differences in their beliefs can be more easily ascribed
to the different national cultures to which they belong.

2. The World Values Survey was first conducted in 1981, with six
subsequent waves. With some 250 items, the survey delves into
many details of a person’s values and beliefs. The current survey
includes a representative sample of the entire population of almost
100 countries. One item of the survey directly asks about trust:
“Generally speaking, would you say that most people can be trusted
or that you need to be very careful in dealing with people?” In a
host of studies, the percentage of the population that answers “most
people can be trusted” has been used as a measure for the societal
level of trust in the respective country. But the survey also asks a
number of questions that have been used as measures for culture.
They include questions about:

beliefs in the importance of individual effort;

generalized morality;

obedience.

3. Gallup is a US based management consultancy firm that has

become famous for its polls. The Gallup World Poll is an opinion
 survey that includes questions on confidence in institutions and
personal well-being. It is conducted in more than 160 countries
worldwide and has been used mainly by international organizations
but also by some scholars.

4. Similar to Gallup, the Pew Research Center is also known for its
surveys. The survey most relevant for the measurement of internal
institutions across the globe is its Global Attitudes Project that
covers topics such as a personal assessment of one’s own life,
religion, crime and corruption, and political participation.

5. The GLOBE study on culture, leadership, and organization is

interested in the impact of different values and norms on firm
behavior, in particular different leadership models. GLOBE is an
acronym derived from “Global Leadership and Organizational
Behavior Effectiveness Research Program.” Some of their nine
dimensions extend beyond firm behavior and have also been used as
proxies for preferences and beliefs more generally. The GLOBE
data are compiled from questionnaire responses of 17,300 middle
managers in 951 corporations and 62 societies.

In Chapter 2, you were introduced to Putnam’s (1993) analysis on the effects of

trust on the quality of local governments. His argument is that the de facto
quality of Italy’s institutions can be explained by the extent of civil society. La
Porta et al. (1997) ask whether these results might be generalizable beyond the
case of Italy. The authors use data from the World Values Survey and attempt to
measure the propensity to trust by examining the extent to which actors exhibit
trust towards others. La Porta et al. (1997) find that trust has a statistically
significant and quantitatively meaningful effect on the economy.

Trust is conducive to economic growth …

La Porta and his co-authors are not the only ones who find that trust has
important economic effects. Guiso et al. (2006) find that trust is associated with
a higher likelihood of becoming a successful entrepreneur. In settings where
contracts are incomplete (in other words, everywhere), contracts always involve
a certain amount of trust. Being perceived as trustworthy has an advantage as it
will facilitate the conclusion of contracts. People believed to be trustworthy,
therefore, enjoy a comparative advantage as entrepreneurs. Higher levels of trust
are also associated with lower levels of corruption (Uslaner, 2002; Bjørnskov,
2010) and stronger economic performance (Knack and Keefer, 1997; Zak and
Knack, 2001).

The relevance of beliefs regarding others’ trustworthiness

Trustworthiness is not only likely to make you a more successful

entrepreneur, it also affects international trade. The trustworthiness of
people in other countries is often not determined by our experience but
by our beliefs. Assume, for instance, that Swedes do not believe
Spaniards to be trustworthy but believe Austrians to be so. If that is the
case, then Swedes are unlikely to trade many goods with Spaniards
which gives them few reasons to ever correct their beliefs. In other
words, beliefs can be an important determinant of trade patterns, even if
they are not substantiated by any real-life experience. These conjectures
 are empirically supported by the work of Guiso et al. (2004a, 2004b).
This holds for trade in goods, as well as investment across borders.

… but what determines trust?

There is, however, an institutionalist school that makes the argument that trust
might also be determined by the institutional environment. In other words, trust
might not be exogenous. On the other hand, the culturalist school argues that
people learn a basic sense of trust early in life. As a consequence, at least the
core of trust is assumed to be stable over time. And there is substantial evidence
that this is really the case. For example, emigrants from low-trust regions in
southern Italy carry their mistrust with them to their new locations (Guiso et al.,
2004a). Similarly but more generally, Berggren and Bjørnskov (2011) find that
differences in trust levels between US states today are directly related to the
country of origin of the families who immigrated to a particular state. To recap,
trust levels are often remarkably stable. This makes it possible to treat them as
“quasi exogenous” and to use them as explanatory variables as has been done
many times as just reported.
If you recall our earlier discussion, the north of Italy performed
significantly differently from the south. This is astonishing considering the entire
country has been subject to the same external institutions for more than 150
years. As described in Chapter 2, Putnam (1993) argued that these differences
could best be explained by historical factors. But there were at least two issues
that shed doubt on the reliability of his results: (1) the number of Italian regions
is fairly small and reliable econometric tests were not possible on the limited
dataset; (2) the study was confined to a single country, namely Italy.
 Being inspired by Putnam’s analysis, and taking the possible weaknesses of
that analysis explicitly into account, Italian economist Guido Tabellini (2010)
puts forth the observation that formally identical institutions can have very
different consequences. He goes on to conjecture that internal institutions might
actually be more important than external ones. He asks whether stable
components of culture can explain differences in the economic development of
regions that share formally identical external institutions. This implies that he
assumes culture is an important determinant in the way external institutions are
actually implemented.
Guido Tabellini expands on Putnam’s study by analyzing a larger number
of regions – namely 69 – in eight different countries (the UK, the Netherlands,
Belgium, France, Spain, Portugal, Italy, and Germany). He relies on survey
answers taken from the World Values Survey to capture four different aspects of
culture: trust, respect for others, individual self-determination, and obedience.
The first three aspects are assumed to have positive effects, the fourth one
negative effects. The first two traits are assumed to increase the number of
welfare-enhancing social interactions, including anonymous exchange, but also
the voluntary participation in the provision of public goods. The latter traits are
assumed to make entrepreneurial behavior more likely. In a sense, the first two
traits capture what has been called “social capital” and the latter ones something
akin to “confidence in the individual.”
There is a strong correlation between culture and economic development.
Unfortunately, that is insufficient to prove that it is culture that determines
economic development. Remember that the causation could also run from
economic development to culture. How do we resolve this ubiquitous problem?
By relying on instrumental variables. Tabellini does not assume culture to be
completely invariant over time. He believes that historical institutions shaped
culture as defined by him. He proposes two instruments, namely the literacy rate
in the second half of the nineteenth century and the quality of political
institutions between 1600 and 1850. The quality of political institutions is
measured by determining the degree to which the executive was constrained in
its actions. The more constrained, the more predictable its behavior. The idea is
schematically depicted in Figure 5.12.

Figure 5.12 Instrumenting culture with historical institutions.

To exclude the possibility that it was economic development in 1850 that

determined culture, Tabellini includes a variable that controls for economic
development at that time. Since no reliable income data are available, he uses the
degree of urbanization in 1850 based on the assumption that city inhabitants
relied on more modern technology and were more productive. Tabellini finds
that his culture variable is significant for explaining both differences in
productivity levels and growth across the 69 regions analyzed.

5.5 On the Interplay between External and

Internal Institutions and its Relevance for
Economic Growth and Development
In Section 5.3, we showed that adequate external institutions are associated with
high rates of economic growth. In Section 5.4, we showed that there are
plausible theoretical arguments and some empirical evidence for a positive
relationship between adequate internal institutions and economic growth. There
are, however, hardly any empirical studies that examine the interplay between
external and internal institutions and its relevance for economic growth.
In Chapter 1, we suggested that it is possible to distinguish four
relationships between external and internal institutions. They can be (1)
complementary, (2) substitutive, (3) conflicting, and (4) neutral. Williamson and
Mathers (2011) inquire whether good external and good internal institutions
independently of each other have a positive effect on growth or whether it is
sufficient to have either good external or good internal institutions. Coined
differently, they are interested in determining whether good external and good
internal institutions act as complements or as substitutes. Their approach is
straightforward. They use the Economic Freedom Index (described earlier) as a
proxy for good external institutions and follow the approach taken by Tabellini
(described in Section 5.4) as a proxy for favorable internal institutions (culture).
They find good external institutions to be vastly more important than good
internal ones, lending support to the view that the relationship between external
and internal institutions is substitutive, rather than complementary. Their study is
definitely only a very first take on this important question.

5.6 Open Questions

Traditional growth economics assumes that economic growth can be explained
solely by the factors of labor and capital. New growth economics brings the role
of human capital into the equation by indirectly measuring the quality of the
educational system in a country. But fundamentally, neither branch of growth
economics considers the quality of institutions, such as economic freedom rights,
to affect the growth rate of an economy. In the language of growth economics:
The effect of institutions on growth is primarily mediated via the so-called total
factor productivity. Institutional economists conjecture that neither physical nor
human capital actually causes growth on its own. It is the interaction of these
factors with institutions that determines the degree of economic growth.
Over the last two decades, many scholars have devoted lots of time to
dealing with these issues and there are many contributions that we cannot
describe in detail here. For instance, whether the legal origins of a country –
operationalized by the distinction between common law and civil law countries –
are relevant for the current quality of financial markets (see e.g., La Porta et al.,
1998, 1999). Another strand of literature considers the conditions that must be
met for “implanted legal orders” to be actually implemented in the importing
country and exhibit positive effects (see Pistor, 2002).

Questions

1. Discuss advantages and disadvantages of subjective data vs. objective data.

2. Think of other criteria you could use to categorize datasets for comparing
institutional quality in different countries.

3. Discuss mechanisms through which a democratic form of government might

impact the growth prospects of an economy.

4. Discuss why a “maximization” of economic freedom is probably not socially

beneficial. Begin by defining what a maximization of economic freedom means.
5. Section 5.4 contains a list of seven factors supposedly conducive to economic
growth without explicitly separating beliefs from internal institutions. Go
through the list and separate them from each other.

6. Show that the widespread acceptance of secondary virtues such as honesty

and punctuality can be associated with reduced transaction costs.

Further Reading
Daron Acemoglu and James Robinson are probably the staunchest
representatives of the view that it is only institutions, not geography or culture,
that determine economic development. An accessible yet precise and detailed
summary of their main contributions is Acemoglu and Robinson (2005).
Jeffrey Sachs is probably their most popular counterpart arguing that it is
geography, particularly the disease environment, that determines the growth
prospects of a country. One concise statement of his position can be found in
Sachs and Malaney (2002). Both Acemoglu and Robinson as well as Sachs have
their own blogs. If you are interested in discovering why each side believes it
has the better arguments, you might want to turn there (whynationsfail.com and
jeffsachs.org, respectively).
Scholars affiliating themselves with the NIE are united in their conviction
that institutions are important. For a long time, however, the question of how to
measure institutions only received scant attention. Voigt (2013) takes up the
question and makes a number of proposals. Some attempts to make institutions
measurable have been met with fierce criticism. The indicators produced by the
World Bank are particularly prone to critique. This holds true both for the
Worldwide Governance Indicators as well as for Doing Business. The latter
purports to measure the difficulty of setting up shop and compares it over many
countries. The underlying assumption seems to be “the cheaper the better.” This
view has been criticized by many. A number of formal requirements to register a
business might be costly now, but might still have overall positive returns.
Arruñada (e.g., 2007) points out that the existence of up-to-date registries can
save lots of costs later on (like finding out who owns what parcel of land, who
are the owners of a particular firm, how creditworthy a firm is, and so on).
The Nobel Prize in 1993 was awarded to Douglass North. As an economic
historian, he put a lot of emphasis on the role of institutions for development
over time (see North, 1994).
Virtually all indicators briefly presented above are available online. The
Economic Freedom Index has an appendix which lists a selection of publications
that utilize the Index. Haan and Sturm (2000) is just one example of a study
which critically discusses the Economic Freedom Index.
The debate as to whether democracy causally induces higher economic
growth or higher economic growth leads to a demand for democracy, originates
from Lipset (1959). Przeworski and Limongi (1993) is a survey of empirical
studies. Acemoglu et al. (2014) is an attempt to prove that democracy does cause
growth, relying on up-to-date econometric tools as well as recently published
datasets. The modern classic arguing that extending the franchise leads to more
redistributive policies is Meltzer and Richard (1981).
Using settler mortality as an instrument for the quality of institutions has
been very successful, but has not remained without critics. For instance, Albouy
(2012) heavily criticizes the way in which Acemoglu et al. (2001) produced their
numbers; Acemoglu et al. (2012) is the response to these criticisms.
The most comprehensive study regarding the function and effects of envy is
by Helmut Schoeck (1987).
 The appendix tries to give you an impression of what econometrics is all
about. There are a host of very serious introductions to econometrics available. If
you want to read a funny one, I suggest you turn to Studenmund (2010). Angrist
and Pischke (2009) is a wonderful companion for people who want to use
econometrics and reassure themselves of the implied underlying assumptions.
How the science of statistics evolved is described amusingly in Salsburg (2001).

Appendix
A Ten-Minute Primer in Econometrics

Econometrics is the subdiscipline of economics that is concerned with the

measurement and statistical analysis of economically relevant variables.
Naturally, ten minutes are not enough to teach you everything that is taught over
several semesters in econometrics courses. Here, we will make you familiar with
some core ideas of econometrics.
Econometric techniques are used to empirically assess questions regarding
causal relationships. An example of a question highly relevant in the NIE could
be: “Does democracy cause growth?” To answer this question (or other
questions on causal relationships) a so-called randomized experiment would be
ideal. With regard to our question, this could mean making half of the world’s
countries democracies and the other half autocracies in a random fashion.
Because countries are chosen randomly, other factors – like their geographical
location, their resource endowment, and so on – are unlikely to distort the
findings. Econometricians would argue that under randomization, selection bias
is negligible or even non-existent. In other words, the findings would be
undistorted. Unfortunately, most real-world institutions do not allow for
randomized experiments. To answer the question whether democracy causes
growth convincingly, we would like to make half of the world democracies not
today, but 100 or 200 years ago to be able to ascertain possible long-term effects.
As time-machines have not been invented, such experiments are impossible even
with loads of research grants.
So choosing a convincing research strategy boils down to the question of
how closely one can mimic randomized experiments when drawing on natural
experiments or on existing observational data. Natural experiments are instances
in which institutional change was implemented thanks to “mother nature.” Some
exogenous event might take place that can be used to make causal inferences.
Earlier in this chapter, we argued that the way Germany was divided after World
War II, and the way their institutions were implemented in the two newly
established countries, was something like a natural experiment.
Even when we think hard about natural experiments that might be used to
establish a causal relationship, sometimes none will come to mind. In such cases,
most researchers proceed by relying on observational data. These come with
many problems, but econometricians have developed lots of useful tools to
mitigate these problems. Selection bias was already mentioned. The influence of
variables not taken explicitly into account (“omitted variable bias”), or the
possibility that growth causes democracy and not the other way round (“reversed
causality”), are other examples of such problems. The ways in which researchers
handle these problems are often called their identification strategy. The term
describes the ways in which observational data are used to mimic a real
experiment.
The final issue is concerned with the most adequate estimators given certain
properties of the conjectured underlying relationship (for instance, if it is linear
or not) and the data (whether the dependent variable is binary or not, for
example). In what follows, our intention is to give you a feel for the most
frequently used estimator in econometrics: ordinary least squares.
Assume we are concerned with the question whether body height is
correlated with body weight. Note that we do not speak of causation here but
simply of correlation. Further assume that we obtained information for some 100
students concerning their body weight as well as their height. In two-
dimensional space, we are then able to depict each student as a point which
reflects the respective combination of body weight and height. We conjecture
that body height and weight might be positively correlated, i.e., taller students
tend to be heavier. Looking at the scatter plot here, we find evidence in favor of
that conjecture. Say we are interested in knowing the expected weight difference
between two students of height 170 cm and 180 cm. In order to find that out, we
draw a straight line through the scatter plot. One common way of determining
the gradient of this line is the following rule: Draw the line such that the sum of
the squared differences between the respective data points and the line is
minimized. This method is called Ordinary Least Squares, often abbreviated
OLS.

In terms of a mathematical equation, what we just described can be

formulated as:

y=α+βx+ϵ
 y = α + βx + ϵ

where yy is the dependent (or explained) variable, in our example body weight.
In another context, the dependent variable could just as well be per capita
income or the rate of economic growth. xx is the independent (or explanatory)
variable, here body height. In another context, this might be the quality of
institutions or democracy. The value of ββ, which tells us about the slope of the
fitted line, is of primary interest. It tells us how strongly a change in xx translates
into a change in yy. However, it makes sense to assume that body weight is not
solely determined by height (in the same manner that economic growth is not
solely determined by democracy). For instance, bone structure (or the rate of
investment) might be another relevant factor. We can account for this additional
factor by expanding the above equation to:

y=α+βx+γb+ϵ
y = α + βx + γb + ϵ

Although we can no longer depict this relationship in two-dimensional space, the

estimation should be more precise. “Estimate” here means that we assume that
there is some “true” relationship between the independent and the dependent
variable in the real world and by drawing on the data at our disposal we try to
“estimate” this relationship as accurately as possible. What is the meaning of the
remaining Greek letters? αα describes the intercept. For instance, a positive αα
shows that even for a value of zero for xx (and ββ), the value of yy is still
positive. ϵϵ is the so-called error term and contains all that cannot be explained
by the explanatory variables.
To be able to “explain” the dependent variable, the independent or
explanatory variable needs to be “exogenous” from the model, meaning that its
value is not influenced by any other component of the model but comes from
outside the model. Until now, we have assumed that this is the case. But in
reality, it is often not the case. For example, to this point we have implicitly
assumed that good institutions (such as secure property rights) will cause faster
growth and higher income. But the reverse relationship might also be true,
namely, that only more affluent societies can “afford” to implement good
institutions. This is also called “reverse causality” which is a particularly severe
form of the absence of exogeneity (the “absence of exogeneity” is also referred
to as endogeneity). This problem is particularly severe with regard to
institutions. Institutions are never truly exogenous, as they are always man-
made. How do we resolve this quandary?
Econometricians have come up with a number of proposals as to how
endogeneity can be dealt with. Here, we focus on a particularly intuitive and
popular approach, called instrumental variables. The basic idea is
straightforward: If we are not sure whether the explanatory variable is truly
exogenous, we ask whether this variable is, in turn, determined by another
variable that could not possibly have been influenced by the dependent variable.
To illustrate, let us continue with the example from above. An adequate
instrument for “good institutions” would determine their quality but would be
completely independent from the assumed outcome, namely income. Acemoglu
et al. (2001) made an ingenious proposal for such an instrument. They assert that
European colonizers had very different incentives to set up good institutions
depending on the local mortality rate in the respective colonies. Their rationale is
that in areas with high settler mortality, colonizers were interested in becoming
rich quickly and then leaving the area. Thus, they had incentives to set up what
Acemoglu and his co-authors call “extractive institutions.” In contrast, in areas
where settler mortality was low, colonizers might really settle and develop a
long-term horizon, perhaps even thinking that their children and grandchildren
could also live there. They had, therefore, incentives to set up good institutions,
including secure property rights. It is easy to see that per capita income today
has no effect on settler mortality rates hundreds of years ago. Endogeneity can,
hence, be excluded, which is exactly the purpose of the instrumental variable.
Finally, a few hints on how to read econometric results tables. After
considering the number of observations (having more of them is better), it is
worth taking the time to look at the so-called coefficient of determination
(R2R2). Put simply, it tells us the percentage of the total variation in yy that can
be explained by the variation in the explanatory variables (here: xx and ββ).
What is central, however, is whether the estimated coefficient (ββ in the example
above) is “significant.” Economists distinguish between two kinds of
significance, namely statistical and substantive significance. The coefficient is
said to be statistically significant at the 5 percent level if the likelihood that it
was caused by a chance event is lower than 5 percent. Substantive significance
asks what the size of the coefficient means for the dependent variable. What the
coefficient means in a particular model depends on the coding of both the
independent and the dependent variable. Ultimately, economists are, of course,
interested in substantive significance. But they will only turn to it given that the
variable is statistically significant.

1 The distinction between correlation and causality is discussed in more detail

in the econometrics primer in the appendix to this chapter.

2In addition, the papers described in this section also take some other
econometric worries – such as endogeneity – explicitly into account. A little
more on these issues can be found in the appendix at the end of this chapter.

3Tocqueville (2003 [1840], 274) describes a society in which social descent is

not associated with stigmatization: “In the United States hardly anybody talks
of the beauty of virtue, but they maintain that virtue is useful and prove it
every day. The American moralists do not profess that men ought to sacrifice
themselves for their fellow creatures because it is noble to make such
sacrifices, but they boldly aver that such sacrifices are as necessary to him
who imposes them upon himself as to him for whose sake they are made.”
 6
Explaining Differences in External
Institutions across Societies
◈

6.1 Introductory Remarks

Chapters 6 and 7 comprise the third part of this book. In Chapters 2 to 4, we
assumed institutions – both external and internal – to be exogenously given and
inquired into the consequences for individual choices. In Chapter 5, we looked at
the consequences of different sets of institutions for economic growth and other
economically relevant indicators at the aggregate level. We attempted to explain
certain phenomena by differences in institutions. Hence, in Chapters 2 through 5,
institutions served as explanans.

Explanans: Explanatory variables

In Chapters 6 and 7, we shift our focus and investigate whether we can use
economic theory to explain the origins and changes in institutions. Institutions
are thus no longer exogenously given; instead, we now ask which incentives and
mechanisms might lead to the choice and change of institutions. Hence,
institutions now serve as explanandum. For purely practical reasons, we first
deal with external institutions, then with internal institutions. Simply put, there
has been more research into the origins of external institutions than into the
origins of internal institutions. If we were to proceed purely chronologically, it
would make sense to first deal with the origins of internal institutions. A great
number of institutions were internal institutions before evolving into external
institutions by collective action. Chapters 6 and 7 each cover “hot” topics in the
sense that over the last couple of years, much original research has been
published on the questions introduced here.

Explanandum: Explained variables

Explaining the origins and the change of institutions also involves questions
regarding groups of institutions that are closely connected to each other and that
as a group constitute a regime type. Democracies, for example, are made up of
dozens of different institutions, many of which deal with the ways in which
elections are to be held, popular votes are to be transferred into parliamentary
seats, the government is to be elected and so on. The rule of law as the attempt to
make everybody subject to rules that share certain qualities and are produced
according to a transparent and highly regulated procedure is another example.
Possible questions regarding these groups of institutions are: Under what
conditions are people likely to establish those institutions that make up
democracy? What are likely paths in the development of these institutions over
time? When will institutions be implemented that foster the rule of law? For a
long time, these questions were almost completely ignored by economists, but
this has changed in the last decades. From the point of view of traditional
economists, these questions seemed a bit aloof. At second glance, however, they
seem almost obviously relevant. After all, the democratic form of government
has been the exception throughout human history; still today, the overwhelming
majority of humans live in autocratic states. In Chapter 5, we saw that economic
freedom is directly related to income and economic growth. Thus, the questions
just posed are also economically relevant. Since the 1990s, there has been a
fundamental transformation in Central and Eastern Europe, and also elsewhere
in the world. Consider, for instance, the processes of democratization in East
Asia and Latin America. To make well-grounded policy recommendations to
policymakers in such states, we first require knowledge about the different sets
of institutions – or regime types – as well as about the difficulties inherent in
transitioning from one form to another. More generally, if we are interested in
successfully implementing a specific set of institutions, we need to be clear
about the factors that determine the presence – or absence – of those institutions.
Suppose some institutions were completely determined by factors beyond our
control, such as the climate or resource endowment. In such a case, trying to
create these institutions in inhospitable climates or in the absence of necessary
resources would be futile.

Under what conditions does democracy manifest?

Chapter Highlights

Critically discuss various theories on the emergence of private

property rights.

Understand how governments use the delineation of property rights to

further their own interests.
 Familiarize yourself with some “grand theories” purporting to explain
institutional change.

Get acquainted with the concept of institutional competition.

Have a look at the components that a “general theory of institutional

change” is likely to comprise.

This chapter is structured as follows. In Section 6.2, we discuss the traditional

theory of the development of property rights which has also been coined the
“naïve” theory. In Section 6.3, we present a theory that is less naïve, as it
explicitly accounts for political economy aspects, i.e., it takes the interests of the
relevant actors explicitly into account. In Section 6.4, we move from discussing
a specific group of institutions – property rights – to institutional aspects of
whole governments, that is, autocracies and rule-of-law states. The concept of
institutional competition is briefly discussed in Section 6.5. In Section 6.6, we
attempt to name the elements for which a general theory of institutional change
needs to account. Section 6.7 formulates open questions.

6.2 Origins and Change of Property Rights:

A Traditional View
In this section, we focus on the development of and change in a specific type of
institution that is crucial for economic development – property rights. When
economists think “high quality institutions” – they often think “secure property
rights.” This is why we begin this chapter by looking into how property rights
might have first emerged and then changed over time.
 Assume that a state exists and that, on a fundamental level, a decision has
been made to grant private property rights. All well and good. After such a basic
decision, a great number of details remain to be resolved such as goods possibly
exempted from being held as private property, the terms under which private
property rights can be exchanged, the responsibilities attached to property, and
so on. To begin with, it seems plausible (and innocent) to assume that the state is
interested in designing private property rights such that private actors are able to
conduct as many mutually beneficial transactions as possible. The better off
private actors are, the higher the national income, and, perhaps more important
to the state, the higher the tax revenues.
Since the 1960s, economists have been devising theories to explain the
origins of property rights, for example, the one by Harold Demsetz (1967),
which Eggertsson (1990, 249ff.) sees as part of a “naïve theory of property
rights.” Models found in this branch of theory refrain from explicitly modeling
the political process or the conflicting interests of the actors involved.
Demsetz’s (1967) central idea can be summarized in one sentence: (Private)
property rights develop if an internalization of externalities is associated with
social net benefits. Hence, the development of and change in property rights can
be due to at least two causes:

Property rights as result of a process of internalization

1. A change over time in externalities associated with some activity.

2. Due to technical change, internalization is possible at lower cost than

before.
Demsetz draws on the case of the Inuit in Labrador, Canada to illustrate his
theory. Originally, the Inuit hunted beavers only for subsistence. In the early
1800s, however, due to a sharply increased demand for beaver fur by the Hudson
Bay Company, the Inuit had an incentive to hunt more and more beavers. You
already know the resulting common pool problem. It is individually rational to
hunt beavers to the extent that the marginal revenue for fur just covers the cost of
hunting. Collectively, this result is not necessarily optimal, as the beaver
population might shrink over time, possibly even become extinct. Thus, it can be
socially optimal (“collectively rational”) to restrict beaver hunting in the present
in order to prevent beavers from dying out in the future and ensure that there still
will be beavers to hunt in the future.
As long as there are no exclusive rights to parts of the beaver population,
hunters have an incentive to “produce” a negative externality, that is, to hunt
more beavers than socially optimal. Internalization was possible in this case as
the cost of implementing private property rights, for instance, in the form of
fences, was lower than the expected benefits associated with it. “Putting up
fences” created private property rights to beavers – as well as the land on which
they lived – and excluded all non-owners from hunting beavers on grounds that
they did not own. Private property rights could also have developed if –
independent of beaver fur prices – the cost of erecting fences had decreased
through technological progress. Demsetz compares the development of private
property rights in Labrador with that of Native Americans in the southwest of
the USA. There, hunting animals was not associated with any commercial
activity. Instead, livestock that required a great deal of pasture space were
important. As there was no benefit to erecting fences in this environment, fences
were not built and no private property rights that would have enabled the owners
to exclude non-owners were created.
 You might have noticed that Demsetz does not explicitly model the political
process. There is no discussion of how the Inuit managed to overcome the
problem of collective action, or of what incentives the local government had to
support the creation of private property rights. Implicitly, this theory is based on
(at least) two problematic assumptions:

1. Governments are benevolent, that is, they have an incentive to design

property rights optimally.

2. Political transaction costs are zero.

In a paper that appeared eleven years later, Gary Libecap (1978) asks the same
question as Demsetz, but with regard to the emergence of property rights in
mining in the western part of the USA. He finds that changes in mining rights
occur as a response to increases in the value of mining resources, so his findings
are completely in line with those of Demsetz. His research deserves mention not
only because he relied on statistical analysis to arrive at his conclusions, but also
because the demand for more precisely defined rights is seen as a function of
how much the resource is valued. The explanations regarding the emergence of
private property rights and their change over time offered by both Demsetz and
Libecap can be interpreted as the view that institutions will adjust to changed
circumstances and that this adjustment will be towards the highest possible
degree of efficiency. Now, institutions do not adjust themselves but as a
consequence of relevant actors bringing change about. Before we proceed to
explanations taking the interests of the relevant actors explicitly into account in
Section 6.3, we turn to a contribution that puts measurement costs at center
stage. Here, change towards more efficient institutions was driven by
technological progress which made the precise measurement of both inputs and
outputs possible.
 Douglas Allen (2011) posits that the Industrial Revolution enabled an
“institutional revolution” that unfolded between 1780 and 1850. “Measurement”
costs play a central role in this theory. Allen argues that before the Industrial
Revolution, reliably measuring time – not to mention the weight of output – was
close to impossible. This makes any kind of cooperation in which time plays a
role costly: for example, meetings at a specific time are difficult to have if those
who want to meet do not have identical information about what time it is. Any
inputs based on time – such as the hourly wage rates covered in most modern
labor contracts – are impossible without being able to reliably measure time.
More generally, monitoring agents is extremely costly in such an environment
and other ways to constrain “cheating, fraud, embezzlement, theft, shirking”
(Allen, 2011, 11) are necessary. One result of the Industrial Revolution was a
significant decrease in measurement costs, thus making certain institutions
possible. Allen is particularly interested in public governance – the ways in
which the state supplies public goods – and argues that the modern public
bureaucracy, which is bound by general rules and largely based on merit, would
have been impossible prior to the Industrial Revolution.

Making sense of the strange mores of British aristocrats

The most fascinating part of Allen’s The Institutional Revolution is his

attempt to make sense of seemingly strange institutions that were in
place before the institutional revolution occurred. Seen from today, the
traditional mores and conventions of British aristocrats are anywhere
between appalling and outright strange or even comic. They used to live
in countryside mansions that were usually much too large for them and
more or less isolated from modern urban life. They socialized only with
each other, making the aristocracy a very homogeneous group. They did
not engage in any kind of traditional business such as buying and selling
goods. Instead, they spent a great deal of time on leisure activities. From
the outside, it might appear that they were just rather lazy parasites.
Allen explains that such an evaluation would be utterly wrong.
In a monarchy, the monarch needs agents that supply public goods,
for example, defense of the country or management of the law courts.
The monarch also, perhaps especially, needs tax collectors, which is,
essentially, the function of an aristocracy. If a public bureaucracy in the
modern sense is impossible (e.g., because of measurement costs, as
discussed above), there are two alternatives: either sell a public office to
the highest bidder or grant patronage to trustworthy aristocrats. Both
mechanisms have their pros and cons and which one is better is case-
specific.
Let us focus on patronage. Patronage essentially means that in the
event an aristocrat was caught cheating, the monarch had the power to
throw him out of the aristocracy. This, of course, could be a serious
threat only if such ostracism was really costly to those caught cheating.
And that is where the strange mores come in. First, to enter into
aristocracy, “fungible” assets had to be converted into assets that were
difficult to liquidate, hence the mansions that were usually much too
large. In the event an aristocrat was banished from the aristocracy, he
could not simply move to the city and start over as an ordinary person
because getting rid of these large mansions was extremely costly.
Making sure that aristocrats got rid of all their business interests ensured
that no attractive option outside of aristocratic life existed for them.
Making sure that aristocrats socialized only with each other ensured that
once removed from the group, a former member would no longer have
any friends, with all that that implies. And so forth. In economic terms:
 By incurring sunk costs and deliberately creating hostage capital,
aristocrats were able to credibly signal their loyalty to the monarch. The
price of being caught stealing or shirking was so high, it virtually
guaranteed that they would not engage in such behavior.

Allen’s “institutional revolution” is fascinating, but not entirely convincing. The

technological advances that accompanied the Industrial Revolution were not
confined solely to the West, and yet the institutional revolution only took place
there. There does not seem to be any plausible reason why the general trend
towards ever more efficient institutions would occur only in the West. And, of
course, we have presented his approach in this section because political economy
considerations are largely absent from his account.

Critique

As mentioned before, this view of institutional development has been called

“naïve” (by Eggertsson, 1990, 249ff.); I prefer to call it the “efficiency view” of
institutions. It is based on the assumption that if the value of a resource increases
and it makes sense (“is efficient”) to clarify ownership by creating property
rights, this will happen. However, there is no attempt to explain the mechanism
through which this occurs. At the extreme, such a view implies that we are living
in the best of all possible worlds, a doubtful proposition at best, given the
poverty and hunger so prevalent across the globe. And yet, such efficiency
arguments continue to be made, most forcefully by Donald Wittman (1995) who
claims that political institutions are efficient in democracies. In Section 6.5, we
present and discuss a mechanism that is said to lead to more efficient institutions
everywhere and that has been discussed extensively over the last 20 years or so,
namely, institutional competition.

6.3 Origins of and Change in Property

Rights and the State: Accounting for
Political Economy Factors
In his 1981 book Structure and Change in Economic History, Douglass North
develops a theory of the state that focuses on the exchange relations between
representatives of the state and the populace. He begins with a paradoxical
observation: On the one hand, the existence of the state is a necessary condition
for economic growth, but on the other, the existence of the state is also a source
of economic decline (North, 1981, 20). North’s theory goes beyond the naïve
theory of property rights, because, according to North, the state is often
responsible for inefficient property rights that do not fully exploit a society’s
growth potential. North uses his theory to explain the origins of inefficient
property rights regimes, i.e., a delineation of property rights that does not lead
to maximizing national income. By accounting for political economy factors,
North explicitly takes the interests of those running the state into account. This is
why this section is broader than the previous one and includes the state as a
subject of analysis.

Why are property rights often designed suboptimally?

North defines the state as an “organization with a comparative advantage in

violence, extending over a geographic area whose boundaries are determined by
its power to tax constituents” (North, 1981, 21). Although property rights are not
explicitly mentioned in this definition, a connection between the state and
property rights is easy to establish. Property rights entail the right to exclude
others from use. An organization with a comparative advantage in the use of
force is capable of delineating and enforcing private property rights. One central
condition for productive domestic exchange of goods is to keep invaders away
from the state’s territory, which has long been recognized as one of the state’s
fundamental functions. North (1981, 21) even claims that it is impossible to
develop a useful theory of the state divorced from property rights.
According to North, all theories on the existence of the state can be
assigned to either of two groups: contract theories (à la Hobbes) or predatory
or exploitation theories (à la Marx). As we just saw, theories regarding the
development of property rights are closely linked to theories of the state.

Contract theories vs. predatory exploitation theories

Note

Contract theories are based on the notion that societies collectively agree
on a social contract that specifies how they will live together. Predatory
exploitation theories are based on the notion that some parts of a society
are able to increase their wealth at the expense of other parts of society
(thus “exploitation”).

The central idea of contract theory à la Hobbes is compatible with economic

arguments: All members of society will be better off by avoiding a state of
anarchy in which life is “solitary, poor, nasty, brutish and short” (Hobbes, 1982
[1651]). They can do so by subordinating to a ruler whose authority is limited by
a social contract. Hobbes assumes that the physical capabilities of individuals are
not so unevenly distributed that one member of society – or a very small group –
is able to impose his ideas on the rest of society. The normative branch of
constitutional economics builds its central idea on the notion of a social contract.
All members of society can be made better off if they voluntarily give up their
(implicit) right to fight, since fewer resources need to be spent on stealing
others’ goods and protecting one’s own goods. James Buchanan is the best-
known advocate of this approach in economics.
In contrast to Hobbes, Marx assumes, first, that common interest within
different social groups (“classes”) leads to collective action and, second, that in
every historical era, one class has been able to enrich itself at the expense of
other classes. For instance, in capitalism, the capitalists exploit the working
class. Predatory theories are quite popular among institutional economists:
Daron Acemoglu and his various co-authors, for example, always start from the
assumption that a small elite runs the state attempting to maximize its rents from
doing so. But North and his various co-authors also rely heavily on predatory
theories of the state. For them, changes of property rights are a consequence of
changes in the bargaining power of the ruling elites vis-à-vis the non-ruling
masses. Technological progress – and in particular technological progress
regarding military technology – is an important determinant of bargaining power.
According to North, both groups of theories have their benefits and
drawbacks. Contract theories emphasize the advantages resulting from the initial
social contract, but tend to ignore later interactions. Predatory exploitation
theories emphasize the potential for exploitation by those who control the state,
but ignore the advantages that can result from the existence of the state.
 The model proposed by North is based on the assumption that all
individuals maximize their utility and is characterized by the following three
properties:

1. The state exchanges several services (protection, justice) for revenues.

Because the production of protection and justice exhibits economies of
scale, the state is able to provide these services at lower costs than the
citizens. This implies that the overall income of society is higher if a state
exists.

Note

Economies of scale exist if production output can be doubled without

having to double production inputs.

2. The state and its representatives attempt to behave like a discriminating

monopolist, and thus try to tax different social groups according to their
inability to avoid taxes in order to maximize government revenues.

3. Maximization of state revenues is subject to a restriction: There are

other states, but also individuals within state territory, that are willing to
provide the same services as the state. The easier it is to substitute these
suppliers for each other, the narrower the scope of actions available to state
representatives.

The services offered by the state include, among other things, the design of
property rights and their enforcement. The governing actors are interested in
maximizing their revenues and thus design property rights accordingly. If
national income can be maximized by reducing transaction costs, rulers will go
for it because this leads to an increase in their tax revenues. According to North,
this implies that the state will provide several public goods. However, the nexus
between lower transaction costs and higher tax revenues frequently does not
hold. From the state’s just mentioned objectives, North derives three
implications (1981, 24f.). Only two of them are relevant here:

1. Maximizing tax revenues is frequently incompatible with maximizing

national income. If such friction exists, rulers will opt in favor of
maximizing their rents – and inefficient property rights will result.

Example

Here is an example for a conflict between maximizing the rents of the

ruler and maximizing societal welfare. Granting a corporation a
monopoly in the production of certain goods – examples range from
lighters to high-tech weapons – is likely to be suboptimal from the point
of view of national income: there will be little competition. High prices
and little innovation are the likely outcomes. A ruler might nevertheless
be interested in granting such monopolies because taxing a very small
number of monopoly firms is a lot easier than taxing many small
competing firms.

Also, if powerful constituents can threaten to move to another state or to stay

and throw out the current ruler, the ruler has incentives to discriminate between
subjects and to offer more favorable property rights to the relatively more
powerful. According to North, these are the two main reasons why states so
often provide inefficient property rights.

2. Specification and enforcement of property rights require that state

representatives delegate part of their power to agents. This implies that the
 principal–agent problem you encountered in Chapter 3 comes into play.
You can also think of the strange mores of the British aristocracy that were
described earlier as the means by which the British king tried to mitigate
some of the principal-agent problems that North has in mind.

For many rulers, granting monopoly rights is attractive

Based on the observation that collective action often occurs even in the
presence of widespread free-riding, North derives several conclusions and open
questions for his model. He summarizes his conclusions thus:

1. The stability of states can, inter alia, be explained by the difficulties

associated with overcoming the problem of collective action.

2. Institutional change is primarily initiated by the rulers, not the ruled, as

the latter are not able to overcome free-riding problems.

3. Revolution will originate within the ruling class, not on the streets. In
such revolutions, the existing ruler is exchanged for a different ruler from
the elites.

4. If the ruler is the agent of a social group or class, succession rules will be
in place so as reduce the probability of violent regime change after the
ruler’s death.

Finally, North suggests that a theory of ideology is necessary to explain under

what conditions the problem of collective action can be solved and under what
conditions there is no solution.

Ideology
 Merriam-Webster defines ideology, inter alia, as “a manner or the
content of thinking characteristic of an individual, group, or culture.” For
North, ideologies are key to understanding human behavior. In Structure
and Change in Economic History (1981, 48), he describes ideologies as
“intellectual efforts to rationalize the behavioral pattern of individuals
and groups.” He emphasizes three functions of ideologies:

1. They are an instrument of economization with which individuals

can reduce decision costs.

2. They are indissolubly linked to moral and ethical judgments

about fairness.

3. They are changed when they are not consistent with individual
experiences.

North stresses, in multiple publications, the crucial importance of

ideologies in explaining human behavior (e.g., North, 2005). Some of his
insights regarding the relevance of ideas are taken up in Chapter 7.

There is a clear difference between the naïve theory of property rights presented
in Section 6.2 and the theory presented here: North offers convincing arguments
why rulers might have an incentive to design property rights suboptimally,
implying that with a different delineation of property rights, national income
could be higher.

6.4 Explaining Differences in Institutions

6.4.1 Preliminary Remarks
For a long time, economists assumed that their results were valid irrespective of
the type of regime in place. They assumed, in other words, that it did not matter
whether the country was ruled by an autocrat or democratically. In the 1950s,
several economists began to ask whether one might be able to explain political
processes using the economic approach. This was the birth of public choice
theory, a research program that began in the USA and spread from there to
Western Europe. Given the history of the economic theory of politics, it is
understandable that most scholars in this field initially analyzed different
institutional arrangements within democratic systems. Thus, the fundamental
assumptions of early public choice theory included (a) that regimes were given
and (b) that they were democratic.
There are many explanations for why institutions vary so widely across
countries. Consequently, there are also many explanations of regime change. I
distinguish between three approaches used to explain these differences here:
approaches based on geography (Section 6.4.2), approaches based on culture or
history (Section 6.4.3), and approaches based on the social conflict view
(Section 6.4.4). The explanations do, of course, overlap sometimes, but they are
distinct enough that sorting them this way has some value. The following
sections can be brief because we touched upon these issues already in Chapter 5.

Geographic conditions can impact the likelihood of state formation

6.4.2 Explaining External Institutions Based on Geography

In Chapter 5, we saw that the quality of some institutions can be explained by a
country’s resource endowment. There, climate and soil, the disease environment,
whether a society had access to the sea or was landlocked, and even the
orientation of continents were mentioned. Here, we go one step further and ask
whether differences in geography can explain even the emergence of states as we
know them. Moselle and Polak (2001) ask how the development of states can be
explained at all. After all, it is by no means self-evident that historical processes
would always lead to the emergence of a single actor or organization enjoying a
de facto monopoly in the use of violence. In countries such as Afghanistan,
Rwanda, or Somalia, the use of violence is not a government monopoly. Indeed,
the phenomenon of failed states is evidence that development towards a state in
the modern sense is by no means certain or guaranteed. Moselle and Polak argue
that the probability of state development varies across different regions of the
world and that statelessness is more likely in lowlands and steppes than in hilly
and fertile regions, as the former are harder to protect. Moselle and Polak use
this idea to explain why there were so few states in pre-colonial Africa. This
approach is thus more interested in explaining the absence of a set of institutions
that make for what we call a state, rather than the existence of a particular set of
them.

6.4.3 Explaining External Institutions Based on Culture or History

It is possible that some of the large differences in external institutions across
countries are due to the history of those countries. Certain historical events
might have very long-lasting effects. This would imply that the external
institutions prevalent in a country today are a consequence of external
institutions possibly implemented hundreds of years ago. Today’s external
institutions might also be determined by the internal institutions that were valid
in a country a long time ago. As a sort of shorthand, one can refer to this as the
effect of culture on external institutions. Let us first look at (historical) external
institutions that have an influence on today’s external institutions.
 Historic external institutions can impact today’s external institutions

Being invaded or even colonized by another power is likely to have

important effects on a country’s institutions. One important example in which
the identity of the colonizer still matters today – often decades or even centuries
after colonization occurred – is the country’s legal system, or, in other words, the
external institutions of a country in their entirety. Legal scholars divide the
world’s legal systems into a very limited number of legal families. Aside from
legal systems based on religion (such as Islamic or Hindu law), the first
important distinction is between the civil law and the common law family. Under
civil law, law is almost exclusively produced by legislators and the role of
judges is limited to “la bouche de la loi” (the mouth of the law). Under common
law, the role of the judge is much more important. Should there be gaps in
legislation, it is the judges who fill them with their decisions. Therefore, this
kind of law is often referred to as case law. Rules regarding court procedure
differ widely under the two families. Under common law, the adversaries
themselves accuse or defend. As a consequence, lawyers and their strategies play
an important role. Under civil law, it is the judge who questions the parties.
The common law emerged in England. Today, England and most of its
former colonies are coded as belonging to the common law family. This includes
countries such as Australia, Canada, and the USA, as well as Bangladesh, India,
and Pakistan, among others. Regarding civil law, many scholars propose a
tripartite division into French, German, and Scandinavian, of which the French
has been most influential. In Europe, countries such as Italy, Spain, and Portugal,
as well as the Netherlands, are coded as belonging to this group. Since Spain and
Portugal exported their laws into their colonies, virtually all of Latin America is
said to belong to the “French civil law” family. There is also socialist law, which
is based on the idea that productive resources should not be the property of
individuals but the state.
In a series of articles, Rafael La Porta and his co-authors show that being
part of a particular family of law has important consequences for a wide variety
of institutions, including how difficult it is to set up a new firm (more difficult in
French civil law countries), the degree to which the media is owned by the state
(higher in French civil law countries), the regulation of labor (more difficult to
fire people under French civil law), and so on. The authors find that countries
belonging to the French civil law family come out worst, a view well
summarized by former US President George W. Bush when he said: “The
problem with the French is that they do not even have an own word for
entrepreneur.” Given that the French civil law countries usually come out worst,
one might expect them to be the slowest growing. However, although there
seems to be a strong link between a country’s colonization experience and many
of its currently valid institutions, there is no strong link between these
institutions and the speed at which the economies in the various countries grow.
The papers on legal origins are among the most cited of all papers in economics,
but they are also among the most criticized. For example, Daniel Berkowitz and
his co-authors (2003) argue that the way the law was initially transplanted and
received is a more important determinant than affiliation with a particular legal
family. They claim that the origin of a legal system is not a good predictor for
the actual implementation of the law. The authors consider as far more important
whether the law was transformed according to the specific situation of a society,
whether it was imported voluntarily or enforced by a colonial power, and so
forth. According to their findings, countries that have developed legal orders
internally or adapted transplanted legal orders to local conditions and/or had a
population that was already familiar with the basic legal principles of the
transplanted law have more effective legal rules than countries that received
foreign law without similar predispositions.
When in 1972 Chinese Prime Minister Chou en Lai was asked about the
impact of the French Revolution, he is said to have answered: “It is too soon to
tell.” Now, Daron Acemoglu and his co-authors (2011) believe that the time for
definitive answers has come. They ask whether countries that were invaded by
the French were observed to grow faster because the French implemented radical
institutional reform that enabled the Industrial Revolution to take off. Examples
of such reforms include drastically reducing the power of the landed aristocracy
and breaking up cartels, such as merchant guilds, that made it very difficult or
even outright impossible for outsiders to enter a market.
Around the turn of the nineteenth century, Germany was made up of dozens
of rather small states. Some of these were not only invaded by French armies but
the French also implemented far-reaching institutional reforms in them. These
are the states that were “treated” by the French. There were also numerous
German states – primarily in the east and south of the country – that were not
invaded by the French and can be thought of as “untreated.” Acemoglu and his
co-authors compare the development of the treated with that of the non-treated
German states. As a proxy for income and wealth, they use urbanization rates
(defined as that part of the entire population that lives in cities with 5,000 or
more inhabitants). They find that urbanization rates in treated areas start to
diverge significantly from those in untreated areas only after 1850.
In Chapter 5, we learned that Acemoglu and his co-authors believe that the
colonization history of a country can have persistent negative effects on its long-
term development. If the disease environment made survival difficult, colonizers
were likely to establish extractive institutions that enabled them to take a great
deal of wealth out of the country in little time. Countries that were so “treated”
still have problems developing. With regard to the French Revolution, the
authors show that development-enhancing treatments are also possible. Their
message is clear: powerful players are free to set and implement external
institutions at their discretion. These institutions are the most important single
determinant of future economic growth.
This approach is not without its critics. There are many scholars who
believe that external institutions, at least to some degree, need to rely on internal
institutions. If this is true, then the power to improve people’s lot in a short time
by importing external institutions that function well elsewhere might be severely
constrained. There are many historical examples of not only foreign powers, but
also domestic revolutionaries, attempting an extreme overhaul of institutions that
failed miserably. Gregory Massell (1968) recounts the story of how the Soviets
tried to make the populations in their central Asian republics give up the Sharia
– and how their efforts ended in almost complete failure. Berkowitz et al.’s
(2003) observation that legal transplants are more likely to be successful if they
are adapted to local conditions was mentioned previously. A more recent
example, and a cautionary tale, is that of the USA – and other Western powers –
spending billions and billions of dollars and sacrificing the lives of hundreds of
soldiers to implement external institutional institutions conducive to growth and
development in Afghanistan and Iraq. As of now, it seems that these efforts have
had very limited success.

6.4.4 Explaining External Institutions Based on Social Conflict View

All of the “social conflict” explanations assume that different actors have
different interests and that their interests would be best served by different
institutions. In that sense, these different actors, or groups of different actors, are
thus in conflict with each other. However, this conflict is only partial because
they would all be worse off if no cooperation between them took place. In game
theory terminology, the game they are playing is, hence, a mixed-motive game.
On the one hand, there are advantages of cooperation, in that everyone will
obtain at least some benefit. On the other hand, there are disadvantages to
cooperation, the chief of these being that no one is going to get exactly what he
or she wants.
Institutions have distributive consequences. In all likelihood, different
institutions will make some people worse off – and others better off. Those who
are satisfied with the currently valid institutions are unlikely to demand major
change, whereas those who believe that the currently valid institutions are
unfavorable to their interests are likely to favor change. The chances of getting
one’s most preferred institutions are assumed to be a function of one’s
bargaining power vis-à-vis the rest of society.

Note

Bargaining power can be defined as the ability and willingness to inflict

costs on others and thereby reduce the total social surplus.

The currently valid institutions can be thought of as reflecting the relative

bargaining power of the relevant groups. As long as their relative power remains
unchanged, the institutional status quo can be considered an equilibrium.
Institutional change becomes more likely when the bargaining power of a
particular group improves relative to the bargaining power of other groups,
which could occur, for example, as the consequence of technological change.
It is important to realize that not all individuals who share the same
interests manage to become groups. The difference between latent and actual or
manifest interest groups is pointed out by Mancur Olson (1965) in a rightly
famous book. We have already relied on some of Olson’s arguments in Chapter
4; here, we present the core of his book in a little more detail.

On the organization of consumer and producer interests: the

collective action problem

In Chapter 4, using the example of the dam, we saw that the voluntary
provision of a public good by those who benefit from it is rather unlikely.
The individual hopes that the sum of voluntary contributions by
everyone else is sufficiently high to ensure provision of the public good.
But because all individuals share this expectation, no public good will be
privately provided. In reality, however, certain groups are able to
overcome the collective action problem. Olson (1965) describes in which
situations this is more likely to occur.

1. When public good provision is coupled with the provision of a

private good that can be consumed only by those who contribute to
the public good. For instance, the public goods bundle provided by
labor unions – improved wages and working conditions – can also
be consumed by non-members. However, labor unions often
additionally provide private goods such as insurance and consulting
services that are limited to their members. If access to these private
goods is attractive, there can be sufficient private incentive to join
and thus contribute to the costs of providing the public good.

2. When there is compulsory membership. For example, perhaps

you can work for a firm only if you are a union member (a closed
shop). This is not necessarily a convincing condition for (initially)
 overcoming the collective action problem, but a mechanism with
which the continuity of an already existing organization can be
ensured. Compulsory membership presupposes legislative action or
a general agreement with the employer. Both require that the labor
union has already overcome the collective action problem and,
furthermore, that it possesses significant strength. Otherwise,
legislators or employers would not have consented to the institution
of compulsory membership.

3. Low number of involved individuals. It is immediately clear

that the provision of the dam is more likely if five farmers attempt
to set it up than if 500 farmers try to do so. As soon as one of the
five is not cooperative, the other four can (informally) sanction him
much more easily than 400 farmers could sanction 100 farmers
because it will be more difficult for 400 than for four farmers to
coordinate their behavior.

The latter argument implies that there is an asymmetry in the

organizability of interests. Since in general, the number of producers is
lower than the number of consumers, producer interests are easier to
organize than consumer interests. Beside the number of involved
individuals, the importance of producing a particular collective good for
the utility level of the potential providers might play a role: For farmers,
subsidies to milk production can be existentially important so they seem
to be more likely to overcome the problem of collective action. On the
other hand, consumers usually spend only a very small part of their entire
budget on agricultural products. Trying to set up the “organization of
milk drinkers” to give weight to consumer interests appears, therefore,
rather unlikely.
Olson’s theory thus predicts that only a few groups are likely to overcome the
problem of collective action. The number of manifest interest groups is likely to
be limited, and the number of those groups commanding veto power will be even
smaller. This view of institutional change is elaborated on in Voigt (1999a).

External institutions reflect the relative bargaining power of competing

groups of society

Daron Acemoglu and James Robinson (2005) proffer a similar explanation

of regime change. They distinguish between two groups: the powerful elites and
the less powerful non-elites. The non-elites demand a distribution of the
collective surplus that is more favorable to them. If their threat to stage a
revolution appears credible, the elites have an incentive to start negotiations and
make at least some political concessions to the non-elites. The credibility of
threats can change over time, for example, because the non-elites overcome the
dilemma of collective action, because of technological progress that makes their
input more valuable, and the like. Acemoglu and Robinson assume that
negotiations take place and the two groups agree on a modified constitution that
entails a larger share of the collective surplus for the non-elites. At this point, the
elites face the problem of being unable to credibly commit to their own
promises. If the non-elites are demonstrating in front of the palace, the elites
have an incentive to promise improvement. But why would they keep their
promise once the heat of the moment has passed and demonstrators are back at
home?
According to Acemoglu and Robinson (2005), democracy can serve as a
tool that helps the elites turn their promises into credible commitments. If most
voters are poor, they are likely to vote in favor of (re-)distribution, for example,
in the form of social and welfare policies. Extending the right to vote to the poor
can thus serve as a commitment device of the elites. Extending the right to vote
to ever more groups of society is equivalent to an extension of democracy. The
authors thus view the transition from autocracy to democracy as the elites’
response to threats from the non-elites. In an extended version of their model, a
third group – the middle class – is introduced. If it is sufficiently large, more
gradual institutional change becomes possible – and also likely.

Democracy as a tool of the elite to make commitments credible

Douglass North, John Wallis, and Barry Weingast (2009) (hereafter, NWW)
have published no less than a “conceptual framework for interpreting recorded
human history” – the subtitle of their book. They start from the observation that
violence has been a major problem for most societies for the whole history of
mankind. In other words, more often than not, there has not been a state, at least
not one that meets Max Weber’s definition, i.e., an organization commanding a
monopoly of legitimately using violence. NWW propose that human history has
known only three types of social order: (1) foraging, (2) limited access, and (3)
open access.
Under this framework, explaining institutional change implies explaining
the transition between these three orders. I here focus only on the transition from
(2) to (3). Limited access orders are based on personal relationships and the
ability to form organizations is limited. In limited access orders, violence is
controlled by relying on a dominant coalition. Members of the dominant
coalition share the rents that emerge from the absence of violence. In open
access orders, cooperation between individuals is based on impersonal
institutions that treat all individuals alike. Positions in both politics and the
economy are open to everyone and are allocated according to merit. All
individuals have the right to found political or economic (e.g., corporations)
organizations. In open access orders, all violence is controlled by the state and
the military is under civilian control. The authors group the overwhelming
majority of today’s countries into their second category. Roughly speaking, only
the (more established) OECD countries are believed to be open access orders.
NWW’s take on the transition from limited to open access orders
emphasizes that doing so must be in the interest of the overwhelming majority of
the players who make up the dominant coalition. When the elites in the limited
access order become able to deal with each other impersonally, then that society
will be on the threshold of becoming an open access order. NWW identify three
threshold conditions: (1) the rule of law for elites, (2) perpetually existent
organizations in both public and private spheres, and (3) consolidated control of
the military by politics. If the vast majority of those members of the elite who
form the dominant coalition realize that they can make themselves better off – in
interactions with each other – by not relying on personal relationships but on
general rules, they will be in favor of what NWW call “rule of law for elites.”
This sounds like a contradictio in adiecto, but what they really mean by the term
is that no member of the elite enjoys particular privileges; all of them are treated
according to the same rules. However, these rules for the elite are not
necessarily, indeed not probably, the same rules by which everyone else has to
live, hence the awkward-sounding term “rule of law for elites.”

When rent seeking is beneficial

In Chapter 4, we saw that rent seeking is conventionally interpreted as

wasteful. Lobbyists not only invest resources into lobbying politicians
 that could be spent more productively, but the rules that they lobby for
are in all likelihood detrimental to overall welfare. NWW propose a
different take on rent seeking: according to them, sizable rents are a
precondition for holding the dominant coalition together. As soon as one
of its members suspects that it is not receiving the rents it deserves, this
member might turn to violence – which is likely to make most everyone
worse off.
This idea can be extended even further: all groups that aim to
change institutions in such a way that they will be getting a better deal
can be viewed as seeking rents. Now, if ever more groups manage to
overcome the dilemma of collective action and, in the end, the
overwhelming majority of citizens are represented by at least one such
group, then it is not unlikely that they will be able to agree only on
general rules according to which all citizens are dealt with in a like
manner. This is nothing else but the rule of law. In other words, even rent
seeking can foster the rule of law and be hugely beneficial (Voigt,
1999b).

The main difference between NWW and Acemoglu and Robinson is that the
latter basically rely on two actors (the elite vs. the non-elite), whereas the former
model the elite as a coalition of a multitude of actors. In their explanation of
transitions, NWW focus on the bargaining that takes place within the dominant
coalition, hence explicitly giving up the monolithic actor assumption relied on
by Acemoglu and Robinson.
There are other theories regarding the transition from an authoritarian to a
non-authoritarian regime. Assuming that such a transition is socially beneficial
and that revolutions waste resources, a non-revolutionary transformation path,
such as a negotiated transformation pact, seems superior, although fraught with
difficulty. Sutter (1995) describes a punishment dilemma that the new (non-
authoritarian) government faces vis-à-vis the former (authoritarian) government.
Before taking over, the new government has an incentive to assure the autocrat
exemption from punishment. As soon as the new government is in power,
however, the population might demand that the former autocrat be punished.
Anticipating this, autocrats have an incentive to block a peaceful transition away
from autocracy. This implies that an optimal political rule is time inconsistent
with respect to dictators (you know about this problem from Chapter 4, where
we discussed it in relation to political business cycles). To explain: In order to
prevent potential dictators from becoming actual dictators, they have to be
threatened with drastic punishments. Ex ante, the optimal rule would thus
contain a serious punishment threat. As soon as a dictator has taken over – and
society would like to get rid of him – it would be desirable to be able to credibly
assure exemption from punishment in order to ensure a peaceful transition to a
non-authoritarian regime. Ex post, the optimal rule would, hence, only threaten
very moderate punishment.

When citizens prefer less – rather than more – separation of powers

In general, it is plausible to assume that citizens prefer more, rather than

less, separation of powers. If various political actors have only limited
powers, misuse of power seems less likely and citizens will consequently
be better off. Interestingly, Acemoglu et al. (2013) identify settings under
which voters have an interest to dismantle checks and balances. Their
model assumes that there are two groups in society, namely, the rich and
the poor, and the poor outnumber the rich. If checks and balances
function well, the executive’s discretion is low, as is its overall income.
 This enables the rich, who are assumed to have solved their collective
action problem, to bribe government into policies furthering the interests
of the rich. In such circumstances, the poor might prefer fewer checks
and balances; because the overall income of the executive will increase,
bribing it will be more difficult, implying that policies are closer to the
preferences of the poor. Acemoglu et al. (2013, 859) point out that this
result is likely in “weakly institutionalized states,” which are described
as states in which “the rich lobby can successfully bribe politicians or
influence policies using non-electoral means.”

The theories presented here emphasize different aspects of regime

transformation. We have not presented a comprehensive theory of regime
transformation because there is none. In the following section, we discuss a
particular approach to explaining institutional change that focuses on the
diffusion of institutional change across space.

6.5 Institutional Change via Institutional

Competition?
In Section 6.2, we discussed the naïve theory of property rights emergence. One
reason why this theory still has many supporters although it is seen by some as
naïve could be the mechanism invoking institutional change that is described in
this section. Douglas Allen – the same author who makes sense of the seemingly
strange habits of British aristocrats – justifies the view of institutions as efficient
when he writes: “in the Darwinian struggle between nations, firms, and
individuals, societies are driven to find institutions that get the job done best
under the circumstances faced at the time” (Allen, 2011, xi). In other words,
entire societies can be seen as in competition with each other and only those
whose institutions are halfway efficient will survive or prosper.
Although the notion of “institutional competition” can be traced back at
least to Kant and Montesquieu, economists consider an essay by Charles Tiebout
(1956) as the cornerstone of the notion concerned with the diffusion of
institutions across space. The basic idea is very simple: It is not only the
suppliers of traditional goods that are in competition with each other, but also
the suppliers of bundles of public goods. Following Tiebout (1956), mayors can
be thought of as providing bundles of public goods that cater to citizens. Citizens
are then assumed to move to the place that offers that bundle of public goods
which best suits their preferences. (Local) institutions can also be thought of as
public goods. This is why Tiebout’s theory is directly relevant here. If a mayor
now observes that other mayors are able to attract more citizens (or firms, or
foreign investment, etc.), she is assumed to have incentives to improve the
quality of the institutions offered by her. There is, hence, a competition for
citizens and one important action parameter are institutions. Therefore, this
process is often referred to as “institutional competition.”
In economics, this idea was first raised in regard to the competition between
local entities within a country but is now found in the context of nation-states
competing for (scarce) mobile resources. Here, the owners of mobile resources
are interpreted as representing the “demand side” for an institutional
environment that allows them to reap the returns on their invested capital.

Governments are also in competition with each other

There are two opposing views on institutional competition. On the one side,
it is argued that institutional competition can lead to more effective control over
governing agents, as the competitive process forces the governing agents to give
more thought to the preferences of the governed (see, e.g., Besley and Case,
1995). On the other side, it is argued that institutional competition might lead to
a race to the bottom: If capital keeps moving to where its returns are highest,
states might not enact regulations that are costly to mobile firms (such as
environmental regulation), and also reduce social and welfare spending (such as
social policy) (see, e.g., Sinn, 1997; see also Mueller, 1998).
Following Albert O. Hirschman (1970), the migration of mobile resources
is called exit. Further, it is assumed that exit leads to loss of popularity of the
government and that the latter thus has an incentive to adjust public goods
bundles such that there is a net inflow of mobile resources. Another mechanism
for effecting changes in public goods bundles, also according to Hirschman, is
voice. Voice means that those who are negatively affected by some policy
choices speak up and demand improvement. If we assume that – due to
globalization – relocation of one’s assets to another country is much easier than
was the case in the past, voice might be sufficient to achieve changes in the
supply of public goods because the threat of exit is much more credible in the
presence of low mobility costs.
Proponents of the first view of institutional competition often posit that
institutional competition increases social welfare by inducing less efficient
institutions to be replaced with more efficient ones. Viktor Vanberg (1992, 111)
argues that two conditions must be fulfilled in order for institutional competition
to be socially beneficial. First, it must be possible to try out potentially beneficial
institutional innovations in order to ensure that they are likely to be factually
implemented. Second, there needs to be a mechanism of selective retention that
reliably eliminates errors, meaning that less efficient practices (routines, tools)
are systematically replaced with efficient ones. This is, therefore, an
evolutionary view of institutional competition. To show that institutional
competition is socially beneficial, one needs to be able to identify the
mechanism through which selective retention takes place.

Conditions for institutional competition to be socially beneficial

Although the analogy between goods competition and competition with

regard to public goods bundles seems convincing at first sight, there are at least
two problems with this analogy:

Problems of the analogy

1. Characteristics of goods.

Competition in goods has to do with individual goods. If supplier and buyer can
agree on a price and conclude a contract, mutually beneficial exchange is
possible. Conversely, institutional competition refers to public goods that are
often intangible. Individual willingness to pay is not sufficient for the provision
of such goods. Rather, collective action – based on collective decision-making
rules – determines which bundles of public goods are actually provided. As
soon as one deviates from the unanimity rule with regard to all individual
constituent goods, it can happen that the public good is a collective “bad” for
some individuals, if only for the reason that they have to pay for its provision
without ever utilizing it. If I hate soccer and all gatherings of soccer fans but am
forced to support the sport because part of my tax bill is used to support it, I
might well perceive this good as a “bad.”
The possibility of exit is only partially relevant, as the same structural
problem is equally present in other jurisdictions. A different picture would
emerge if an individual could assemble his or her own individual “menu” of
public goods from a variety of suppliers.

2. Communication of preferences.

Following the terminology of Hirschman, the demand-side preferences are

communicated to the supply side via exit and voice. Within the realm of regular
goods competition, buyer exit requires some interpretation on the supplier’s side,
as the buyer usually does not specify a reason for exit. With respect to
institutional competition, exit requires a lot more interpretation. After all, the
institutional supply side is only one factor determining the expected returns to
mobile resources. In the final investment decision, many other, non-institutional
factors also play a role, for instance, the number of potential consumers and their
purchasing power.
Voice is unlikely to have any effects if it does not occur collectively.
Individuals who observe a deterioration in the quality of the provided bundle of
public goods will be able to do something about it only if they are able to
overcome the problem of collective action (Olson, 1965). Due to the
asymmetric organizability of interests, only certain preferences are articulated
via voice. Often, this results in institutions being changed in the manner
suggested or demanded by the organized actors. It appears problematic to claim
that institutional competition closes the gap between politicians and voter
preferences because “the” preferences of the voters might not even exist.
Finally, the signals sent by exit and voice are not always crystal clear. We
already stated that the signals induced by institutional competition usually
require more interpretation than signals in simple goods competition. Due to the
combination of public goods characteristics and the asymmetric organizability of
interests, it seems questionable whether consumer preferences (in the traditional
sense) can be communicated clearly. Put differently: Exerting the exit option is
by no means sufficient evidence of actual deterioration in the quality of the
public goods bundle and neither does the absence of voice necessarily imply that
the demand side is satisfied with the quality of the supplied public goods.
In recent years, the “spatial diffusion” of institutions has been discussed.
The idea is that institutions do not spread across space randomly but that factors
like geographical proximity, but also cultural or historical closeness, make
adoption more likely. This concept is broader than the one just discussed as
institutions could also spread across space via coercion. In a paper analyzing the
diffusion of constitutional rules, Goderis and Versteeg (2014) explicitly name
four instruments that are used for coercion. Whereas colonization and military
occupation seem both outdated and outlawed, making membership in
international organizations contingent on first implementing certain institutions
seems to be a very current practice. This can also be said of making payment of
foreign aid conditional on certain institutional reforms. Regarding the spatial
diffusion of constitutional rules, Goderis and Versteeg (2014) find that shared
legal origins, competition for foreign aid, a shared religion, and shared colonial
ties are the main drivers.

6.6 Elements of a General Theory

6.6.1 Preliminary Remarks
In Sections 6.2 to 6.4, we covered several specific aspects of change in external
institutions. The aim of this section is to assemble a list of elements that a
general theory of institutional change requires. A general theory of institutional
change would be able to explain all kinds of institutional change, no matter
where or when it occurs. As there is no generally accepted theory on this topic
yet, we cannot present one. The book by Acemoglu and Robinson (2005) is
probably closest to such a theory.
First, changing external institutions requires an explicit process of
collective decision-making. This is most obvious in a country with a democratic
constitution where at least a parliamentary majority is required to amend the
constitution. That the needed majority has been achieved is often due to the
efforts of interest groups who demand certain institutional changes. Note that
this aspect of institutional change is unique to external institutions; parliaments
cannot change internal institutions.
Economics is based on methodological individualism, meaning that in
explaining any phenomenon (e.g., a change in external institutions), we need to
show that the relevant actors have an incentive to act in a particular manner.
Otherwise, we would risk committing the functionalist fallacy (Elster, 1984,
28ff.). So, the question is: What role do individual decisions play in regard to the
origins and change of institutions?

Definition

Functionalist fallacy: Improper direct linking of the social function of

an institution and its origin.

The decision situation of an actor who is subject to any set of external

institutions can be schematically illustrated using Matrix 6.1.

Matrix 6.1 Individual decision situation with regard to the choice of external
institutions

Choice within rules

 Comply with Not comply with
institutions institutions

Choice Not demand institutional A C

of rules change

Demand institutional B DD
change

Each cell of the matrix describes individual behavior vis-à-vis a set of

external institutions. The four letters depicting the four possible combinations
are used to structure the arguments in this section. If the behavior of most
members of a group can be grouped into cell A, institutional change appears
unlikely. If, however, the behavior can be grouped in cell D, institutional change
appears a lot more likely.
Here, we combine two levels of analysis that are usually considered
separately in constitutional economics: the level of choice within rules, where
one can either comply or not comply with (given) institutions, and the level of
choice of rules, where one can either demand or not demand institutional
change.

Note

Constitutional economists distinguish between the choice of rules and the

choice within rules.

Determinants of institutional change

It would be very useful to be able to predict under which conditions we should
expect which behavior, but even if we cannot predict specific behavior – and
thus institutional change – six factors should be particularly relevant:

1. The bounded rationality of actors.

2. The problem of collective action.

3. The path dependency of institutional change.

4. Political transaction costs.

5. The relative power of the relevant actors.

6. Prevalent internal institutions.

As we will see right now, more often than not, the first four factors inhibit
institutional change. But if they do not inhibit such change, factor 5 can give us a
clue regarding its direction: If the power of a certain group has increased relative
to the power of all other relevant groups, we expect to see change in line with
the interests of the group whose relevance has increased. Finally, factor 6 can be
considered a constraint on the set of external institutions that can be enforced.
All six aspects are briefly discussed in the following.

6.6.2 Satisficing Behavior

Recall the concept of bounded rationality discussed in Chapter 1. Within this
concept, Herbert Simon (1955) posits a hypothesis regarding the utility function
of boundedly rational actors. He assumes that actors do not attempt to maximize
utility in each and every situation, but that they satisfice, that is, they are content
once they attain a certain utility level. As soon as that threshold is reached,
actors have no incentive to change their behavior. Thus, if an actor has so far
behaved in conformity with existing institutions, there is no reason to believe he
or she will start disobeying rules or insist on institutional change. The necessary
condition for changing one’s behavior from cell A to any of the other cells in
Matrix 6.1 is that the utility experienced from unchanged behavior has
significantly decreased in comparison to previous periods. Note that these
considerations take place within a single person – and that no cooperation with
others is necessary.

6.6.3 Collective Action Problems

Satisficing behavior is not the only reason why not every reduction in utility
(relative to the utility associated with other options) is accompanied by a demand
for comprehensive institutional change. Institutions are made up of rules that all
actors in society are expected to comply with. They can, therefore, be thought of
as public goods, the effects of which unfold because a multitude of actors is
bound by them. An institutional change would affect not only one person, but all
persons with similar preferences. And as you now know, in such a situation, each
actor hopes that the – costly – demand for institutional change will be made, and
paid for, by someone else, thus allowing him or her to free-ride.

Definition

Free-rider: Actor who benefits from a good without contributing to its

provision.

As all actors hope to free-ride, collective action is unlikely to happen

frequently, even in situations where taking collective action could benefit
everyone. The behavior of discontented actors who are not able to overcome
collective action problems so as to demand institutional change will either
remain unchanged (and can thus be grouped in cell A in Matrix 6.1), or switched
to breaking existing rules (i.e., be grouped in cell C). Whether institutional
change is more likely to occur if more people break existing rules individually is
entirely uncertain. The problem of collective action will only be overcome every
now and then and not regularly. This is one way to explain why institutional
change does not occur continuously but rather discretely.

6.6.4 Path Dependency of Institutional Change

Definition

Path dependency: Present decisions are influenced and constrained by

past decisions.

The concept of path dependency is usually employed to explain the diffusion of

technologies. However, according to Douglass North (1990a, 92–104), the
concept is also very useful in the analysis of institutional change and, with just a
few modifications, it is possible to draw an analogy between competing
technologies and institutions (for a detailed discussion of this analogy, see Kiwit
and Voigt, 1995). The central point of the original path dependency argument is
that technologies can persist even though there might be more efficient
competing technologies (see, e.g., Arthur, 1989). This is due to network
externalities: The more people use a technology, the greater is the utility of
everyone using the technology. For example, if I am the only person in the world
using Facebook, I am never going to have any “friends.” If one specific
technology enjoys a widespread user base, suppliers of competing and possibly
more efficient technologies will find it difficult to capture market share due these
network externalities. The most frequently used example to illustrate path
dependency is the arrangement of letters on modern keyboards. Supposing that
you use an English version, the letters on the upper left hand side of your
keyboard are almost certain to read QWERTY. Now, some people claim that a
different arrangement of the letters on the keyboard would have been more
efficient – but that it never became generally accepted due to substantial
switching costs. New keyboards would need to be installed; everybody being
accustomed to the current arrangement would need to be retrained and so on.
Proponents of path dependency claim that inefficient technologies can often
come out on top and that competing, superior technologies cannot make any
headway without government intervention. Thus, a purely market-based solution
could lead to sustained inefficiencies. If the concept of path dependency can be
applied to institutions and the function of institutions is to reduce uncertainty
(and thereby enable economic prosperity), it must be concluded that institutions
can originate and change without any improvements being made to economic
growth and development. Along these lines, Paul David (1994, 218f.) writes:

[I]nstitutions generally turn out to be considerably less ‘plastic’ than is

technology and the range of diversity in innovations achieved by
recombinations of existing elements is observed to be much broader in the
case of the latter. Thus, institutional structures, being more rigid and less
adept at passively adapting to the pressures of changing environments,
create incentives for their members and directors to undertake to alter the
external environment. … Finally, it may be remarked that because the
extent of tacit knowledge1 required for the efficient functioning of a
complex social organization is far greater – in relation to the extent of
knowledge that exists in the form of explicit, codified information – than is
the case for technological systems, institutional knowledge and the
 problem-solving techniques subsumed therein are more at risk of being lost
when organizations collapse or are taken over and ‘reformed’ by rivals.

If institutional change is subject to path dependency, this could be part of an

explanation why inefficient institutions can survive. As such, the presence of
path dependency would rather help to explain the stability of institutions over
time rather than their change.

6.6.5 Political Transaction Costs

Under the Coase theorem, scarce goods will be used efficiently given that
property rights are well specified (see Chapter 2). Assuming that political
markets are analogous to goods markets, does this mean that, in political
markets, efficient policies and institutions are always chosen?

Note

Reminder: The Coase theorem only holds if property rights are well
defined and transaction costs are zero.

Remember from Chapter 2 that the Coase theorem only holds if there are
enforceable property rights and transaction costs are negligibly low. If the Coase
theorem is going to work for political markets, it means that these conditions
must be met in these markets, too, which is even more doubtful than it is for
traditional goods markets.
Transaction costs are the costs of using the market. In turn, political
transaction costs are the costs of using the “political market.” Binding
agreements should be much harder to achieve on political markets than on
traditional goods markets. Even defining the exchange will be difficult.
Furthermore, in case of contract breach, it is unclear how, or even if, the conflict
could be mediated. All in all, there are many reasons to believe that political
transaction costs are highly relevant. They constrain the possibilities for
changing the status quo, thus contributing to stabilization. Twight (1992)
conjectures that politicians deliberately manipulate political transaction costs in
order to limit political opposition with respect to certain political domains.
Political transaction costs stabilize efficient as well as inefficient institutions.
Acemoglu (2003) wonders why there is no political Coase theorem. He points
out that there is no generally accepted “initial allocation” nor is there a neutral
third party endowed with any sanctioning power that could enforce any potential
deal between any of the concerned parties. He concludes that the origins and
change of institutions can be better explained with recourse to the relative power
of the relevant actors. This leads us directly to the next argument, namely the
relative power of the relevant actors.

6.6.6 The Relative Power of the Relevant Actors

Until now, we have identified several factors that are obstacles to fast and
comprehensive institutional change, rather than being conducive to it. To explain
institutional change, it seems plausible that we need to inquire into the incentives
of the involved actors. This involves identifying how well they are organized,
which resources they can use, which strategies are at their disposal, and so forth.
If some group becomes more relevant over time, we would also expect the
design of institutions to change. Institutions influence the distribution of
incomes. Groups whose relevance for national product has increased and who
have managed to overcome the problem of collective action will sooner or later
demand that institutions change to better meet their needs. One way to think of it
is to contrast de jure and de facto power. De jure power is reflected in external
institutions. When the actual power of a relevant group increases relative to that
of all other groups, its de facto power increases. In order for de jure and de facto
power to be aligned again, the external institutions are likely to be changed to
reflect the new situation in the country.
For example, until the sixth century BC in Rome, the cavalry, provided by
the nobles, were the only relevant factor in the empire’s military strategy.
Introduction of the phalanx – which had been invented in ancient Greece – led to
a strengthening of the infantry. Use of the phalanx was considered necessary
because Rome had suffered a devastating defeat in 477 BC. However, the
infantry was composed mostly of plebeians, or plebs, who were not politically
involved at all. This resulted in class struggle, as the plebs were burdened with
increasing duties (such as military service) without any additional benefits (such
as political participation). Due to their increased relative power, the plebs were
able to force several institutional changes such as participation in political
decisions, lifting of restrictions regarding both occupation and marriage, and
some release of debts incurred for buying armor necessary for becoming part of
a phalanx (more details and additional examples can be found in Voigt, 1999a,
128–137; Acemoglu and Robinson, 2005 provide a very similar approach).

Institutional change depends both on the demand side and the supply
side

6.6.7 The Relevance of Internal Institutions

The above-discussed elements of a general economic theory of institutional
change emphasize the demand side. These elements focus sharply on the ability
of potential beneficiaries of institutional change to realize their demands. For a
comprehensive theory, however, we also have to account for the supply side. In
a democracy, political entrepreneurs have an incentive to discover the
preferences of unorganized voters and provide suitable legislation. In this
context, the norms prevalent in large portions of the population should play a
major role. From empirical evidence (Lewis-Beck and Stegmaier, 2019), we
know that many citizens do not condition their voting decision solely on their
expected individual monetary benefits, but also on their perception of whether
groups they care about are treated fairly. This can explain why public servants –
who usually cannot lose their jobs – might vote for a party that champions the
interests of the jobless. In turn, this provides an incentive for politicians to take
prevalent justice and fairness norms seriously.

6.6.8 A Short Summary

Institutional change is a rather unlikely event as many conditions need to be met
before it occurs. A first necessary condition is that a sufficiently large number of
people are unsatisfied with the currently valid institutions and that they are ready
to incur costs to demand institutional change. Efficiency-enhancing institutional
change is by no means guaranteed, as political transaction costs are likely to be
significant. Although institutions tend to be resistant to change, shifts in the
relative power of social groups will be reflected in corresponding changes in
external institutions. The shifts will also indicate the direction of institutional
change. Finally, politicians have an incentive to take into account the justice and
fairness norms prevalent in large portions of society as these can be decisive in
elections.

6.7 Open Questions

This chapter has made clear that there is a multitude of approaches to explaining
specific aspects of institutional origins and change. There is no one
comprehensive approach that integrates traditional political economy arguments
(relevance of power) as well as specific institutional economics assumptions
(bounded rationality, relevance of internal institutions such as justice norms).
Thus, one central question raised by this chapter is whether such an integrated
approach is possible.
Many other questions also arise: To what degree is a country’s current
development determined by its past? To what degree is it possible to change a
development path?

Questions

1. It is not very flattering to call a theory “naïve.” Explain why the theory
proposed by Demsetz (1967) is called a naïve theory.

2. Discuss how North’s theory of property rights development bridges the gap
between contract theories à la Hobbes and predatory exploitation theories à la
Marx.

3. Explain why – using North’s theory – maximization of ruler income and

maximization of social product can be irreconcilable.

4. What competition and transaction cost restrictions is a ruler subject to

according to North’s theory? To what degree do both restrictions make likely
inefficient property rights?
5. What is the role of collective action for institutional change? How can
institutional competition be linked to collective action?

Further Reading
The commonalities, but also the differences, between public choice, social
choice, and political economy are discussed in Mueller (2015). Tullock (1987) is
one of the first monographs to provide an economic theory of autocracy. It
contains a number of empirical examples, but no integrated theoretical approach.
Wintrobe (1998) offers such a theory, based on the application of simple
economic arguments.
The publications of Mancur Olson on the transition from anarchy to
autocracy have inspired a number of other essays, including Niskanen (1997).
Moselle and Polak (2001) distinguish between anarchy, organized banditry, and
the predatory state. In direct contrast to Olson, they argue that “the unbridled
predatory state is likely to reduce the welfare of the populace relative to anarchy
and organized banditry” (Moselle and Polak, 2001, 5).
Nunn (2014) is an up-to-date survey on how historical events affect current
institutions. The various findings of the economic theory of legal origins are
summarized in La Porta et al. (2008). Those interested in digging deeper will
find Zweigert and Kötz (1998) helpful. Among the very many critical
assessments regarding the significance of legal origins, two are particularly
helpful: Spamann (2010) recodes the original coding – and ends up with a
completely different dataset. Klerman et al. (2011) point out that colonial history
might be more important than belonging to a particular legal tradition.
Kirstein and Voigt (2006) discuss the self-interest of rulers. They conjecture
that promises to behave in a specific manner are not credible at the constitutional
level. The authors argue that constitutional-level promises will be implemented
only if all actors involved have an interest in the implementation, not only at the
time of signing the contract but also at the time of its implementation. The
authors identify parameter constellations under which neither the ruler nor the
ruled can increase their payoffs by unilaterally deviating from their promises.
The concept of “spatial diffusion” is described in more detail by Elkins and
Simmons (2005).
A critical and entertaining account of the traditional concept of path
dependency can be found in Liebowitz and Margolis (1989).
Alesina and Spoalore (2005) discuss the determinants of state size. Dixit
(1996) provides a detailed analysis of political markets using the concept of
political transaction costs.

1 The term tacit knowledge dates back to Michael Polanyi (1998 [1952]). Tacit
knowledge is knowledge that is incorporated in our actions, even though we
are not able to articulate this knowledge. With regard to institutions, tacit
knowledge implies that institutions also contain knowledge that cannot be
articulated. If institutions are abolished, the tacit knowledge contained in them
is also lost.
 7
Explaining Change in Internal
Institutions
◈

7.1 Introductory Remarks

In Chapter 6, we asked whether we can use the instruments of economic analysis
to inquire into the origins and change of external institutions. We identified
factors that are likely to be an explanation of both the choice of external
institutions, as well as their change over time. In this chapter, we ask whether
economic analysis can contribute to understanding the origins and change of
internal institutions. In Chapter 6, we emphasized the role of explicit collective
decisions for external institutions. Type 4 internal institutions (those with
organized enforcement) can also be changed via explicit collective decision-
making. We will not delve further into the topic of type 4 internal institutions, as
the factors identified in Chapter 6 are also relevant for them. Type 1 institutions
are solutions to coordination games. Lacking any element of conflict, it is easy
to imagine their spontaneous emergence and high stability over time. Thus, we
will rather address the hard cases in this chapter, that is, the determinants of type
2 and type 3 institutions (ethical rules and customs, respectively).
 We will not attempt to explain the origins of specific institutions. Instead,
we ask whether we can identify mechanisms that contribute to the development
of diverse institutions. In a literature survey that appeared nearly 30 years ago,
Jon Elster (1989b) did not want to exclude the possibility that norms – which are
closely related to type 2 and type 3 institutions – develop randomly. That is
equivalent to saying that we simply do not know of a general mechanism
underlying their emergence and change over time. Since Elster’s survey, in the
last few years in particular, there has been an enormous interest among
economists in both the determinants and the effects of “culture.” No matter how
culture is defined, internal institutions are likely to be an important part of it. In
this chapter, we develop a “synthetic approach” made up of approaches found in
various disciplines. This approach focuses on the conceptual. If relevant
empirical evidence is available, we do mention it.

Can we identify mechanisms of institutional development?

Chapter Highlights

Frame the emergence of norms as an economic problem.

Consider the potential roles of repetition and reputation in norm

emergence.

See under what conditions (costly) sanctioning can be rational.

We proceed as follows: First, we define the terms “values” and “norms” and
discuss their relation to institutions. We proceed by describing the issue of the
origins of norms in economic terms (Section 7.2). In Section 7.3, we briefly
present and critically discuss different hypotheses concerning the origins of
norms. This section also contains the “synthetic approach” just mentioned.
Whereas this approach focuses on possible transmission channels by which
internal institutions might spread, it is rather silent on potential triggers for the
choice of internal institutions and their change over time. In Section 7.4, a
number of exogenous factors that might induce change in internal institutions are
discussed. These include both geographical factors and external institutions.
Section 7.5 concludes the chapter with open questions.

7.2 The Problem in Economic Terms

Type 2 and type 3 institutions are based on values and norms. Conceptions
regarding right behavior are presupposed for both types of institutions. For type
3 institutions, behavior that is not compatible with normative conceptions is
sanctioned by third parties. In a first step, we need to define both values and
norms. Following the International Encyclopedia of the Social Sciences (Darity,
2007), values can be defined as “conceptions of the desirable, influencing
selective behavior. Values are not the same as norms for conduct. … Values are
standards of desirability that are more nearly independent of specific situations.
The same value may be a point of reference for a great many specific norms; a
particular norm may represent the simultaneous application of several separable
values” (see Figure 7.1). Thus, justice is a value that can be found in many
specific norms, such as concerning the fair share of the pie, fair parental
treatment of children, fair treatment of workers, and fair grading of exams.
 Figure 7.1 One value can be a reference point for multiple norms; one norm
can represent the application of multiple values.

Definition of values

Values are not equal to norms

Traditionally, the topic of values and norms has been more prominent in
sociology than in economics. You might have heard James Duesenberry (1960)
quipping that “economics is all about how people make choices; sociology is all
about why they don’t have any choices to make.” Well, that was decades ago.

Definition

Homo sociologicus: Behavioral model used in sociology. Put very

simply, homo sociologicus attempts, by his or her actions, to fulfill role
expectations of relevant reference groups.

Nevertheless, traditional sociology does not appear to be the right place to look
for explanations of why norms develop, because it deals with the roles assigned
to individuals by society while assuming that norms are given. We, however, are
interested in the origins of norms here.
In the last few decades, a competing sociological approach has been
developed (rational choice sociology) which shares with economics the
paradigm of rational decision-making. One of its leading representatives was
James Coleman. In his Foundations of Social Theory (Coleman, 1990), he
argues that the existence of externalities is a necessary condition for the
development of norms. In an earlier work he wrote: “The central premise … is
that norms arise when actions have external effects, including the extreme cases
of public goods or public bads. Further, norms arise in those cases in which
markets cannot easily be established, or transaction costs are high” (Coleman,
1987, 140). Norms structure social interaction. However, if social interactions do
not affect third parties (and thus do not exhibit externalities), there is no need for
norms.

Externalities are a necessary condition for the development of norms …

… which are almost universally fulfilled

Unfortunately, it is possible to assign an externality to virtually every

action. As a consequence, norms might develop to structure virtually any
interaction situation. This necessary condition is almost universally fulfilled,
thus making it difficult for us to distinguish between situations in which it is
plausible that norms might develop and situations in which it is not. We require a
way to assess whether externalities are perceived as significant by the parties
affected.
 Littlechild and Wiseman (1986, 166) provide a nice illustration of how
differently externalities can be perceived:

Consider some [of] the various ways in which smoking by one person A
might be argued adversely to affect a non-smoker B:

a) B’s health may be adversely affected, in ways that can be verified

by persuasive empirical evidence.

b) Even without such evidence, B may believe that his health is

adversely affected.

c) B may be simply annoyed by tobacco smoke.

d) B may be concerned about the effect of smoking on A’s health.

e) B may be concerned about the effect of A’s smoking on the

happiness of third party C, who is exposed to A’s smoke, or on third
party D, who is a concerned friend or relative of A.

f) B may be annoyed at what he believes is A’s lack of awareness of

the suffering he is causing.

This example shows how differently one situation can be interpreted and how
many possibilities there are to assign externalities to a simple everyday situation
such as this one.
Aside from the existence of externalities, Coleman (1987) mentions a
further condition for the development of norms: the individual willingness to
sanction norm-deviant behavior. If a sanction can be carried out by a multitude
of persons, it represents a public good. Many people have an interest in
sanctioning behavior that deviates from an accepted norm. Because sanctioning
is associated with costs, however, each individual prefers that someone else
carry out the sanction. Thus, we need to clarify how the associated free-rider
problem can be solved. The involved problem is a classical problem in the
provision of public goods. Though this insight is important, it does not provide
an explanation, but is merely a precise statement of the problem.

Willingness to sanction noncompliant behavior

In a 1986 essay, Robert Axelrod mentions meta norms – norms concerned

with the sanctioning of norm-deviating behavior – as a solution to the public
good problem. However, such recourse to meta norms does not solve the
problem, it merely transfers the problem to a different level, as one has to show
how the free-rider problem concerning meta norms can be solved, and so on.
This line of reasoning thus leads to an infinite regress. Sanctioning by third
parties is not the only way to ensure compliance with a norm. Individual
internalization of a norm represents a further possibility. In our lingo: We need to
explain both the development of mechanisms for the enforcement of type 3
institutions and the process of internalization that leads to the development of
type 2 institutions.

Definition

An infinite regress arises if the truth of a proposition requires the

support of a second proposition, the correctness of which requires the
support of a third proposition and so on ad infinitum.

7.3 Hypotheses on the Origins of Norms

The conditions just sketched represent the basic problem in economic terms, but
do not contain any explanation yet. Thus, let us briefly present some explanatory
approaches. We will start with evolutionary (game) theory, move on to ask
whether we should explicitly take into consideration that interactions can be
repeated and that reputations might emerge out of one’s behavior, and finally
present an attempt to combine theory elements from such thinkers as Hume,
Weber, Hayek, and Lewis.

Explanation of the survival of competing behavioral strategies

7.3.1 Evolutionary Approaches

In contrast to traditional game theory, evolutionary game theory attempts to
avoid demanding assumptions with regard to the rationality of actors.
Representatives of evolutionary game theory are not interested in explaining
individual decisions, but rather the survival of competing behavioral strategies.
Imagine a situation in which an individual can either apply the strategy “tell a
lie” or the strategy “tell the truth.” Evolutionary game theory now inquires into
the survival probabilities of these strategies. Actors are not considered as
persons, but rather as carriers of strategies. Strategies that factually survive must
have functioned as if they had pursued the objective to survive (Alchian, 1950;
Friedman, 1953). Within evolutionary game theory, arguments exclusively based
on genetic evolution are rare. Thus, you will rarely find the argument that
humans are genetically determined to be liars or non-liars. If one is interested in
explaining the many commonalities that are shared by mankind all over the
planet, this approach might have some merit. Here, however, we are mainly
interested in explaining the differences in norms across different societies. For
that, recourse to purely genetic arguments is unlikely to be helpful.

An interesting aside

One interesting exception to the general evaluation that arguments based

on genetics are unhelpful is the commitment approach by Robert Frank
(1988). Frank considers the question of how exchange partners can
communicate the earnestness of their intent (you have already
encountered the dilemma of the strong state – a special case of the more
general commitment problem discussed here). Verbal promises such as
“Trust me!” are called cheap talk by game theorists, as anyone who is
interested in exchange is able to make such promises at virtually zero
cost. Frank argues that emotions – that is, seemingly irrational
expressions – can be of high strategic relevance. Emotions such as anger
or guilt can help others assess a person. Emotions that are genetically
predetermined – and that are thus not easily imitated – can provide
valuable signals for predicting the behavior of others. Thus, the problem
of credible self-commitment would be lessened. Emotions can allow
individuals to categorize other individuals with high reliability as
cooperators, allowing cooperators to structure their interactions primarily
with other cooperators.

Evolutionary approaches often focus on memes instead of genes (Dawkins,

1989). Memes are cultural traits that are transmitted and spread via memory and
imitation. Colman (1982, 267) describes it thus: “A meme will spread through a
population rapidly if there is something about it that makes it better able than the
available alternatives to infect people’s minds, just as germs spread when they
are able to infect people’s bodies. This analogy draws attention to the fact that
the fittest memes are not necessarily ones that are beneficial to society as a
whole.” In their anthropological approach to norm evolution, Boyd and
Richerson (1994) argue that memes spread like innovations.

Definition

Meme: Ideas or thoughts that spread via communication.

Definition

Norms: Memes that influence behavioral standards.

Norms can then be defined as memes that influence behavioral standards.

Boyd and Richerson (1994) describe cultural evolution as a process that is
driven by three forces. It is driven by:

Cultural evolution as process

1. Unbiased transmission during the childhood of individuals. This

implies that children are characterized by the same values and norms as
their parents. As long as carriers of different norms exhibit constant and
identical birth rates, the population composition remains the same.

2. Biased transmission. This takes place when children grow up and come
into contact with other systems of values and norms. This type of
 transmission is thus explicitly influenced by choices of the relevant actors.

3. Natural selection, i.e., higher reproduction rates of individuals with

specific traits.

Using this approach, Boyd and Richerson attempt to create a bridge between
approaches that are frequently perceived as competing: the approach of genetic
evolution following Darwin, and the approach of cultural evolution. In fact, they
have coined the term “gene–culture coevolution” to indicate that evolution takes
place via both culture and genes. According to that concept, culturally
transmitted information can lead humans to change both their physical and their
social environment which can, in turn, change the selective pressures on genes.
Boyd and Richerson describe biased transmission analogously to the
diffusion of innovation. In the same manner that an individual can choose to use
an innovation or not, an individual can choose to adopt a meme or not according
to his or her preferences. However, this notion is not compatible with the above
described diffusion process of memes. From our point of view, the notion that
norms are subject to conscious choice is neither practical nor right. Norms can
influence our utility even if we do not individually accept or reject specific
norms. The analogy is also somewhat misleading, as the use of innovation is
subject to conscious choice, while the use of institutions is not. Social
interactions that lead to the diffusion of norms are not discussed. However, the
discussion of precisely such processes should be the focus of an explanatory
approach. Another reason why this approach is not satisfactory is the assumption
that individuals can choose from a pool of memes those that they prefer the
most. Thus, the emergence of such a pool of memes is entirely random; no
further attempts to explain the origins of memes are made.
Similar to gene–culture coevolution, Samuel Bowles and Herbert Gintis
(2011) also draw on multilevel selection, just as Boyd and Richerson (e.g., 2005)
do. The idea here is that selection takes place on the individual, as well as on the
group level. In their account of why humans are a cooperative species, Bowles
and Gintis argue that war plays a crucial role. It frequently leads to the extinction
of entire groups. Simultaneously, war helps spread the norms of the winners.
Wars will regularly be won by those groups who have more altruists in their
midst. This is how Bowles and Gintis hope to show that altruism does entail
evolutionary advantages. It seems a bit ironic that war – certainly one of the less
civilized activities of mankind – is thought to foster altruism.
Many representatives of evolutionary approaches employ evolutionary
game theory for their analysis. In contrast to the theoretical approaches of
traditional game theory, evolutionary game theory requires rather lax
assumptions regarding the rationality of individuals. Indeed, a bird or a rat that
behaves according to trial-and-error is sufficiently rational for the use of this
approach. We could also interpret this as a disadvantage of the evolutionary
approach, as it does not take into account the human capability to weigh
competing hypotheses, anticipate consequences of decisions, and so on.

Critique

7.3.2 Repetition or Reputation as Explanatory Factor?

As previously mentioned, repetition can be associated with an immensely
increased number of equilibria (you remember the Folk theorem discussed in
Chapter 4). This can even be the case if, although interactions are not repeated
between the same two individuals, it is possible to obtain and communicate
information regarding the behavior of others displayed in previous rounds at low
cost. We saw that conditional cooperation (for instance in the form of tit-for-
tat) is one of many possible equilibrium strategies in the repeated prisoner’s
dilemma. If information regarding other players can be easily and reliably
communicated, defecting behavior can destroy an individual’s reputation and
reduce their future chance of finding exchange partners. It follows that each
individual is forced to weigh the (one-off and present) benefit from defection
against the (repeated and future) cost of not being able to find transaction
partners.
In order for reputation to be this effective, three conditions have to be met:

1. The respective “case” of defection needs to be sufficiently public. It is

not only known to the parties involved.

2. The perception of the relevant facts is shared by most observers. That

is, most observers perceive the case identically.

3. The relevant facts are evaluated similarly: Norms that are used to
evaluate the case are shared by most of the observers.

Conditions for reputation to be effective

However, this implies that reputation can only effectively shape behavior if
“proto-norms”1 are already in place. If this is true, we have to conclude that
reputation by itself cannot explain the formation of norms, but may be useful for
explaining the origins of norm-complying behavior. Moreover, scholars who
argue in favor of an evolutionary approach insist that cooperative equilibria will
only be sustainable in very small groups (e.g., Boyd and Richerson, 2005).

Critique
 7.3.3 An Attempted Synthesis
In the previous two sub-sections, we presented strategies that might be used to
explain the formation of norms. We evaluated both rather critically. In this sub-
section, we will attempt a third explanatory approach. It is by no means an
original one. Rather, you can see it as a synthetic approach that tries to integrate
explanations by a variety of thinkers that span several centuries.

7.3.3.1 Regular Behavior

Assume that one person has exhibited distinct behavioral regularities in his
exchange with another person. Based on this experience, the exchange partner
has formed expectations regarding the first person’s future behavior. If these
expectations are not met – implying a negative externality for the other person –
the result will be anger towards the person who behaved disappointingly. We
thus assume that individuals – based on previously observed regularities – form
the expectation that this regularity can be extrapolated into the future. Put
differently, an individual will expect that another individual who has acted in a
certain way in a given situation will continue to act in the same way in the
future. Thus, coordination is facilitated when individuals transform actual
regularities into the normative expectation that this regularity will continue into
the future. Assuming that there is a basic human need to be appreciated by
others, this mechanism could well provide a reason for continued compliance
with the rule which has now attained normative status, even if external factors
might have changed in a manner that makes other behavior seem more
reasonable.2

Regularities shape expectations

 Expectations facilitate future coordination

This notion regarding the origins of norms can be traced back at least to
David Hume (1990 [1740]). Robert Sugden (1986, 152) offers a modern
interpretation: “Our desire to keep the good will of others … is more than a
means to some other end. It seems to be a basic human desire. That we have
such a desire is presumably the product of biological evolution.”3 Introducing a
preference as “inherently human” could be criticized as prematurely suspending
the search for insights. However, we can justify it with a simple counterfactual
argument. Let us assume there are two groups of humans. Members of the first
group exhibit an inherent preference to seek appreciation by other group
members, while members of the second group do not. In consequence, norms
that encourage productive activity will evolve in the first group, for instance
because honesty is widespread in the first, while it is not in the second group.
Sooner or later, the second group will be crowded out by members of the first
group. Notice that, at the end of the day, this is also an evolutionary argument.
However, this line of argumentation should not be overreached. Differences
in norms of different groups are too large to be explained solely as the result of
genetic dispositions. Furthermore, we need to account for the fact that the circle
of persons that we seek acknowledgment from is apparently highly variable.
Thus, we need to be clear about the factors that determine the composition and
size of the reference group.

7.3.3.2 Interdependent Utility Functions

A very simple way to let costly sanctioning behavior appear straightforward is to
claim that evolution has supported other-regarding preferences and that,
therefore, they are assumed to exist. Fehr and Schmidt (1999) have chosen a
different path; they assume a particular preference function which they christen
“inequity aversion”. Simply put, inequity aversion means that people
experience negative utility from unequal outcomes, such as unequal incomes.
People are even assumed to suffer utility losses when they are better off than
their reference group (although less so than if they are worse off).
Now, many questions can be asked, like how the reference is defined, what
the ratio is between being better off than the reference group versus being worse
off, etc. But the remarkable consequence of inequity aversion is that punishing
non-cooperative behavior can be completely rational. In other words, the
sanctioning part of type 3 institutions has been systematically integrated into
economic models. A very simple way to think about inequity aversion is to think
of it in terms of interdependent utility functions. My utility is influenced by how
others do.

Definition

Interdependent utility functions: Utility function in which my utility is

also determined by the utility that others enjoy.

Interdependent utility functions can be used to explain the origins of norms.

Interdependent utility functions might help us explain why apparently
uninvolved third parties are willing to sanction norm-reneging behavior even
though this is associated with costs (Figure 7.2). If the utility of person Q is
negatively influenced by noncomplying behavior of person P, and Q’s utility
positively affects the utility of a third person R, one could easily envision
situations in which person R has an incentive to sanction person P’s
noncomplying behavior.

Figure 7.2 Using the concept of interdependent utility functions to explain the
existence of costly sanctions.

Traditionally, utility functions are assumed to be non-interdependent in

economics, such that the utility of others is irrelevant for an individual’s utility.
Individual utility is then neither positively nor negatively affected by the fact
that someone else’s utility is reduced.

Far-reaching consequences of interdependent utility functions for

sanctioning

If, conversely, we assume interdependent utility functions, person R’s

utility is not only a function of her available bundle of goods pRpR, but also of
another person’s bundle of goods pQpQ.

UR=fα·pR+β·pQ
Traditionally, it is assumed that ββ is zero, that is, the utility of R is not affected
by the utility of person Q. Introducing interdependent utility functions also has
far-reaching consequences for sanctioning and internal institutions. We can now
explain the existence of costly sanctions. For instance, if your little brother’s
utility is an argument of your utility function, you might be able to increase your
utility by sanctioning his friend who just took away his toy. Within the scope of
rational choice, you will carry out a sanction if the costs of sanctioning are lower
than the additional utility gained from the fact that your brother’s utility just
increased. Thus, the probability of sanctioning depends on the weight that the
other person’s utility has in your utility function and the available sanctioning
technologies. Traditionally, homo economicus is modeled to be atomistic, that is,
a utility maximizing individual who acts in isolation. If it were possible to
formulate the conditions under which interdependent utility functions can be
expected to occur, an adequate extension of the concept could be useful in
explaining the development of the sanction component of type 3 institutions. The
transition from non-interdependent to interdependent utility functions can be
justified by the fact that it increases the explanatory and predictive power of
models. However, the introduction of modified utility functions is also
accompanied by a host of new questions. For instance, one needs to clarify the
weight with which other persons’ utility affects your utility.

7.3.3.3 Norms of Cooperation

The Folk theorem states that cooperation can evolve in repeated games even for
relatively high degrees of conflict. However, the degree to which groups actually
manage to cooperate varies significantly. One could suspect a learning process
behind this variation. The better groups of individuals are able to coordinate
their behavior in a game with little or no conflict, the more likely they are able to
solve games with a higher degree of conflict by cooperating. This hypothesis is
based on a simple consideration: The higher the degree of conflict inherent in a
game, the larger the risk to be exploited by the respective other player. If
members of a social group are able to solve a game that has a certain degree of
conflict in a cooperative manner, the likelihood of solving a game with a degree
of conflict just a little bit higher should be greater than if that group was not able
to solve the first game (Axelrod, 1970 defines the degree of conflict in games).

Path dependency in the development of norms?

The hypothesis just outlined implies that the development of norms might
be path dependent. The probability that, in a certain situation, a norm of
cooperation develops and is sustained depends, among other things, on whether
members of a social group were previously able to structure interactions
cooperatively. This hypothesis reminds us that we should not neglect the
cognitive dimension. Two situations that appear identical to external observers
might be reconstructed very differently by the parties involved. The resulting
degree of conflict and, in consequence, the probability of solving the game
cooperatively might vary significantly.

North on cognition and beliefs

Nobel laureate Douglass North has been a crucial advocate for

relentlessly pushing the research agenda of institutional economics
forward. In his 2005 book Understanding the Process of Economic
Change, he points out the importance of both beliefs and cognition for
institutional change. He argues that institutions are created based on the
 relevant actors’ beliefs. If the results of the institutions people create are
not as expected, people will update their beliefs – they will learn – and
institutional change will continue. To understand the process of
institutional change, then, one must understand how beliefs come into
being, receive updating, and form the basis of human action.
North tries to deal with the question by delving into cognitive
science. To understand how beliefs are formed and how humans learn, he
asserts, we must first understand better how our brains work. Thus, he
enters territory where, owing to the academic division of labor,
economists are amateurs. Here, North comes very close to an argument
made by Friedrich A. Hayek in the early 1950s in a book called The
Sensory Order (Hayek, 1952). In that book, Hayek developed a number
of hypotheses about how the brain works and how external sensations
are structured in ways that allow the experiencing being to make sense of
them. Although North makes frequent references to Hayek, his own
excursion into cognitive science remains largely unsatisfactory.
Many questions regarding the relationship between cognition,
beliefs, and institutions remain to be answered. For example, institutions
are collective phenomena whereas beliefs are individual phenomena, and
updating beliefs – learning – is an individual experience. If institutional
change is interpreted as a consequence of changing beliefs, an
aggregation problem needs to be explicitly dealt with: How are
individual beliefs transformed into modified institutions?

The Israeli social scientist Edna Ullman-Margalit (1977, 121–127) proposes an

explanation that is close to the above-sketched hypothesis. She discusses the so-
called stag-hunt game. It is a game in which the degree of conflict lies
somewhere between a pure coordination game and the prisoner’s dilemma. She
argues that the prisoner’s dilemma can be transformed into a stag-hunt game if
there is a general expectation that the actions of individual actors are stabilized
by habit, and if there is a favorable starting point at which, somehow,
cooperation is established.

The stag-hunt game

Let us briefly explain the nature of the stag-hunt game: In order to catch a
stag, two hunters need to cooperate. One hunter flushes the stag out, which
allows the other hunter to shoot it. If the two hunters do not cooperate, each can
merely catch a hare. Both hunters prefer catching a stag to catching a hare.
Catching a hare, however, is preferable to catching nothing, which is the case if
one hunter attempts to cooperate while the other hunter is off hunting a hare.
This results in the payoffs depicted in Matrix 7.1 (the first number respectively
denotes the payoff for the row player, the second the payoff for the column
player).

Matrix 7.1 The stag-hunt game

Hunter C

C1 (stag) C2 (hare)

Hunter R R1 (stag) 3 2

3 0

R2 (hare) 0 2

2 2
 As opposed to the prisoner’s dilemma, this game does not have a dominant
strategy, that is, the best response of the row player (R) depends on the choice of
the column player (C) – and vice versa. The game is characterized by two
symmetric Nash-equilibria in pure strategies: (R1, C1) and (R2, C2). At first
glance, it should be easy to switch from the non-cooperative equilibrium (R2,
C2) to the cooperative equilibrium (R1, C1), as both hunters would be better off.
However, each hunter depends on the respective other hunter’s cooperation in
order to achieve the cooperative equilibrium, while non-cooperation yields a
payoff of 2 with certainty. In his discussion of the game, Binmore (1994,
120–125) describes players that achieve (R1, C1) as players that have learnt to
trust each other.

The original stag-hunt game

The game we just discussed can be traced back to Geneva philosopher

Jean-Jacques Rousseau (1992 [1755]). In the second part of his
Discourse on the Origen of Inequality, he writes:

This is how men could imperceptibly acquire some crude idea of

mutual commitments and of the advantages to be had in fulfilling
them, but only insofar as present and perceptible interests could
require it, since foresight meant nothing to them, and far from
concerning themselves about a distant future, they did not even give
a thought to the next day. Were it a matter of catching a deer,
everyone was quite aware that he must faithfully keep to his post in
order to achieve this purpose; but if a hare happened to pass within
reach of one of them, no doubt he would have pursued it without
 giving a second thought, and that, having obtained his prey, he
cared very little about causing his companions to miss theirs.
(Rousseau, 1992 [1755], 46f.)

Our basic argument is that cooperation is more likely in a game with a higher
degree of conflict if the players are part of a social group in which the
equilibrium (R1, C1) is a commonly accepted social norm. However, this also
means that we are leaving the safe grounds of game theory, as the solution to the
game in question depends on the solution of other previously played games that
are not explicitly considered in the analysis.

Trust and internal institutions

By now, there is a huge body of literature on the effects of trust on

economic outcomes. In a word, since high levels of trust can save
individuals a lot of transaction costs, high trust societies are better off in
many dimensions compared to low trust societies. But what is the
relationship between trust and internal institutions?
We propose to think of trust as a consequence of internal institutions
– and not as an internal institution in and of itself. If I trust someone, I
essentially expect that the person I am trusting behaves according to the
values and norms embedded in the relevant internal institutions.
Interestingly, trust levels have been shown to remain amazingly stable
over generations. The offspring of migrants who came to the USA two or
even three generations ago still display trust levels very similar to those
found in the originating country. Since all of the migrants were subject to
the same external institutions – namely, those of the USA – the internal
 institutions underlying different trust levels must have remained
unchanged over a number of generations. Fernández (2010) nicely
summarizes the relevant literature.

Let us summarize the argumentation developed so far:

1. Individual decision rules and habits can attain normative status.

2. Principally, it appears reasonable to work with interdependent utility

functions. However, the question how another person’s utility and how the
utilities of any number of other people exactly affect individual utility
remains open.

3. The development of cooperation norms might be path dependent. The

more stable such norms are in games of a given level of conflict, the more
likely it is that members of a social group are able to solve games designed
with a high level of conflict.

We have not yet discussed in detail how the sanction component of type 2
internal institutions might evolve. (Type 2 internal institutions are those ethical
rules to which the actors commit themselves.) This entails bad conscience or the
psychological costs that can arise, even if one is sure that no one is watching.

Adaptive egoism

A two-stage behavioral model

7.3.3.4 Concerning the Sanctioning Component

Dennis Mueller (1986) argues that actors who have been taught to cooperate by
threat of sanctions will continue to cooperate in the absence of sanctions. This
argument can help us explain how type 2 internal institutions are transmitted.
Mueller proposes to modify the commonly used behavioral assumption of
rational egoism to an assumption of adaptive egoism. In doing so, Mueller
supports the acknowledgment of psychological research results in economics.
However, proposing that norm-complying behavior learned in childhood is fully
retained in adulthood would be equivalent to abandoning the economic
approach. After all, the basic premise of economics is that virtually any action
can be invoked by incentives. Thus, it appears reasonable to introduce a two-
stage behavioral model. In the first stage, the decision problem is classified as
involving little or high costs. In the second state and given that the costs of
norm-compliance are rather low, there is a high chance that the individual will
comply with the norm. But if the costs of complying are high, the individual is
more likely to think the entire problem through systematically. Framed
differently: The higher the costs of norm-compliance, the higher the likelihood
that the decision problem is subjected to a rational choice calculus. Now, the
apparent problem is how to identify regularities in the transition from one to the
other decision-making procedure.

7.3.3.5 Outlook
Many attempts to explain the origins of internal institutions presuppose the
existence of some explanatory factors such as the existence of shared values. A
natural corollary is to ask whether one is able to use an economics approach to
explain the origins of these presupposed factors. In recent years, more and more
researchers have concluded that the economics approach by itself is not
sufficient for this purpose, and that results from studies conducted by other
disciplines, such as cognitive science, need to be accounted for. We argued
above that one condition for the existence of shared values and norms is that the
actors involved perceive a given situation in a similar manner. Representatives of
the cognitive sciences primarily inquire into questions of exactly that nature,
which is why there is hope that economists might be able to learn from them.

7.4 Potential Triggers for Change in

Internal Institutions
7.4.1 Introductory Remarks
Whereas in Section 7.3 we were primarily interested in identifying possible
mechanisms for determining the origin of internal institutions, here we focus on
potential determinants of their change. A precondition for observing changes in
internal institutions seems to be that the environment must have changed,
somehow implying that the net benefits of complying with the internal
institutions must also have changed. Changes in the environment might include
natural disasters or changes in the microclimate, but also technological advances
that allow for different and more useful cultivation methods. But since there is
no explicit procedure for changing internal institutions, it seems quite possible
that they remain unchanged. In other words, changes in the environment are a
necessary, but not sufficient, condition for systematic changes in internal
institutions. This implies that although society as a whole would be better off if
institutions changed, such change often does not take place. We now set out to
discuss two factors of external change that could trigger change in internal
institutions, namely, geography and change in external institutions.

7.4.2 Geography Again

In Chapter 6, we saw that geographic conditions can have an impact on the
likelihood of state formation, as well as on the kind of regime that is likely to
emerge. Here, we ask whether geographic conditions can be one determinant for
the internal institutions used by societies. Even in Chapter 5, we discussed an
example of such possibility. We brought up the work of Alesina et al. (2013)
who demonstrated that in societies where the use of the plough was suitable (a
geographic aspect) the status of women is affected until today, measured by the
percentage of women in the workforce or the percentage of female
parliamentarians. Norms regarding the role of women in society are elicited by
the consent – or not – to statements like: “When jobs are scarce, men should
have more right to a job than women.”
Platteau (2000) is particularly interested in possible explanations for the
(non-)development of many African societies. Most of these societies have
internal institutions that aim at a high degree of equality among their members.
Today, the growth-retarding effect of these institutions is widely acknowledged.
Investments that are both sizable and obvious are less likely to be made.
Promotions to better paying jobs are frequently turned down because the
additional income would have to be shared with one’s relatives. But equality-
enhancing, i.e., redistributive, institutions not only lead to a suboptimal
allocation of resources, they can also drive up transaction costs which can cause
more growth-retarding effects. For example, to hide the size of my financial
assets from my environment, I might prefer not holding a bank account, or
putting only a fraction of my assets there. To hide how wealthy a farmer I am, I
might disperse my cattle geographically, which implies, however, higher
monitoring costs (chapter 5 of Platteau’s book contains more examples).
Given that most observers agree that these institutions are inhibiting
growth, two questions need to be dealt with. First, how could these institutions
ever emerge in the first place, and second, how come they have survived until
today? Traditional agrarian societies heavily depend on the climate, the weather
in particular. In such societies, the pooling of risks, i.e., mutual insurance, is an
important means to reduce uncertainty. According to Platteau, it is the very
structure of tribal society that makes the emergence of strongly egalitarian norms
seem beneficial. Interestingly, this is not the full story. If (economic) success was
primarily attributable to entrepreneurial skills and effort, then unequal outcomes
might appear justified. To cut the strong link between effort and success, tribal
societies have often rationalized the unpredictable aspect of nature by resorting
to magical practices. Individuals who are too successful are often constrained
through witchcraft. As soon as a single person believes in it, it already has a
factual effect. This is another example for the relevance of beliefs already
alluded to earlier.
So how can these norms survive given that they are inhibiting growth and
development today? Well, simply because once established, such norms are
extremely difficult to change. After all, many people appear to benefit; each time
a relative gets an increase in pay, they can claim their share. Individual evasion
seems frequently easier than collective change. In some regions, “stranger”
entrepreneurs are not subject to the equality norms, hence some entrepreneurs
move away from home. Sometimes, individuals convert to religions that are less
strict about equality. So this is one example where, due to many changes in the
environment, a society would be better off if its internal institutions changed, but
this change simply does not occur.

Internal institutions might survive although they are making society

worse off
 Trust has been mentioned a number of times throughout this book as an
important resource for keeping transaction costs low. Trust itself is not an
institution – but can be a consequence of institutions. Since the evidence is
almost undisputed that trust has important effects on many walks of life (Algan
and Cahuc, 2014 is a recent review), it is of interest to ask why trust levels differ
so dramatically across the world. One explanation is closely connected to the
climate–insurance nexus just probed into with regard to Africa. Ruben Durante
(2010) conjectures that mutual trust developed in pre-industrial times as a
consequence of farmers insuring each other because they had to cope with
climatic risks. He simply assumes that farmers in areas with higher variability of
weather conditions were more likely to set up mutual insurance schemes and
learned to trust each other. Today, weather conditions have become a lot less
important for agricultural output. Still, Durante is able to show that in those
European areas subject to higher year-to-year variability in precipitation and
temperature, people still display higher trust levels. A particular aspect of
geography has, therefore, induced mutual insurance schemes that have taught
people to trust each other. The enhanced levels of trust help people in these
regions to save on transaction costs to this very day.

Trust levels might have geographic origins

7.4.3 External Institutions

So far, we have discussed what an economic explanation for the origins of norms
might look like. We have ignored, however, the possibility that the development
of norms might also be influenced by existing external institutions. To be able to
further delve into this possibility, we need to clarify whether and how external
institutions that were in place a long time ago can still impact on individuals’
behavior today.
Italy is characterized by marked differences in behavior between the north
and the south. In the north, the likelihood that people trust each other and
cooperate with each other is markedly higher than in the south. Putnam (1993)
(whom you encountered in Chapter 2) ascribes these differences to differences in
history. More precisely, to differences in the history of how cities gained their
independence between the years 1000 and 1200. In a nutshell, the argument is
that having gone through the experience of becoming an independent city-state
implies having had the experiences of self-administration, of being responsible
for one’s own res publica. Having successfully mastered the administration of
one’s own affairs was likely to lead people to trust each other. So the argument
essentially is that a particular set of external institutions – namely, those involved
in becoming an independent city-state – has very long-lasting effects on how
people deal with each other. Putnam refers to this as trust and social capital; we
would refer to it as internal institutions.

Then again, trust might also be the consequence of external institutions

The argument, as such, might sound plausible but a thousand years is a very
long time so the story also sounds rather far-fetched. It is fortunate for us that
Guiso et al. (2008) tested it empirically. They identified the 400 largest Italian
cities in 1871 (the year of the first census after Italy became a nation-state) and
traced their history back to the beginning of the last millennium. And indeed,
they found that cities that became independent almost a thousand years ago are
still very different from cities that did not. There are more not-for-profit
organizations in the former, participation in referendums is higher, and the
likelihood that an organ donor organization exists is also higher. The authors
claim that at least half of the differences in social capital can be explained by
referring to the history of the specific city.
A similar point has been made more recently by Sascha Becker and his co-
authors (Becker et al., 2016) who look into the long-term effects of the Habsburg
Empire. Compared to neighboring empires such as the Russian or the Ottoman,
the Habsburg Empire is said to have had a fairly efficient, little corrupted, and
widely accepted bureaucracy. The Empire ceased to exist in 1918, and Becker et
al. are interested to find out whether it lives on in how citizens think of the state
and its representatives. They are able to do this because the Empire’s borders cut
through five currently existing states: Montenegro, Poland, Romania, Serbia, and
Ukraine (Figure 7.3). In other words, today, at least formally, populations in each
of these countries live under identical external institutions. But distinct parts of
these countries were “treated” by the Habsburg administration before 1918,
while other parts were not. Is the amount of trust that citizens in these five
countries display towards their bureaucracy affected by whether they live in a
region that was formerly run by the Habsburg Empire? Yes, trust levels are
significantly higher in those regions than in other parts of the country, and the
degree to which today’s administration is perceived as corrupt is significantly
lower in regions that had been run by the Habsburgs a century ago.
 Figure 7.3 The Habsburg Empire in Eastern Europe.

Source: Becker et al. (2016)

Now, are citizens in regions formerly governed by the Habsburgs simply

more naïve because they put more trust in their local bureaucracy and perceive it
to be less corrupt? This is, of course, not what Becker and his co-authors have in
mind. The argument is that due to the constraints established by an
administration more than a hundred years ago, today’s administrations still
function better than those administrations that were never governed by the
Habsburgs. Since the former borders of the Habsburg Empire do not play any
role in the five countries, external institutions can be excluded as a potential
reason for these differences. In all likelihood, the external institutions put in
place by the Habsburgs more than a hundred years ago had an effect on the
internal institutions that constrain the bureaucracy even today, making it more
efficient and less corrupt.

7.5 Open Questions

That external institutions can influence the development of internal institutions
was shown, for the most part, using an example. Even though we know that case
studies cannot replace a precise theory, we simply do not possess such a theory
yet. Developing such a theory is associated with some difficulties, as economists
are used to being able to cleanly distinguish between dependent and independent
variables. Here, there is ample potential for mutual interactions. Internal
institutions can affect the development of external institutions, while external
institutions can also influence internal institutions. Undoubtedly, we are dealing
with very complex relationships that require further analysis. We still have a
long way to go in order to arrive at an “economic theory of the origins of
internal institutions.” In this chapter, we attempted to identify a few building
blocks that might be useful on the path towards such a general theory.
Even though we are still very far from a fully-fledged economic theory of
internal institutional change, we can, nevertheless, attempt to draw policy
conclusions based on the few things we do know. This includes the insight that
the development of internal institutions, for the most part, occurs spontaneously,
and that conscious interventions via economic policy are usually not feasible. On
the other hand, we have just seen that certain external institutions can be
associated with predictable consequences with respect to internal institutions. If
internal institutions present in a society are relevant for economic transactions,
changes in external institutions should always attempt to account for this
relevance. Furthermore, we have emphasized multiple times that
incompatibilities between internal and external institutions can lead to increased
transaction costs. From this, we can derive the policy conclusion that
(consciously modifiable) external institutions should not be completely
incompatible with existing internal institutions.
In Chapters 8 and 9, we will offer a more detailed discussion of the
consequences for economic policy that can be drawn from the NIE.
 Questions

1. Give additional examples of behavior that follows instrumental rationality and

behavior that is belief-oriented.

2. Following the smoking example from Section 7.2, discuss the problem of
externalities with respect to a situation on a train where a passenger who is
suffering from a cold sits down next to a passenger who is talking very loudly on
his mobile phone.

3. Think of further examples for the development of social norms via factual
behavioral regularities.

4. Discuss determinants that might be relevant for explaining the development of

internal institutions which are not accounted for by evolutionary game theory.

5. Why might the (original) development of social norms not be sufficiently

explained with recourse to the concepts of repetition and reputation?

6. Clarify the attempted explanatory approach sketched in Section 7.3.3 using an

example.

Further Reading
A critical discussion of homo sociologicus can be found in Dahrendorf (1968)
who actually coined the term.
 Weibull (1997) is probably still the best introduction to evolutionary game
theory. Boyd and Richerson (2005) is a volume comprising 20 of their papers.
Bowles and Gintis describe their approach in detail in A Cooperative Species
(Bowles and Gintis, 2011) The book is also extremely useful because it
summarizes the insights of a half a century of research in sociobiology using a
unified notation which allows the reader to see commonalities and differences
between the various approaches very easily.
Bowles and Gintis are not the only social scientists who ascribe to war an
important function in the development of institutions. Tilly (1992), for example,
made the argument that fighting war increases the odds of successful state-
building. More recently, John Ferejohn and Frances Rosenbluth (2014) have
argued that traditional forms of war-making, involving a large percentage of the
population, have fostered democracy because those fighting demanded a say in
decisions regarding public goods. More recently, however, war has become a
high-tech affair and it might no longer foster the advent of democracy.
In various publications, Alberto Bisin and Thierry Verdier have dealt with
the question of how values are transmitted across generations. It is important to
identify the transmission mechanism to understand why some populations seem
to converge in their values whereas others remain heterogeneous for a long time.
Their contribution in The New Palgrave Dictionary of Economics (Bisin and
Verdier, 2008) is a very accessible survey to that literature.
Jack Knight has dealt with the issue of internal institutional change in
several publications. Here, let us merely mention Institutions and Social Conflict
(1992), which focuses on the relevance of power to the development of
institutions.
Alesina and Giuliano (2015) is an excellent survey on the relationship
between culture and institutions. A recent contribution by Algan and Cahuc
(2014) reviews the contributions regarding the impact of trust on various
economic outcomes. Fehr (2009) critically discusses the various ways trust has
been used to explain the origin of a number of effects and convincingly
demonstrates the endogeneity of trust. This supports the position taken in this
chapter that trust is determined by both internal and external institutions.
The contributions dealing with possible interrelationships between (both
external and internal) institutions and historical development are summarized in
Nunn (2014). Nunn puts particular emphasis on the observed historical
persistence of institutions.

1 The prefix means “first.”

2 Similarly, Majeski (1990, 276) argues: “The first time a rule that eventually
becomes a norm is invoked by an individual in the group it is not a norm. It is
an individual contextually generated decision rule. … An individual rule
becomes a norm when the application of the rule by other members of the
social group is justified by appeal to the precedent application, or when the
application is justified by the individual as the expected and/or appropriate
behavior of a member of the group. Also, an individual rule becomes a norm
when the rule is so established in the group that individuals perceive it to be
the only plausible alternative.”

3 Very closely related hypotheses are put forward by Max Weber (1964
[1922], 191f.), Friedrich A. Hayek (1973, 96), William Graham Sumner (1992
[1906], 358), and David Lewis (1969, 99). These arguments can be traced
back as far as the Nicomachean Ethics of Aristotle.
 8
On the Need for Normative
Theory
◈

8.1 Introductory Remarks

So far, we have dealt mainly with positive questions. In Chapters 2–5, we
discussed the consequences of different institutions on economically relevant
variables. In Chapters 6 and 7, we explored the origins of institutions and how
they change, from an economic perspective. We now consider normative
questions. Which institutions should be implemented? Which institutions can be
legitimized and with what methods? Chapters 8 and 9 will examine some of
these normative questions. In Chapter 9, we will investigate how the perspective
of the NIE might influence policy decisions. However, in order to be able to
derive policy consequences, we need a normative foundation. By that, we mean
establishing criteria that will enable us to judge what is “good” or desirable. In
this chapter, we delve into the necessity for, and the possibilities of, such a
normative foundation.
We have seen throughout this book that good institutions cause high levels
of prosperity. Private property rights and the possibility to exchange them
voluntarily can lead to enormous gains in welfare, which is assumed to be an
important goal. Nevertheless, we observe many institutions which limit private
autonomy and the freedom of contract. Could it be that private autonomy (or
freedom of contract) must be limited in order to secure the very existence of
private autonomy (or freedom of contract)? Should the sale of human organs be
limited and, if yes, how? Should female genital mutilation be prohibited? Should
there be constraints on selling hard or soft drugs?

Chapter Highlights

Familiarize yourself with arguments that support the importance of a

normative approach.

Get to know the “coordination approach” as an alternative to the more

standard way of thinking about welfare economics.

Become acquainted with different ways to explicitly deal with

bounded rationality.

We proceed as follows. In Section 8.2, we define normative theory and explain

why it is important. In Section 8.3, we encounter arguments that are useful in
determining whether an institution (or an institutional arrangement) is legitimate.
In Section 8.4, we discuss requirements for a normative theory that are based on
insights that arise from the NIE and, thus, differ from more established
normative theories.

8.2 What is Normative Theory and Why

Should We Study It?
In a series of essays written at the beginning of the twentieth century, Max
Weber argued that value judgments can never be thought of as scientific. The
freedom-from-value-judgment postulate has since been associated with his
name. In 1904 he wrote: “An empirical science cannot tell anyone what he
should do – but rather what he can do – and under certain circumstances – what
he wishes to do” (Weber, 2011, 54). Before we deal with the need for normative
theory, let us first consider why Weber denies normative theories scientific
status.

Value judgments cannot be falsified

Value judgments are statements about how something should be, in contrast
to how something is. While positive statements can be tested empirically (given
that all relevant terms are defined), normative statements cannot. If we define the
goal of science as the search for truth and if statements are considered to be true
only if they match reality,1 normative statements cannot be described as
scientific, because they cannot be falsified. In other words, it is impossible to
show that they do not match reality.

Definition

In the social sciences, falsification refers to proving a conjecture,

hypothesis, or theory as false or not in accordance with reality.
According to Karl Popper, a philosopher of science, proving conjectures
wrong is a central element of scientific progress (Popper, 1959).
Falsifiability is a precondition for falsification. It presupposes that
 conjectures have empirical content. This, however, is not the case with
regard to normative statements.

Why, then, are we dealing with the “need for normative theory” in this chapter?
If economists are not content with explaining the world as it is, but are interested
in giving advice on how the world could be made “better,” they require a
benchmark so that they can compare the “better” world to the actual state of the
world. To be able to identify deviations of the actual world from some ideal
world and then be able to formulate proposals concerning how to reduce these
deviations, conceptions of how the world should be are required.
How are we to arrive at such normative conceptions? Naturally, we could
justify certain values by meta-values or fundamental values. An example could
be: “Government should support the poor to keep them from starving because
this is an imperative of basic justice.” In this example, a normative statement
(“government should support the poor”) is based on a more fundamental value
(“justice”), which seems capable of achieving widespread consensus. The idea
of supposed general consensus will be dealt with in Section 8.3. Here, let us
point to the problem of ultimate justification, which has been discussed in
philosophy for millennia. Philosophers also refer to it as Agrippa’s trilemma.
The term “trilemma” implies that we are dealing with an unsolvable problem.
According to this trilemma, the attempt to justify norms and values with higher-
level norms and values has to result in one of three unsatisfactory options. One
can run into a circular argument (that is, at some point, having to “justify”
some fundamental value with recourse to a lower-level value), an infinite
regression (that is, referring to a higher-level norm ad infinitum), or cancel the
process with recourse to a dogma (that is, a set of beliefs that is accepted
without explicit justification). Thus, one is forced to choose between three
unsatisfactory options.

The problem of ultimate justification

In Section 8.3, we encounter an attempt at practicing normative institutional

economics as satisfactorily as possible. But before we move on, let us mention
two pitfalls of normative theorizing:

Pitfalls of normative theorizing

1. Many thinkers are liable to commit a naturalistic fallacy. This involves

wrongly deducing an “ought” from an “is.” Because something is the way
it is, there must be a good reason that it ought to be thus. This fallacy has
already been dealt with in detail by David Hume.

2. Economists are also prone to committing an instrumentalist fallacy.

This fallacy assumes that some politically mandated goals are “given,” and
economists are required to identify the means by which these goals can be
best attained. It is a fallacy because tools can also be goals in themselves
(and goals can be tools if we think of vertical tool–goal relationships), but
also because tools can have effects not only on the one goal under
consideration but also on other goals (often called side effects or spillover
effects). This fallacy was criticized back in the 1930s by Gunnar Myrdal. It
implies that means (or instruments) are value-free.

As we move on to our encounter with two competing normative concepts, be

careful not to be seduced by either of the two fallacies just described, regardless
of which concept you prefer.

8.3 Two Competing Normative Concepts

8.3.1 The Welfare Theoretical Approach

The dominant normative approach in economics – the so-called welfare

economics – was developed around 100 years ago. Welfare economists are
interested in optimal allocation, which they describe as the maximization of a
social welfare function under constraints. It is easy to see that welfare
economics is derived from utilitarianism.

Definition

Utilitarianism is the ethical – normative – theory that justifies behavior

if it is conducive to maximizing utility – or happiness – of the greatest
possible number of people. It was first proposed by Jeremy Bentham in
the late eighteenth century and then refined during the nineteenth century
by John Stuart Mill.

Assumptions of the allocation approach

In economics, allocation refers to the assignment of scarce resources and goods

to competing uses. If the market does not establish an “optimal” allocation,
economists often support government intervention, which is supposed to bring
the actual allocation closer to the optimal one. Due to this clear focus on optimal
allocation, we could also refer to this approach as the allocation approach.
Under this approach, cases when the market process does not lead to an optimal
allocation are referred to as market failure. The allocation approach is based on a
number of assumptions, the most important of which are: (a) that a social
maximand can be identified, (b) that government representatives intervene in the
market, and (c) that representatives of the state face incentives to maximize
social welfare. Whether or not these assumptions are useful has been doubted
regularly by representatives of different normative programs. Here, we briefly
present three points of criticism put forward by Harold Demsetz back in 1969
about the link between market failure and the demand for governmental
intervention.
The welfare economic ideal is based on assumptions that will never be met.
If this ideal state of the world is compared to reality, reality will regularly fare
very badly. The attempt to realize a state of the world which is impossible to
realize has been dubbed the Nirvana approach by Demsetz (1969).
Nobel laureate George Stigler describes the approach of welfare economics
by telling an ironic story. He compares welfare economists to jurors of a piano
competition between two players who after listening to the first, bad, piano
player, immediately crown the second player the winner without bothering to
listen to the latter play. This is like crowning state intervention as the winner of a
contest without having taken the possibility of government failure explicitly into
account. Some representatives of the NIE claim that attempts to establish an
optimal allocation are fundamentally flawed. According to them, the economy is
not some organic unit which can be maximized meaningfully. Instead, these
critics are interested in the question of how interactions of a great number of
actors can be coordinated so that order – and prosperity – result. Within this
approach, coordination is emphasized by asking what set of institutions is best at
enabling citizens to develop expectations that stand a high chance of turning out
to be correct. These expectations should develop outside the framework of some
central plan, implying a situation where actors are able to pursue a host of
different individual goals. This approach could be labeled the coordination
approach. Whereas the allocation approach has its philosophical roots in
utilitarianism, the coordination approach has its roots in social contract theory.

The coordination approach

Definition

Social contract theory is the notion that the legitimacy of the state – and
the behavior of its representatives – can be legitimized only by the
consent – be it explicit or tacit – of the individuals living under it. One of
its best-known representatives, Thomas Hobbes, describes the state of
nature not only as a state being absent, but where life is “solitary, poor,
nasty, brutish and short.” To leave the war of all against all behind,
rational individuals would have incentives to establish a state through
voluntary consent. Other well-known representatives of social contract
theory are John Locke, Jean-Jacques Rousseau, and in the twentieth
century John Rawls and James Buchanan.

To some degree, representatives of the coordination approach operate on a

different level of analysis than representatives of the allocation approach.
Representatives of the coordination approach are interested in institutions that
facilitate (or impede) economic exchange. They are, therefore, interested in
describing rules that enable different actors to coordinate their behavior.
Representatives of the allocation approach are more interested in evaluating the
outcomes of different allocation mechanisms. Coined differently, representatives
of the allocation approach strive to achieve specific results, while representatives
of the coordination approach are interested in creating the necessary
preconditions to establish a process that helps individuals reach their individual
goals.
In Chapter 1, we mentioned that representatives of the NIE do not agree on
whether the NIE is primarily located within the realm of the allocation approach,
asking questions that have not been asked yet by its more mainstream
representatives, or whether the NIE is based on a fundamentally different
normative approach. A description of the welfare theoretic allocation approach is
contained in most introductory economics textbooks. Instead of describing it yet
again, we rather focus on a more detailed description of the coordination
approach which has been described far less often but is preferred by some
representatives of the NIE.

Definition

Welfare economics is a branch of economics concerned with

maximization of welfare on the group (often the nation-state) level. To
make various feasible outcomes comparable in terms of their welfare
implications, it is based on a social welfare function.

8.3.2 Hypothetical Consent: A Heuristic to Derive Normative

Statements
In this sub-section, we discuss whether the notion of hypothetical consent can be
used as a heuristic to derive normative statements.
 Definition

“Heureka!” is Greek and means “I have found it.” A heuristic is a

pragmatic approach to finding hands-on solutions to problems.
Heuristics are used to identify sensible solutions in little time. Relying on
a rule of thumb is an example.

James M. Buchanan is a constitutional economist. He is a scientist who utilizes

the instruments of economics in order to analyze fundamental rule systems,
specifically, constitutions. Constitutions consist of institutions, thus, one can
consider constitutional economics to be part of the NIE. Buchanan’s central aim
is to explain the origins of institutions and to develop norms for evaluating
existing legal systems (Buchanan, 1975, 50ff.). In this effort, without recourse to
external norms, he attempts to derive the logical structure of social interactions
solely from the perspective of a self-interested desire to maximize one’s utility
(Buchanan, 1975, 80).
In Section 8.2, we saw that the problem of ultimate justification is
unsolvable. Buchanan also needs to presuppose norms. The central normative
pillar of his theory is that goals and values of any one individual should a priori
not be more important than those of another individual. This position is also
referred to as normative individualism. You have encountered methodological
individualism as one of the cornerstones of economics. According to this
concept, only individuals can act, not organizations, systems, or other entities.
According to normative individualism, individuals are the only source of values
or value judgments. This implies that there are no external sources of norms,
such as divine commands or natural laws. As soon as we allow for the possibility
that individuals have different values or pursue different goals, it is very difficult
to apply the allocation approach we just discussed.

Normative individualism

Derivation of a procedural norm

It is possible to derive a procedural norm from the assumption of

methodological individualism. Buchanan adopts this argument from Knut
Wicksell (1896), a Swedish economist. Economic exchange of private goods is
considered to be beneficial if the involved exchange partners voluntarily agree to
it. Everyone involved expects to gain from it, otherwise they would not agree to
it voluntarily. Frequently, exchange activity is conceptualized as involving
merely two parties, the buyer and the seller. Buchanan follows Wicksell, who
applied the same valuation criterion for decisions which affect more than two
parties, extending the criterion to an entire society. Rules that are supposed to be
valid for all members of society can only be assumed to be beneficial for all
members of society if one can reasonably assume that each societal member
would agree to these rules. Rules are considered to be legitimized if no rational
individual is expected to oppose their introduction. Thus, we are applying the
Pareto criterion to the whole of society.
Achieving unanimity can be associated with enormous costs, particularly in
large groups. No rational individual will insist on requiring unanimity for all
collective decisions as long as the expected consequences of a decision are not
very costly. I might never use the local swimming pool but still be willing to
bear some of the costs incurred for its maintenance. Still, I am unlikely to insist
on being involved in making decisions regarding the local swimming pool,
because the costs I expect to bear are simply not worth it. But there are policy
areas in which potential costs can be huge. Imagine a majority decision that
implies I cannot practice an important part of my religion anymore (like coloring
my hair green). This involves basic human rights, and at least conceptually, they
should only be changeable if everybody agrees to the proposed change. More
generally speaking, constitutional rules can be considered the most basic rules of
society. Changing them can have important consequences for many people. This
is why the decision rule regarding constitutional rules should be more inclusive
than the decision rule on the opening hours of the local swimming pool. In most
countries, this is indeed the case.

Definition

Interdependence costs: In their The Calculus of Consent (1962), James

Buchanan and Gordon Tullock propose a simple way to derive optimal
decision rules. Assume that the least costly way of providing some good
is by making it available to the public (this implies that both private
provision and provision by a club are more expensive). But what
proportion of people should optimally vote in favor of some proposal?
How inclusive should the decision rule be?
Buchanan and Tullock propose to frame the issue as a trade-off
between two cost categories, namely, decision-making costs on the one
hand and external costs on the other. Decision-making costs are at their
minimum when a single individual can decide. The larger the number of
individuals involved in consenting to a proposal, the higher the decision-
making costs. External costs are the costs individuals must bear as a
consequence of being outvoted. When the decision rule is unanimity,
 external costs are by definition zero – as nobody is outvoted. Buchanan
and Tullock propose to add the two cost curves and call the resulting
curve an “interdependence cost curve.” According to them, the
minimum of this curve is equivalent to the optimal decision rule. If this
logic is shared by everybody, there will be unanimous consent in favor of
making some decisions with a decision rule that is below unanimous
consent. In Figure 8.1, interdependence costs have their minimum at k,
implying that the optimal decision rule should be k/n.

Unanimity is costly

The normative approach at hand utilizes the Pareto criterion which is

fundamental to welfare economics, but offers an alternative interpretation of it:

1. The criterion is not used to evaluate specific results, but rather rules or
institutions, the use of which lead to certain results. If a rule can be
considered to be legitimized, there is no reason to consider the results that
arise from it to be “unjust” (Hayek, 1976 argues very similarly).

2. Furthermore, “Pareto optimality” is replaced by “Pareto superiority.”

Conceptually, an optimum is a situation that cannot be improved any
further. However, if we identify a rule to be Pareto superior, we are merely
applying comparative institutional analysis. If, at any point in time, we find
that there is general approval of a rule other than the rule in place, the status
quo is being compared to an alternative rule. If the alternative is able to
generate unanimous consent, it can be considered superior to the existing
rule. However, this does not exclude the possibility that there might be yet
another rule which is even better.
 3. This approach questions whether a single welfare economist is able to
evaluate if a specific state of affairs is Pareto optimal. If this was the case,
one would ascribe a specific kind of omniscience to the evaluating welfare
economist, as he or she would need to know all of the preferences of all of
the actors. Buchanan considers this position to be “wholly unacceptable”
(Buchanan, 1959, 126). He argues that just because a group of scientists
considers a policy to be Pareto superior does not make it so; the explicit
consent of everyone who is affected by the policy is required to make it so.

Figure 8.1 The interdependence cost calculus.

Alternative interpretation of the Pareto criterion

Thus, Buchanan’s normative approach does not tell us which institutions

should be implemented in society. Instead, it provides a procedure to determine
whether there are specific institutions that individuals might be willing to accept
under certain circumstances. If this is the case, these institutions are legitimized
and should be implemented. Taken as heuristic, this procedure is quite
convincing. It focuses on the individual and does not require recourse to external
sources of values or value judgments. Nevertheless, let us discuss some
weaknesses of this heuristic.

8.3.3 Some Critical Comments on the Unanimity Test

Many years back, Buchanan himself explicitly recognized that the actual
implementation of the unanimity test just described was fraught with some
difficulties (Buchanan, 1959, 134ff.). To avoid these difficulties, Buchanan
pleads to replace the concept of factual consent by the concept of hypothetical
consent. Buchanan uses speed limits as an example of hypothetical consent: “it
seems clearly possible that general agreement on the imposition of some limits
might well have emerged … within reasonable boundaries” (Buchanan, 1978,
35). The general consent presumed by Buchanan is based on hypothetical
reasons alone. A purely hypothetical consent concerning institutions gets us very
close to the omniscient scientist that was criticized regarding the allocation
approach. The fragility of such a “conceptual consent” is revealed as soon as
different external observers do not agree on which rule a population might have
consented to. Thus, the attempt to evaluate and legitimate collective goods
decisions beyond the formal procedural norm is also confronted with very
serious problems.

Hypothetical vs. factual consent

Veil of ignorance following Rawls

 The possibility of a hypothetical consent also depends on the assumptions
regarding the information available to the actors. If actors are precisely aware of
their individual socioeconomic status, they can use this information to
extrapolate their future status. Proposed rule changes that are associated with
anticipated utility decreases are unlikely to be supported, thus failing the test of
consent. Uncertainty regarding one’s own future position is also referred to as
the veil of uncertainty. John Rawls (1971), who is interested in identifying
universal principles that rational people could agree on, introduced a slightly
different perspective, namely the veil of ignorance. Rawls asks whether
individuals could (or would) consent to a set of basic rules if they did not
possess relevant information that they actually possess. In this manner, one could
assume individuals do not know whether they are rich or poor, young or old,
strong or weak, and so on. This thought experiment is supposed to ensure that
the only rules that can be considered as legitimized are those that do not
disadvantage (or reversely privilege) certain social groups. It remains, however,
a bit unclear what can be learned from this exercise in terms of possible
consequences. Imagine an existing institutional arrangement that could not be
legitimized (because certain groups simply do not consent) while a supposed
change of this arrangement passed the hypothetical consent. If the supposed
reform could not be supported by political and actual majorities, the non-
legitimized status quo would remain in place.
To sum up, the coordination approach is concerned with the rules of the
game, rather than with its outcomes. To ascertain whether specific changes in
basic institutions can be considered an improvement – and hence normatively
desirable – one needs to ask whether all individuals affected by such change
could agree to them. As a heuristic, the coordination approach seems an
improvement over the allocation approach, although it also suffers from a
number of important weaknesses.

8.4 Requirements for a Normative Theory

from the Perspective of Institutional
Economics
As a central assumption of the NIE, we have repeatedly noted that the bounded
rationality of actors implies positive transaction costs. It follows that this central
assumption should also be reflected in a normative theory of institutions, i.e.,
that part of the NIE that is concerned with identifying what institutions are
desirable for a society. In this section, we present two possibilities to explicitly
account for this assumption. Unfortunately, the two approaches lead to
completely different conclusions. This goes to show that a mere accounting for
the central assumption of the NIE is not sufficient to derive generally agreeable
statements.

Efficiency according to Williamson

8.4.1 The Approach of Williamson

Oliver Williamson adheres to the concept of “efficiency,” but defines it in a very

unconventional manner: “An outcome for which no feasible superior alternative
can be described and implemented with net gains is presumed to be efficient”
(Williamson, 1996, 195, italics in original). Remember that Demsetz (1969)
accuses welfare economists of comparing perfect government action with
imperfect market results. This leads Williamson to propose his modified
definition of efficiency. In this view, only realized or realizable alternatives can
be compared with each other. Thus, an institutional change can only be evaluated
as beneficial if the costs of implementing it are accounted for, based on the
current status quo (which is already in place). If the relevant transaction costs
are so high that there is no superior policy which can be implemented, then
Williamson refers to the current state of affairs as “efficient.” The deduction of
theoretical optima often disregards factual political restrictions, such that states
of the world in which there is no implementable improvement are incorrectly
regarded to be inefficient.

8.4.2 The Approach of Hayek

During his entire academic life, Friedrich August von Hayek was always
concerned with the quality of rules that would enable people to live together not
only peacefully but also in prosperity. He can, therefore, be considered a new
institutional economist before the advent of the NIE. Hayek always emphasized
that we are suffering from constitutional ignorance. With that term, he meant
that human ignorance cannot be reduced by any amount of research, because it is
inherent in humans. Taking constitutional ignorance seriously, he warned against
a pretense of knowledge. With that term, he meant to say that due to the fact
that a large part of our ignorance is constitutional, humans often attempt to
create social order based on knowledge they do not possess or cannot possess.
Although Hayek does not explicitly refer to transaction costs, his insistence on
constitutional ignorance indicates that the assumption of bounded rationality
played an important role in his work.

Constitutional ignorance and the pretense of knowledge

 If ignorance is constitutional, the question arises how we can best cope with
it. Hayek’s answer to this is neither new nor very original. Echoing Kant (1991
[1797]), Hayek demands that rules – as one part of institutions – should be
characterized by certain properties that can be summarized by the term
universalizability. According to this criterion, rules should be:

1. General, that is, applicable to a non-foreseeable multitude of persons and

cases.

2. Abstractly (or negatively) formulated, that is, they should prohibit certain
behavior rather than demanding a specific behavior.

3. Specific in the sense that individuals can always ascertain whether a

behavior is prohibited or not.

Universalizability

Consequences of universalizable rules

According to Hayek, universalizable rules are associated with at least two

desirable consequences. On the one hand, they reduce uncertainty, a trait highly
appreciated in institutions. This is primarily ensured by the trait of specificity.2
On the other hand, innovations are possible due to the trait of abstractness,
which is very important for an open and dynamic economy. The utilization of
universalizable rules implies that policymakers, for the most part, refrain from
corrective interventions, as the latter are not universalizable. Hayek (1964) is
aware that the use of universalizable rules can lead us to ignore knowledge that
we actually possess in some cases. Apparently, he places more value on the
stability of law resulting from universalizable rules, than on potential gains
sacrificed by not using knowledge which is actually available.

8.4.3 Consequences of the Two Approaches

Both Williamson and Hayek emphasize the limits of human knowledge and
rationality; however, they draw different conclusions. An interpretation of
Williamson could be: Ex ante, we cannot be sure that we have found the best
possible rules. Over time, our knowledge concerning the effects of rules can
improve and it is in our best interest to be able to make use of that newly gained
knowledge. One way for us to make use of the newly gained knowledge is to
formulate rules – in this case laws – so generally that we are able to reinterpret
their contents in the light of newly gained knowledge. If, however, despite
having framed legislation in a general fashion open to very different
interpretations it is necessary to reform a law formally, the costs of doing so
should not be too high, in order to not delay the use of newly acquired rule-
relevant knowledge.

Hayek: bounded rationality of all actors

Hayek, on the other hand, emphasizes that all actors are boundedly rational.
This not only pertains to lawyers who have to interpret abstract and openly
formulated law, but also to legislators who transform new knowledge into
institutional bodies via amendments. Because the level of complexity that all
relevant decision-makers can deal with is limited, it appears advisable to
formulate rules in general and simple terms.
Williamson might counter that it would be foolhardy to consciously refrain
from utilizing existing knowledge. It appears that his recommendations are
characterized by the hope that our knowledge concerning the functions of
institutions can be expanded and is thus not subject to constitutional ignorance.
However, the question of how we can be sure of whether we have attained new
knowledge remains. Experiences from economic policy seem to suggest that
seemingly certain knowledge can be proven wrong very quickly.
Hayek and Williamson differ in their assumptions concerning what humans
are capable of knowing. Their diverging conclusions on how to cope with our
ignorance could be interpreted as a consequence of differently weighed sub-
goals. While Williamson hopes that new knowledge is embodied in institutions
as quickly as possible, Hayek is primarily interested in reducing the legal
uncertainty of all actors involved. Here, we will not further pursue the question
of whether it is possible to dissolve the sketched trade-off using (meta-
)theoretical arguments.

8.5 Open Questions

In this chapter, we introduced welfare economics as the dominant normative
approach to economics. Our discussion included a treatment of several problems
with arguments based on welfare economic theory that concern representatives
of the NIE. We then encountered an alternative approach that is for the most part
attributed to James Buchanan. It should be clear by now that this approach also
exhibits several problems and weaknesses. Thus, in a further step, we presented
two approaches in which bounded rationality and positive transaction costs play
a role. However, the conclusions that Hayek and Williamson draw are by no
means identical. In Chapter 9, we will present policy recommendations that
representatives of the NIE can give at this point.

Questions
1. Illustrate the meaning of the naturalistic and the instrumentalist fallacy with a
respective example of your own choosing.

2. Try to use the heuristic of hypothetical consent to legitimize constitutional

rules in a policy area of your own choosing.

Further Reading
Audi (2010) is a contemporary introduction to epistemological questions.
Johansson (1991) offers an accessible introduction to welfare economics. The
Nobel Prize in economics was awarded to James M. Buchanan in 1986. His
prize lecture (Buchanan, 1987) is an accessible summary of what I have called
the coordination approach in this chapter.

1 This definition of truth can be traced back to the philosopher Alfred Tarski
(1902–1983) and is also referred to as the correspondence theory of truth.

2 Nevertheless, the observation of one of the authors of the Federalist Papers

– the collection of essays which advertised the acceptance of the new US
constitution of 1787 – should be valid even today. Alexander Hamilton wrote
that “All new laws, though penned with the greatest technical skill, and passed
on the fullest and most mature deliberation, are considered as more or less
obscure and equivocal, until their meaning be liquidated and ascertained by a
series of particular discussions and adjudications” (Hamilton, Madison, and
Jay, 1961 [1788], no. 37). This observation in conjunction with the desire for
less uncertainty leads to the recommendation of changing rules and
institutions as seldom as possible.
 9
Consequences for Economic
Policy
◈

9.1 Introductory Remarks

In Chapter 8, we dealt with the problem of deriving normative statements
regarding institutions. In this chapter, we consider whether the NIE does and
should have consequences for the theory of economic policy. The latter
traditionally deals with the description and identification of policy goals, the
identification of means to attain those goals, and the identification of the
respective actors responsible for implementing policy measures.
Representatives of the NIE assume that it makes sense to explicitly account
for bounded rationality and the ensuing positive transaction costs in economic
models. In this chapter, we inquire into the consequences of accounting for these
assumptions with regard to policy recommendations from economists to
policymakers. Put differently, how does the optimal use of policy instruments
change if we explicitly account for the fact that actors are boundedly rational and
that transaction costs are larger than zero?
 Chapter Highlights

Discuss policy recommendations based on insights from the NIE.

Ask whether internal institutions can be activated by government

action.

Study an example of far-reaching institutional reforms.

In Section 9.2, we proceed in a traditional manner. We begin by assuming

that policymakers are benevolent and attempt to maximize some kind of social
welfare function. By doing so, we ignore a number of arguments that have
occupied center stage in previous chapters. In Section 9.3, one specific aspect is
analyzed in more detail. Namely, can external institutions be utilized to activate
latent and functional internal institutions? In other words, we ask whether
policies can be designed such that they help to alter internal institutions in an
intended direction. Section 9.4 presents a case study. We describe how New
Zealand has implemented in practice far-reaching reforms. New Zealand was
chosen, because time and again observers refer to the NIE when explaining the
reforms there.

9.2 Policy Recommendations: The

Traditional – Naïve – Approach
In this section, we present several consequences for economic policy that can be
derived from the NIE. These recommendations are not naïve in and of
themselves. However, they do not account for the incentives of policymakers.
Thus, it would be naïve to expect policymakers to immediately implement these
suggestions. Nevertheless, this traditional approach has a right to exist. It shows
which measures would be implemented by policymakers if they were either
benevolent or subject to restrictions that make them behave as if they were
benevolent.
The policy recommendations we name here are derived from the preceding
chapters. Let us describe them in detail:

Economic policy consequences

Recommendation #1: It is not sufficient to strive for improvements of

physical and human capital. It is at least equally important to install institutions
that are conducive to economic growth.
This suggestion represents an extension of economic growth theory. In
economic growth theory, institutions were neglected almost entirely for a long
time. In the long term, economic growth is only possible through growth of total
factor productivity. In Chapter 5, we found that total factor productivity
decisively depends on the quality of institutions.
Recommendation #2: Institutional change should be the exception, not the
rule. If institutional change promises net gains, it should be carried out as
transparently as possible to enable actors to formulate expectations that have a
good chance of being confirmed.
The function of institutions is to enable actors to formulate expectations
that have a good chance of turning out to be true. Any type of institutional
change, even with the best of intentions, runs, however, the risk of increasing
uncertainty. Institutions need to be enforced by administrators, police officers,
judges, and so on. Newly created or modified institutions can increase
uncertainty because the specific way in which the content of the institutions is
interpreted by the enforcers is unclear initially and needs to develop over time.
An increase in uncertainty seems, therefore, very possible, at least during some
initial period. Conversely, the longer certain institutions remain unchanged, the
easier it becomes to formulate adequate expectations. Institutions exhibit capital-
like characteristics if they increase in value with age (see Buchanan, 1975,
chapter 7).
Transparency is desirable at all levels of legislation, as it reduces
uncertainty. This is true for the process in which new legislation is produced, for
the immediate publication of laws newly passed (not the norm in many
countries), and for transparency concerning their implementation. Many
countries have introduced freedom-of-information acts which are supposed to
enable citizens to know how laws are implemented. If these freedom-of-
information acts are factually implemented, they can increase transparency.
Recommendation #3: When trying to implement institutional change,
governments should strive to commit to this change as much as possible.

Institutional change and economic growth

If the goal of economic policy is to increase per capita income, and external
and internal institutions are crucial for per capita income, the demand for
installing growth-enhancing institutions is certainly not surprising. Naturally, the
implementation of this recommendation is subject to great difficulties.
Otherwise, why would so many dysfunctional institutions exist? Institutions are
of little use if they are merely formally in place, and do not enhance the ability
of interacting partners to form stable expectations. One of the goals of economic
policy should be to work towards a convergence of de facto and de jure
institutions. However, the government typically has trouble committing credibly
to the rules it sets in place (you recognize this as the dilemma of the strong
state). Why, then, should private citizens believe any of the promises of a
government to safeguard private property rights, when at the same time the
government has the power to expropriate? One suggestion in the literature is to
consolidate the security of property rights by making them (legally) part of the
constitution of a country (Gwartney and Holcombe, 1999). Again, we can ask
why a governmental promise should be believed to be more credible solely
because it is part of a written document with a different name. It has been argued
that – at the end of the day – constitutional rules need to be self-enforcing
(Hardin, 1989; Ordeshook, 1992). One way to make institutional change credible
is, therefore, to install self-enforcing institutions. If that is not possible, an
alternative is to create a high number of stakeholders that are likely to oppose the
government if it does not comply with its promises. An example for such
behavior is described in Chapter 4. One way to privatize state-owned companies
consists in selling shares to large segments of the population. Any expropriation
attempt by the government would be very costly, as many of the shareholders are
likely to protest against such government behavior.
If the government of a country simply cannot credibly commit to
institutional change domestically, Levy and Spiller (1994, 210) propose that
governments have the option of binding their hands by making commitments to
international organizations. Whether the World Bank or other international
organizations are suitable for this, needs to be considered case by case.
Recommendation #4: When reforming external institutions, the existing
internal institutions need to be accounted for. By and large, the external
institutions should be compatible with the internal institutions of society.
Institutional change that enlarges the gap between de jure and de facto
institutions tends to imply higher transaction costs and is thus counter-
productive. Keefer and Shirley (1998) point out that policies aimed at inducing
change in external institutions have often proven ineffective in the past. The
authors consider the alternative approach of focusing on change in internal
institutions.1 However, they point out that adequate internal institutions are, in
and of themselves, not sufficient to induce sustainable economic growth.
Attempts to induce change in internal institutions have frequently failed. If
change is attempted nevertheless – for instance by establishing external
institutions that sanction the use of specific internal institutions – there will be an
increase in enforcement costs. If private actors continue to use these internal
institutions that are now sanctioned, they need to be more careful, which
amounts to an increase in transaction costs.
This insight has been expressed by different authors in different ways. For
instance, North (1990a, 140) writes: “When there is a radical change in the
formal rules that makes them inconsistent with the existing informal constraints,
there is an unresolved tension between them that will lead to long-run political
instability.”
Recommendation #5: The untapped productive potential of internal
institutions should be identified and private actors should be encouraged to
function as catalysts to spread these institutions.
Recommendation #4 seems to imply that governments should not even
attempt to tinker with the internal institutions of a society. However, this might
be a premature conclusion. In many parts of the world, farming communities are
responsible for the maintenance of their irrigation systems. Some communities
have managed to develop internal institutions that ensure a steady flow of water,
while others have failed to develop such institutions. This is described in more
detail in Chapter 4. Following her research on irrigation systems, Ostrom (1996,
226) proposes that farmers whose irrigation system does not work properly
should be given the chance to visit communities in which it does work well, to
learn from them and to create adequate internal institutions.
 Recommendation #6: When implementing institutional change via
deregulation, it is advisable to implement comprehensive packages
simultaneously, in order to give actors who suffer losses due to deregulation in
their respective industry the opportunity to realize gains due to deregulation in
other industries.
This recommendation is less naïve, as it accounts for political economy
aspects. Assume a government aims to increase economic growth and at the
same time strives for re-election. To improve growth prospects the government
might want to implement institutional reform. But if reforms are met with
opposition from potential voters, the government will need to make trade-offs.
The popularity of a government also depends on the sequencing of institutional
change.

Institutional change and political sustainability

In the 1980s, the government of New Zealand implemented a whole series

of far-reaching reforms to encourage renewed growth in the country. Observers
of the reforms in New Zealand (Evans et al., 1996) report that the simultaneous
implementation of a multitude of reforms helped the government to remain
reasonably popular. While some industries suffered losses due to the reforms
(e.g., through reductions in subsidies and protectionism), reforms implemented
in other industries increased competition, prompting higher quality products and
potentially lower prices for consumers. The widespread implementation of
reforms across industries was likely to make people both worse off (as
producers) as well as better off (as consumers). In the case of New Zealand,
industries in which comprehensive deregulation was implemented early on often
demanded similar deregulation for other industries. They became, therefore,
stakeholders in favor of institutional change.
Recommendation #7: Only feasible alternatives should be compared with
each other. This involves explicitly accounting for the implementation costs of
new institutions.
One of the fundamental insights of the NIE is that the allocation and
coordination mechanisms can never be perfect or without cost. Before
policymakers decide to correct some market failure previously identified using
abstract criteria, they need to consider the possibility of government failure. As
discussed in Chapter 8, institutional change only makes sense if the benefits of
change outweigh the cost. These include not only the set-up and operational
costs of institutions, but also the political costs that are incurred to get a
sufficient number of parliamentarians to vote in favor of new institutions.

Institutional change and government failure

9.3 Activation of Internal Institutions

through Government Action?
Throughout this textbook, we have emphasized the relevance of internal
institutions. Some of the policy recommendations just developed are concerned
with the relationship between internal and external institutions, primarily their
compatibility with each other. In this section, we build on our previous
reflections and ask if there are situations where the state can act as a catalyst for
activating internal institutions. Imagine the existence of some internal
institutions that encourage people to provide themselves with a public good.
Further imagine that if a minimum number of people participate in the private
provision of a public good, many others would also do so. In such a situation, an
actor able to help a group of individuals meet that threshold could act as a
catalyst, inducing private actors to rely upon those internal institutions. We will
analyze whether government action, or even the mere announcement of a
specific action, can affect the activation of what could be termed “latent”
internal institutions. These “latent” internal institutions will only be used if
somebody kicks off their use and the question is whether the government can be
that somebody.
Assume that virtually all citizens of a country perceive environmental
pollution to be a grave problem and that – in principle – all citizens are willing to
do something to reduce pollution. Moral suasion – that is, the attempt by
policymakers to induce changed behavior by moral pressure – is, however,
ineffective. Even if we assume that basically all citizens are willing to bear the
costs for better environmental protection, there is little reason to believe that
citizens will reduce their individual pollution without any external incentives.
Individual reduction of pollution is associated with costs, but the effect of this
individual effort on aggregate environmental quality is virtually zero. Thus, the
activation of internal institutions requires different forms of governmental
intervention.

Moral pressure: a dubious tool

Reducing environmental pollution is equivalent to the provision of a public

good. Everyone gains from a cleaner environment and no one can be excluded
from this benefit. Robert Sugden (1986, 137) shows that the voluntary provision
of public goods often fails because of the great difficulty in creating a simple and
transparent rule which allocates the individual contributions required for the
production of the public good. Thus, we need a rule that informs individual
polluters about their respective new level of pollution. By doing this, we would
take an important first step towards overcoming the social dilemma.

The state can help citizens to coordinate behavior

9.3.1 A Specific Example: Voluntary Commitment Declarations

Let us now turn to voluntary commitment declarations (VCDs) as an example of
how internal institutions can be activated by appropriate government action.
VCDs are declarations by groups of polluters (usually associations) to achieve
some environmental goal within a specific time frame. VCDs are often induced
by governmental announcements to pass certain decrees. The fact that
associations prefer VCDs to direct regulation shows that they anticipate lower
costs from the former. Often, VCDs involve some form of exchange in which the
government commits to refrain from using regulatory instruments for the
duration of the VCD. Prominent examples for VCDs include the declaration by
automakers to reduce CO2 emissions, take back scrap cars, and to develop and
produce a three-liter car. These declarations have been made on the European
level, as well as in various nation-states such as Germany, Japan, and Korea.
Within the framework of this particular example, we will examine the potential
of all four types of internal institutions to channel the behavior of polluting
firms. In terms of game theory, agreements between the government and
associations would be declared as cheap talk as neither side can credibly commit
to its respective promises. Formulated differently, there are strong incentives for
ex post opportunism on both sides. The government could break its promise to
not use regulatory instruments, while firms within the association could break
their promise to stick to self-declared environmental goals. Game theorists
would, therefore, predict that such agreements are unlikely to induce any change
of behavior.

Problems of voluntary commitment declarations.

Definition

Cheap talk: Game theory term which describes the ability to costlessly
communicate declarations of intent. As the prisoner’s dilemma has an
equilibrium in dominant strategies, such communication should be
without consequence for the outcome of the game.

In Section 9.2, it was argued that one way to make promises credible is to design
them as self-enforcing agreements, i.e., agreements in which all involved parties
have ex post incentives to stick to their ex ante agreed upon commitments: in the
language used in this book, to design them as type 1 institutions. Clearly, VCDs
do not represent such agreements. Both parties have trouble credibly committing
to their promises given as part of the VCD. Thus, the political transaction costs
of VCDs appear to be rather high. For those individuals who are critical of
VCDs, the story ends here. As no sanctions are to be expected, none of the
involved parties has an incentive to change their behavior.

Self-enforcing agreements
 For those familiar with the NIE, the story goes on. One could ask whether
VCDs could induce behavioral change by activating internal institutions in the
members of the association. Assume the pollution reductions committed to at an
association level are broken down to its member firms, thus, “allocated.” If
member firms perceive the rule of allocation to be fair, we could already expect
certain behavioral changes even if noncompliance has no legal consequences. A
breach against the rule pacta sunt servanda (agreements must be kept) can
induce (psychical) costs for the breaching party if they have been socialized
accordingly. In the typology you have come to know, type 2 internal institutions
are able to channel behavior. The sanction against a member firm that does not
comply with the agreed upon reduction in pollution consists of lowered utility
due to the breach of an ethical rule (in this case the rule that promises ought to
be kept).

Activation of internal institutions as solution?

On the other hand, some of those who are willing to contribute in principle
might only contribute for real if others also contribute an amount that is
perceived to be appropriate.2 It appears that the regular monitoring of VCDs
fulfills just this function. By permitting monitoring at regular intervals,
contributors can assure themselves that they are not suckers,3 but rather part of a
functioning private provision of a public good. Frey (1997) argues that voluntary
contributions can transform intrinsic motivation into action, while governmental
distrust can lead to crowding out and evasive behavior. It might make sense to
have the monitoring overseen by independent third parties, not suspicious
government officials. For instance, the RWI Institute for Economic Research – a
German economics think tank – is commissioned to monitor the VCD declared
by a broad range of German industries to reduce CO2 emissions. Any individual
firm can assure itself by the numbers provided by its association that they are
contributing to a functioning public good. The track records of all associations
that participate in the VCD are collected and documented by the RWI. The
degree to which these associations comply with the promises is, therefore, easily
visible by all interested parties – not only within an association, but also across
associations.

Monitoring by independent third parties

Advocates of VCDs often argue that when a vast majority of a society’s

members care about the environment, noncompliance with the agreed upon
environmental goals would be associated with reputational damage. The
possibility of incurring this damage represents incentives for firms to comply
with publicly agreed upon goals. The reputation mechanism can be interpreted
as part of an institution that informally sanctions the noncompliant party by
revoking its social recognition and reducing its social interaction with third
parties. We have, thus, arrived at type 3 institutions.

Further incentives via type 3 institutions

However, the recourse to the environmentally responsible society might be

hasty and imprecise for two reasons. First, we need to assume the presence of a
critical public that follows up on the compliance of VCDs in the medium to long
term. For now, let us take this as given. Then, reputation would be relevant only
if noncomplying parties could be specifically targeted with costs that they could
avoid by complying with the VCD. If we take a look at the German CO2
reduction VCD, it includes associations from very different industries. The
potential of individual consumers to sanction such associations by exit or the like
is rather low.
Even if such a withdrawal of approval was possible, we cannot exclude the
possibility that just a few free-riders within an association are responsible for
noncompliance of the association as a whole. This means we have come round to
the association-internal prisoner’s dilemma. Costs through deprivation of
reputation should be imposed on free-riders primarily by other association
members. This is probably easier too, as the frequency of interaction is higher
within an association. Put differently, association members are playing a
repeated game. Whether the internal sanctioning mechanism reputation works –
thus increasing the likelihood of compliance with the VCD – depends, among
other things, on the number of association members, the precision with which
members can assess the environment-related actions of other members, and the
time preference of individual members.

Loss of reputation

Furthermore, it is at least possible for an association to formally sanction

defecting member firms, that is, utilizing type 4 institutions. This is more likely
to occur if rule compliance cannot be adequately ensured by informal sanctions
alone. At this point, it is important to explicitly inquire into the kind of
relationship that member firms have with their association. Is membership
voluntary? Is membership important for the business success of the member
firms? Does the association have any kind of power it can exert on a
noncomplying firm? Should the answer to the last question be yes, type 4
institutions might, indeed, play an important role.

Type 4 institutions could also be relevant

We can conclude that a latently present willingness to voluntarily contribute

to the production of a public good can be activated by representatives of the
state by: (a) threatening to pass external institutions (in this case, regulatory
requirements) in the case of non-activation, and (b) supporting private actors to
overcome relevant social dilemmas. Before representatives of the state attempt to
move in this direction, however, it needs to be verified whether the necessary
conditions exist or can be created. For the case of VCDs, one necessary
condition is that a high percentage of the respective harmful substance is emitted
by a relatively small number of polluters and that they can be divided into
sufficiently small groups to allow the application of some allocation rule.
Referring to necessary conditions more generally, for the state to be able to act as
catalyst: (a) appropriate type 2 institutions need to be present for the majority of
the individuals involved, and (b) sanctioning mechanisms for type 3 institutions
can be activated (if they already exist) or be created (if they do not exist yet).

9.4 Policy Reforms in Practice: Case Study

of New Zealand
9.4.1 The Initial Situation in New Zealand
In 1840, New Zealand was annexed by Great Britain. As an agriculturally
oriented country, it primarily exported meat, wool, and dairy products to Great
Britain, which enabled it to attain an excellent standard of living for decades.
Starting in the 1930s, New Zealand set in place comprehensive social security
systems. The economic collapse of New Zealand began in 1973, when the UK
joined the European Community (EC). After this, the potential to export
agricultural products from New Zealand to Europe became more and more
restricted. The potential for New Zealand producers to spread into other markets
was limited by both protectionist policies of other countries, as well as
subsidized agricultural exports from EC producers.
As a response to the two oil crises in 1974 and 1979, the New Zealand
government began a policy of import substitution. This policy was intended to
encourage the domestic production of goods that were previously imported. A
similar policy was attempted by many Latin American countries and has mostly
proven to be of little use as it involves deliberately refraining from exploiting
specific comparative advantages. Because domestic producers were protected
from foreign competition both by high tariff and high non-tariff barriers,
competitiveness was even further decreased. In the 1970s and 1980s, the growth
of both productivity and GDP remained well below the OECD average. While
New Zealand’s per capita income in 1950 was 26 percent above the OECD
average, in 1990 it was 27 percent below the OECD average (Bollard, 1994).

Import substitution

9.4.2 Overview of the Most Important Reforms

In 1984, the Labour Party emerged victorious in New Zealand’s parliamentary
elections. The incumbent conservative Prime Minister Robert Muldoon was
replaced by David Lange. Immediately after the change of government,
comprehensive reforms were implemented, initiated primarily by Minister of
Finance Robert Douglas. In 1987, Labour was re-elected. Compared to the first
Labour legislative period, the speed of reforms decelerated significantly. Even
though there was another change of government in 1990, the newly elected
Conservative government continued the comprehensive reform efforts of the
Labour government. In 1994, the Conservative government was re-elected.
Similar to the Labour government, the Conservative government significantly
decelerated their reform efforts in their second legislative period.
Over a period of more than ten years, New Zealand’s governments passed
and implemented a multitude of reforms. Naturally, we cannot describe them in
detail here (for a comprehensive account, see for instance Bollard, 1994 or
Evans et al., 1996). Instead, here is a brief overview:

Deregulation of the financial sector: The government abolished interest

rate regulation, capital transaction control, and minimum reserve
requirements.

Clear priorities in monetary policy: In 1989, the Bank of New Zealand

became independent, its sole purpose being to maintain price stability.
Central bankers are responsible for meeting the goal of price stability,
risking dismissal if failing to meet the goal.

Fiscal policy: From the beginning of the reform period, the government’s
efforts at generating surpluses in order to amortize debts were successful.
By broadening the tax base, the government managed to reduce the top
income tax rate from 66 to 33 percent. Indirect taxes were unified by the
introduction of a value-added tax. Government expenditures were
reduced by drastically cutting the level of subsidies.
 Civil service: Some departments were converted into state-owned
enterprises that were later sold. Employment was reduced in the civil
service sector. The management of state-owned enterprises was
established on merit-based contracts. State-owned firms were made
subject to the same competition law as private firms, and are, for the
most part, subject to the same competitive pressures.

Labor market deregulation: Master contracts were replaced by firm-level

contracts. This change disempowered labor unions practically overnight.
Within three years, there was a 38 percent reduction in union
membership. The incidence of labor strikes has decreased significantly.

Industry and trade: Widespread trade barriers were rapidly reduced. This
has led to an increase in the proportion of imported goods. Consumers
now face a much broader selection of products, often at lower prices.

Agriculture: Deregulation and liberalization of agriculture was one of the

first steps the Labour government took in 1984. Previous subsidies were
abolished almost completely.

For some of the measures, the delay until there was noticeable improvement in
the respective indicators was remarkable. For instance, the GDP share of public
expenditures continued to rise until 1988. It took ten years for GDP to begin
growing again.

9.4.3 Explaining the Reforms

The New Zealand reforms are noteworthy for two reasons. First, it is remarkable
that they were implemented at all. Second, it is extraordinary that the respective
governments were re-elected (the last time a Labour government had achieved
this before 1987 was in 1946!). We will identify four factors that together
facilitated the implementation of the reforms: (1) the ideas and theories upon
which the reforms were built; (2) the persons who promoted the implementation
of the reforms; (3) the institutions and organizations which supported – or at
least did not impede – the reforms; and (4) the specific circumstances under
which the reform process was initiated.

9.4.3.1 Underlying Theories

The encompassing interventionist policy administered until the mid-1980s was,
for the most part, founded on the predominant economic theories of the time– a
welfare economic approach that subscribed to the ideal of perfect competition
and demanded state intervention if the optimal results of welfare economic
models were not attained. The import substitution policies following the oil
crises in the 1970s were induced by the same underlying theories.
In the meantime, more recent theoretical approaches had spread within the
New Zealand Treasury, which comprises not only the ministry of finance, trade
and industry, but also acts as the prime economic advisor to the government (we
will come back to this later). Bollard (1994, 90f. and 94f.) describes the theories
that began to assert themselves in the mid-1980s:

The market failure approach was replaced by the transaction cost

approach which explicitly accounts for the fact that political and
bureaucratic coordination is associated with costs. Thus, it is not only
markets that can fail, but also bureaucracies and even the government.
The immediate consequence is the use of comparative institutional
analysis (Evans et al., 1996, 1862). The publications of Ronald Coase,
Harold Demsetz, and Oliver Williamson probably played an important
role in this regard.

The usual arguments in favor of state-owned enterprises (“national

 interests”) lost most of their appeal. Instead, and drawing on
principal–agent theory, it was now argued that state-owned enterprises
are particularly plagued by inefficiencies due to incentive and monitoring
problems.

In addition, the rationality of relying on the government to provide

services was doubted more and more. Supply-oriented theories that
pointed to crowding out effects of a large public sector replaced the
incumbent theories.

At the beginning of the 1980s, strongly influenced by the work of

William Baumol, the traditional regulatory approach was replaced by the
approach of contestable markets. According to this approach, the
number of competitors in a market is irrelevant to market outcomes (such
as price and quantity), as long as potential competitors are not prevented
from entering the market. Often, however, state-issued regulations are a
serious kind of entry barrier that keep innovative firms from entering a
market.

Beyond these, Bollard (1994, 90f.) names the theories of James Buchanan and
Gordon Tullock as relevant concerning the functioning of political processes and
the theories of Armen Alchian as relevant with regard to private property rights.

9.4.3.2 Persons Involved

In the past, one could observe again and again that the successful passing and
implementation of comprehensive reform packages was closely linked to
specific persons. The introduction of the social market economy in Germany is
inseparably linked to Ludwig Erhard, and the 1980s reforms in Great Britain and
the USA to Margaret Thatcher and Ronald Reagan respectively. The same is true
for the New Zealand reforms. Roger Douglas was chief of the Treasury for the
Labour party; for the national party it was Ruth Richardson. Interestingly, both
stepped down during the respective second legislature period of their parties.
Economic theory categorizes actors with recourse to a very simplified
behavioral model. Using this behavioral model, a great number of different
behavioral outcomes can be predicted with surprising reliability. However, the
economic model is less suitable for the explanation – and even less so for the
prediction – of innovations. The behavior of firms that engage in creative
destruction in the Schumpeterian sense and create completely new products by
recombination of resources is very difficult to integrate into the economic model.
The same restrictions apply to the analysis of political entrepreneurs who – in
the realm of politics – conduct recombinations, leaving aside trodden paths.

9.4.3.3 Behavior-Channeling Institutions, Relevant Organizations

Although we have just emphasized the importance of political entrepreneurs for
the successful implementation of comprehensive reforms, these political
entrepreneurs require an appropriate institutional framework to implement these
reforms. Not all institutional frameworks are equally suited for this purpose.
Different observers point out that the framework in New Zealand was very
accommodating for reform-minded policymakers.
The New Zealand system, like the English system, is characterized by the
so-called Westminster model. When the reforms were initiated, New Zealand
had a majority voting system. For each electoral district, there is one
representative, the candidate with the majority of votes is sent to parliament, and
all other votes are disregarded. Such a voting system regularly leads to a two-
party system. The party with the parliamentary majority creates the
government. The New Zealand political system is unicameral. There is no
second chamber that needs to approve the passing of proposed laws. As New
Zealand does not have a written constitution, even far-reaching modifications of
the legal system are possible by simple majority.

Westminster model

This type of system gives great power to the respective government. This
power can be used to adopt a high degree of interventionism and regulation, like
in the years before 1984, or to push deregulation and opening up, like in the
years after 1984. In the meantime, New Zealand has introduced a proportional
representation system similar to the system used in Germany. A number of
splinter parties have formed on both the left and right of the political spectrum.
Majority voting rules very regularly lead to two-party systems, implying that a
single party will form the government. To gain the majority of the popular vote,
party platforms need to cater to general interests rather than to small special
interest groups. Proportional voting rules regularly lead to multiple party
systems implying the need to form coalition governments. Party programs are
more likely to cater to smaller groups with less general interests. To remain in
government, coalition governments need to agree on many compromises
between the coalition partners. In this sense, the change of the New Zealand
voting system is an indicator that reforms would not continue at the same pace.
However, since a proportional representation system limits the scope for
government-induced change in all directions, it also should be (rather) difficult
to take back the reforms achieved.
We already mentioned the Treasury as a relevant organization. Knorr (1997,
145) points out that it is mostly staffed by economists rather than lawyers, as in
many other countries.
 9.4.3.4 Favorable Circumstances
John Williamson (1994) claims there are a number of factors that influence
whether or not newly elected governments are able to implement reform
packages. These include:

1. The “crisis hypothesis.”

2. The “mandate hypothesis.”

3. The “honeymoon hypothesis.”

4. The “presence of a fragmented and demoralized opposition.”

Bollard (1994) argues that three of these factors were present in New Zealand
during the period of reform. Both the long-term worsening of the terms of trade
and the short-term deterioration of the balance of payments (which led to the
replacement of the Muldoon government) were perceived as a crisis by the
population. Times of crisis can be used by governments to implement reform
packages.
The mandate hypothesis claims that the size of the parliamentary majority
over the minority is an indicator of the legitimacy with which the new
government implements comprehensive reforms. The Labour victory of 1984
appeared to be a landslide victory with Labour winning 56 out of 95 seats, 13
more than in the previous election. Thus, the second factor was also present in
New Zealand.4
The honeymoon hypothesis states that the electorate attributes negative
outcomes to the former government and gives newly elected governments a
certain period of time to change course. This, too, could have been the case in
New Zealand.
Finally, the losing national party was indeed in a state of dissolution after
the loss in 1984. For a long time, it was occupied with trying to find a successor
for Muldoon and formulating the party’s future programs. Its reconsolidation
lasted till 1990 when it succeeded in defeating the Labour party. Thus, one could
characterize the opposition as fragmented and demoralized.
Another lucky circumstance named in the literature is that the Labour
government was confronted with a remarkable number of foreign policy
incidents during its first legislative period. This could mean that the attention of
the public and the prime minister were diverted from the radicalness of domestic
economic reforms (Knorr, 1997, 143f.). These incidents include disputes within
the then existent defense alliance ANZUS (Australia, New Zealand, USA), the
sinking of the Greenpeace ship Rainbow Warrior by the French secret service,
and the sinking of a Soviet warship to the south of New Zealand.

9.5 Open Questions

The example of New Zealand constitutes empirical evidence that reform
proposals that are based on institutional economic insights can be realized
politically. But the somewhat detailed account of the New Zealand case shows
that beyond the insight that improving institutions is important, the likelihood of
seeing any such improvements implemented depends on the specific context as
just pointed out.

Questions

1. Illustrate the logic of the argument developed in Section 9.3 concerning VCDs
in environmental policy using the prisoner’s dilemma.

2. Analyze reforms undertaken in your country using the framework provided in

this chapter.
 Further Reading
Freedom-of-information acts have been implemented in many countries with the
aim of making the behavior of an administration and its bureaucracy more
transparent and accountable. Whether freedom-of-information acts actually
achieve these goals, remains doubtful. Costa (2013) deals with the issue. Blume
and Voigt (2013) inquire into the consequences of transparency in the way
budget laws are produced and implemented, and find that transparency is
significantly correlated with the effectiveness of government.
The use of voluntary commitment declarations among European automobile
manufacturers is discussed in Fontaras and Samaras (2007). The OECD report
“Voluntary Approaches for Environmental Policy: Effectiveness, Efficiency and
Usage in Policy Mixes” (OECD, 2003) is a more general overview of voluntary
commitments. The monitoring reports by the RWI are available online but only
in German (http://en.rwi-essen.de/media/content/pages/publikationen/rwi-
projektberichte/RWI_PB_Monitoringbericht-2011-und-2012.pdf).
The possibility to induce change in internal institutions via external
institutions is discussed in Aldashev et al. (2012).
New Zealand offers an example of very comprehensive national reforms.
Naturally, insights from the NIE can also be applied to different situations. Every
amendment is associated with the hope of changing incentives for the relevant
actors in order to achieve better outcomes. Lawyers refer to this as a “regulatory
impact assessment.” In the past, empirical social studies have not been an area of
expertise for lawyers, but we see great potential and manifold reasons for
economists and lawyers to cooperate. Economists can support lawyers by
predicting potential effects of changed laws and in analyzing factually induced
behavioral changes ex post. In some jurisdictions, this is firmly established as
regulatory impact assessment. Comparative studies on the experiences with
regulatory impact assessment have been put forward by the OECD (2004) and
the European Council (2004).

1Whether, and if so to what degree, this can be achieved will be discussed in

Section 9.3.

2 Sugden (1986) describes this as a “reciprocity principle.” Weimann (1994)

refers to a strong “exploitation aversion” which is found in experiments.

3In the prisoner’s dilemma, suckers are actors who cooperate while the other
party is defecting and thus realizing gains at the cost of the sucker.

4 With 93.7 percent the turnout at this election was the highest ever recorded
in New Zealand. This has been interpreted as a desire by voters in favor of
change.
 10
Outlook
◈

10.1 Introductory Remarks

The previous nine chapters can be grouped into four broad parts. In the first part
(Chapter 1), we encountered the questions that institutional economists pose and
the instruments that can be used to answer those questions. In the second part
(Chapters 2–5), we assumed that institutions are exogenously given. We then
considered how different institutions affect different subjects: simple
transactions (Chapter 2), firm structure (Chapter 3), and collective decisions
(Chapter 4). In Chapter 5, we looked at the effects of institutions on economic
growth and development. In the third part (Chapters 6 and 7), we proceeded to
“endogenize” institutions, that is, consider institutions as determined by other
factors. We asked how an economics approach can help us explain the evolution
and change of external institutions (Chapter 6) and internal institutions (Chapter
7). In the fourth part, we turned to potential policy implications (Chapters 8 and
9). In Chapter 8, we discussed the need for a normative theory. In Chapter 9, we
examined specific policy implications.
 In this chapter, we will review the questions posed in the Introduction and
examine whether we have gotten any closer to answering them.
If you are indeed one of those readers who reads this book from front to
back, please re-read the Introduction and try to answer the questions posed there
using what you have learned. If you choose to proceed immediately, you will
miss a nice opportunity for repetition.
Let us proceed to the questions posed in the Introduction and potential
answers.

Why are so many people malnourished?

We asked why the majority of humans worldwide command a low per

capita income. One way to answer this is using property rights theory. But we
can also resort to the relationship between institutional quality and economic
growth discussed in Chapter 5, as well as the theories of institutional change
presented in Chapter 6. We cannot truly understand why it is so difficult to
implement institutions that are commonly known to be conducive to economic
development unless we accept that there are individuals in low-income countries
who profit from the status quo and expect to suffer from growth-enhancing
institutions. As we have seen repeatedly, it does not suffice to implement a set of
adequate external institutions to promote economic development. Rather, a set of
internal institutions is required that, at the least, does not fundamentally conflict
with those external institutions.
Another question was why the import of constitutions that have proven to
be successful elsewhere often does not yield the desired results, such as
prosperity and stability. The easiest way to answer this is with recourse to the
compatibility between external and internal institutions. If the imported
institutions are not compatible with conventions and traditions prevalent in a
society (internal institutions), any imported constitution (external institution)
will remain a mere piece of paper. Another answer could be that conditionality
imposed by the IMF and World Bank can lead to window dressing.
Conditionality basically means that the IMF offers credits to a government
conditional on implementing a number of reform measures. Frequently, these
reforms are unpopular among the population and governments will therefore
only pretend to implement them in order to receive the credits needed from the
IMF. Laws are passed de jure in a country that no one in that country de facto
considers enforcing.

Why is it so difficult to transplant constitutions successfully?

We discussed several studies in Chapter 5 that addressed the question

whether there is a relationship between individual liberties and per capita
income, all of which point to the conclusion that this is not a mere correlation,
but a causal relationship.

On the relationship between individual liberty and economic growth

Is there a silver bullet for transforming entire countries?

Then there was the question whether there is one correct way of reforming
previously socialist societies, namely fast and far-reaching privatization. This
topic has not been explicitly discussed in this book. You might know that,
initially, there was serious dispute about whether transformation should occur as
a big bang or rather more gradually. From discussions in numerous chapters of
this book, two potentially contradictory arguments can be derived. On the one
hand, the necessity that external institutions must not be fundamentally at odds
with internal ones might suggest that reforms should only take place gradually.
On the other hand, there are many aspects belonging to the political economy of
reform that we discussed with regard to the example of New Zealand in Chapter
9. There, we saw that fast and encompassing reform can be conducive to a large
pro-reform coalition across very different interest groups. In the meantime, we
have assembled a lot of empirical evidence regarding the effects of slow vs. fast
transition. The evidence suggests that nations that undertake rapid reforms have
managed to increase their living standards far more readily than nations that
pursue more gradual reforms.
At this point, you might wonder why this chapter is called “Outlook” if all
we have done so far is remind ourselves of all the puzzle pieces that we have
encountered in the first nine chapters. That is why we now proceed to presenting
several areas in which there is both need and potential for further development.
If you are interested in what you have read so far, why not consider conducting
your own research in this exciting area?

Open questions

Let us start off with several unexplained aspects you might remember from
previous chapters. We have discussed internal and external institutions more or
less equitably. Giving equal weight to internal and external institutions is not
common in most current economics research. The vast majority of studies deal
exclusively with external institutions. The few studies that consider internal
institutions treat them neither equally nor exclusively.
 In Chapters 8 and 9, you probably noticed that the normative foundations of
institutional economics are still rather thin. Most scholars within the NIE have
some quarrels with the established welfare approach. But refusal of an
established approach does not in itself represent an alternative, no matter how
good the reasons for the refusal. The alternative approach we presented in
Chapter 8 does suffer from many caveats. As soon as we attempt to apply that
approach to economic policy, there is uncertainty how exactly that should be
done.
In what remains of this concluding chapter, we briefly address four areas
that have not received much attention so far, but that we expect to play a far
greater role in the future. We start with the role of cognition for the relevance of
institutions, which represents a rather abstract aspect. We then discuss the role of
ideas for the emergence of novel institutions. The question whether the personal
traits of individuals can be decisive in policy outcomes is taken up in Sections
10.3 and 10.4. In Section 10.5, we inquire into possible consequences of
globalization for the relevance of institutions. Section 10.6 deals with the most
serious challenge for empirically validated institutional economics, namely,
identification, a technical term used by econometricians to ask how
observational data can be used as if they had been produced by a real
experiment. In a sense, we inquire into the relevance of “four i’s” – namely
ideas, individuals, internationalization, and identification – for the relevance of
“the fifth i” – namely institutions. At the very end of this chapter, we have a few
suggestions where to turn to in case you are enthusiastic about the NIE and want
to start your own research right away.

10.2 Institutions and Mental Models

Mental models crucially affect how we view the world. Naturally, we need to ask
how they develop, how they spread socially, and so on. Human cognition is a
necessary part of this investigation. Due to cognitive constraints with respect to
information reception and processing, information is received and processed
selectively. Perceptions and experiences that are culturally passed on or based on
direct experimental learning lead to the forming of neuronal links. These
structures include classifications that are used to select information. However,
this also implies path dependency in that previous perceptions and expectations
determine which information is received in the future.1 How is this relevant for
institutional economics?

The role of mental models

The relevance of communication and culture

1. Our considerations make it clear how important communication and

cultural background can be. The interpretation of new information depends
on which internal model an actor has of his or her environment. If that is the
case, we could well assume that different and totally separated groups will,
at best, randomly achieve converging internal models. Given that there is a
multitude of institutional arrangements to structure repeated interactions
and the above mentioned cognitive path dependency, it seems probable that
institutions might differ significantly between different groups.2 This
clarifies the relationship between institutional change and perceptions.
Roughly speaking, cognitive path dependency leads to converging internal
models, which assume rule character if they are associated with behavioral
regularities within the group in question. At the same time, institutions that
are culturally passed down from one generation to the next can modify
human perception by excluding certain courses of action. This is obvious
for type 2 and type 3 institutions.

2. The second aspect is closely related to the first. Path dependencies in

learning can help prevent conflicts if they provide a shared pre-
understanding or common ground. The set of available actions is perceived
through this filter. By this filtering, the amount of information that needs to
be received and processed is reduced. This reduction, for its part, is relevant
for interactions and potentially resulting conflicts in that individuals only
perceive a subset of all possible actions from which the optimal one is
chosen. Consequently, the risk of conflict is less prevalent than the model of
a perfectly informed utility maximizer might suggest. However, a shared
cultural common ground can also turn out to be a disadvantage with regard
to institutional change. Shared views and convictions of how the world is to
be interpreted can hardly be changed overnight, as they result from a
learning process that is characterized by path dependencies. Modifications
are possible in principle, but if prevalent approaches lead to “satisfying”
results (relative to one’s individual acceptability threshold), there is no
incentive to look for new courses of action. Thus, the notion that perception
is based on path dependency reveals a social friction between stability and
flexibility. This has to be accounted for when attempting to steer social
processes.

Shared common grounds can reduce conflicts

 3. Finally, the limitation of human perception can have different effects,
depending on the institutions under consideration. Culturally transmitted
institutions such as social rules concerning customs, morality, and decency
(type 2 and 3 internal institutions) directly affect external institutions via the
interpretation of laws. Some of the implications resulting from this
interaction on the controllability of social processes have already been
discussed in different parts of this book.

Cognition and internal institutions

A number of branches of the study of economics have started to delve into these
issues. The most prominent branch is definitely behavioral economics whose
representatives not only want to observe how real people behave, but why they
behave as they do. Some behavioral economists have even gone one step further,
examining the brain activity of individuals while they make their choices. This
research is often referred to as “neuro economics.” If we are able to determine
why people behave the way they do, we will get closer to a better understanding
of why some institutions work better than others.

10.3 Institutions and Ideas

Cognition – the topic of Section 10.2 – and ideas are closely interrelated. In this
brief section, we deal with the possible relevance of “imagining institutions,”
that is, the capacity of the human mind to think up institutions that have never
been implemented in reality before. For the sake of brevity, we refer to this
possibility as “ideas.” If we want to understand why some institutions undergo
considerable change over time, it might not be sufficient to point to the interests
of the relevant actors. Sometimes, completely new institutions seem to pop up in
almost no time. After these new institutions are implemented in various places,
one might wonder why now, why not before, or where did the impetus come
from?

Ideas as “imagined institutions”

For institutional economists, the interplay between institutions and ideas is

an interesting challenge.
Is a certain institutional environment a precondition for the genesis of new
and innovative ideas? Are ideas really an important causal factor for institutional
change? Is institutional change driven by a set of determinants other than ideas,
only to be theorized after the change has taken place? Are general statements
regarding causality possible at all?
These questions are, of course, not new. Karl Marx, for one, famously
claimed that (political and ideological) consciousness is determined by the
relevant class structure (in German: “das gesellschaftliche Sein bestimmt das
Bewußtsein”). It is the mode of production that determines one’s consciousness
and, hence, ideas. It is well known that Marx developed many of his arguments
in direct opposition to German philosopher Friedrich Wilhelm Hegel who
insisted on the primacy of ideas. Whether or not this evidence supports Marx,
there are many cases in which institutions emerged or changed, and their
theoretical underpinning or even justification was only delivered ex post.
Historian Paul Kennedy (1987, 20), for instance, has this to say: “Long before
Adam Smith had coined the exact words, the rulers of certain societies of
western Europe were tacitly recognizing that little else is requisite to carry a state
to the highest degree of opulence from the lowest barbarism, but peace, easy
taxes, and tolerable administration of justice.” In other words, it was not the
ideas of Adam Smith that laid out the core institutional features of a prosperous
market economy before they were implemented but, rather, Smith was able to
astutely observe, evaluate, and describe those crucial ingredients after they had
been implemented. Myriad other examples led science writer Stephen Jay Gould
(1985, 335) to conclude that “Pristine originality is an illusion.”
On the other side of the spectrum there is the belief that creative minds are
capable of imagining views of the world that do not need to be based on the
status quo. If their ideas are able to infiltrate the minds of many who use them to
coordinate their behavior in novel ways, institutional change becomes a
possibility. Of course, the status quo has the simple advantage of being realized
already. To make novel ideas the new status quo requires, however, some sort of
collective action as extensively discussed in Chapter 7. Oftentimes, new ideas
will therefore not have important effects but, as John Stuart Mill observes, there
might be exceptions: “Ideas, unless outward circumstances conspire with them,
have in general no very rapid or immediate efficacy in human affairs; and the
most favorable outward circumstances may pass by, or remain inoperative, for
want of ideas suitable to the conjecture. But when the right circumstances and
the right ideas meet, the effect is seldom slow in manifesting itself” (Mill, 2006
[1845], 370).
The potential role of ideas for economic development has long been
neglected entirely by economists. More recently, some economists have begun to
deal with the topic. One of the better-known advances is called Identity
Economics written by Rachel Kranton and Nobel Prize winning economist
George Akerlof (Akerlof and Kranton, 2010).

10.4 Institutions and Individuals

This book has presented many different arguments making the case that
“institutions matter.” This does not, however, imply that nothing else matters.
For a long time, economists simply ignored the possibility that personal traits of
politicians could matter too. This is astonishing, as it seems straightforward to
assume that notwithstanding the binding constraints introduced via institutions,
politicians are left with some discretionary leeway that they can use in very
different ways. The decision to go to war or not is only one of the many
decisions that might be impacted by specific personal traits. Others are the
willingness to run huge deficits, the quality of public goods provided, the degree
to which policies improving the rule of law are pursued, and many others.
Over the last decade or so, economists have begun to fill this research gap.
A very ingenious approach was chosen by Jones and Olken (2005) who wanted
to know if individual leaders make a difference with regard to the growth path of
the countries they govern. Leadership change is usually not a random event.
Important parts of one’s own faction might be unhappy with the decisions of
their prime minister and might, therefore, try to agree on a different one. This
makes it almost impossible to claim a causal relationship between the leader and
the subsequent growth path. To account for this possibility, Jones and Olken
decide to analyze only one particular kind of change (or non-change) in political
leaders, namely those resulting from assassination (attempts). The underlying
rationale is that whether such an attempt is successful or not depends on a
number of chance events and the result can, therefore, be considered a random
event. Based on this identification strategy they show that the unexpected death
of a leader can have substantial repercussions for the country’s economic
growth.

Institutions matter – but individuals matter too

 Quite a few studies have since followed suit. Besley et al. (2005) show that
more highly educated politicians are less likely to use power opportunistically.
Building on their earlier work, Besley et al. (2011) also find that more highly
educated politicians are good for economic growth and are less likely to enroll
their country into military conflicts. Göhlmann and Vaubel (2007) analyze the
impact of the professional background of central bankers on inflation. Dreher et
al. (2009) provide evidence suggesting that the professional background of a
nation’s political actors has an impact on the likelihood of implementing market-
liberalizing reforms.
Taking the potential influence of individuals explicitly into account can
have important consequences for the NIE. As spelled out before, some scholars
point out that many studies purporting to measure institutions and their impacts
really only measure policies. Now, policies are chosen by politicians. If it is
possible to adequately control for the influence of politicians, we might be able
to unbundle policies from institutions. This is closely related to the issues raised
in Sections 10.2 and 10.3, because the behavior of politicians (individuals) is
heavily influenced by their mental models, as well as the ideas that they have or
that are communicated to them.

10.5 Institutions beyond the Nation-State

In economics (including institutional economics), the sovereign nation-state is
usually considered to be exogenously given. It is frequently assumed that the
government of the nation-state possesses the exclusive monopoly on the use of
force within the boundaries of a certain territory. Theories of economic policy
are traditionally concerned with representatives of governments that are
territorially defined. There are different statistical methods for measuring
prosperity on the level of the nation-state, such as GDP. The primacy of the
concept of the sovereign nation-state is not restricted to state matters; firms are
usually headquartered and associated with one or another nation-state. Societies
are often defined by nation-state boundaries. We then speak of the French
society, the Italian society, and so on.
Sociologist Ulrich Beck (2000) distinguishes between the nation-state and
the nation society. He points out that societies are conceptually subordinate to
nation-states (Beck, 2000, 23): “This is expressed in a vision of societies as (by
definition) subordinate to states, of societies as state societies, of social order as
state order.” In a similar context, historian Anthony Smith (1983) has coined a
specific way of thinking as “methodological nationalism.” That the concept of a
nation-state, both sovereign and identified by territorial boundaries, has become
so successful in economics might seem rather unlikely. True, Adam Smith’s
most famous work is called The Wealth of Nations, but the central subject of
economics is the individual. In the light of how economics has evolved, it
appears all the more difficult to understand how the concept of “nation-state”
could achieve such undisputed primacy. While Adam Smith’s individuals still
possess social ties to other individuals, the individual of twentieth-century
economics is modeled as an atomistic unit.
The term “globalization” has become popular in the last few decades. It is
beyond the scope of this work to analyze whether increasing globalization is
associated with fundamental changes in the relationships between state
governments, transnational firms, and international non-governmental
organizations. However, it is apparent that the number of significant
international and supranational organizations has increased in the last decades.
The basic rules that govern the EU constitute an unprecedented institutional
arrangement beyond the nation-state. But there are also other international
organizations that have contributed to an increased institutionalization (in our
sense). Rather than provide a comprehensive list of international organizations
here, the WTO offers us an excellent example. The WTO provides certain rules
for the design of national trade policies, the breaking of which is subject to
sanctions. Thus, the WTO rules are institutions as defined in this book.
There is a host of new questions regarding institutions beyond the nation-
state that have yet to be answered in institutional economics:

How can we explain that nation-state level politicians are willing to cede
part of their competencies to international organizations? Prima facie,
less competency equals less power. One approach to answering this is
already known to you. Politicians might be willing to cede part of their
power in order to have a better shot at dealing with the dilemma of the
strong state.

How can we explain the high degree of stability found in international

trade rules? After all, the argument for the nation-state is that stability
can only be ensured by the state’s monopoly on the use of force.
Intriguingly, the international trade order is characterized by the absence
of a super state or a world government.

How can we explain that private firms, in cases of cross-border exchange

disputes, often resort to private arbitration (a type 4 internal institution)
instead of state arbitration?

Are there alternative institutional arrangements that might provide a

substitute to the nation-state? How might such institutions be designed?
Would they be complementary or conflicting?

Will the increase in international links affect the design of nation-state

institutions? For instance, could we expect presently non-democratic
 states to transition towards democracy?

How do differences in corporate culture affect fusions of firms from

different countries? Could these differences help explain why sometimes
desired synergies are not realized? Consider the case of Daimler-
Chrysler! We could also apply the concept of corporate culture to
international organizations. Employees of international organizations are
from different societies with different internal institutions; this could
affect the manner in which such employees communicate with each
other.

Globalization implies new questions for the NIE

Hopefully, you are realizing that globalization-induced developments of

organizations and institutions lead to a great number of (so far) open questions, a
few of which we have formulated above. These questions will increasingly be
the subject of institutional economics research in coming years.

10.6 Institutions and Identification

We have saved the most serious challenge for the NIE for last: identification.
The term is used by Angrist and Krueger (1999) to ask how a researcher uses
observational data to approximate a real experiment. To firmly establish causal
relationships, one would ideally run an experiment in which some societies are
“treated” and others remain “untreated.” Whether a society is treated or remains
untreated would be decided randomly. If outcomes in the treated societies
change relative to the untreated ones, we can be relatively confident that this
effect has been caused by the treatment. For institutional economics, an ideal
type of treatment would be the random introduction of a new institution or a
significantly changed institution in comparison to what has been used in that
society.
Since experiments with real institutions will certainly remain the exception,
identification becomes a crucial problem for empirical institutional economics.
This is because institutions are not exogenously given but humanly devised. This
raises, inter alia, the question whether the observed outcome has been caused by
an institution, or by those choosing this institution. In the appendix at the end of
Chapter 5, we briefly explained the use of instruments in the NIE. Ideally, one
would like to address this problem by “instrumenting” institutions with some
exogenous variables. Convincing instruments are, however, very rare. On top of
that, the more narrowly defined the institution under scrutiny, the less likely it is
that the exclusion restriction regarding instruments will be fulfilled. This is one
pragmatic reason why many empirical analyses regarding the effects of
institutions do not focus on single institutions but rather on the quality of entire
bundles of institutions.

10.7 Where to Turn to Start Your Own

Research?
In this book, I have tried to summarize the most important findings of the NIE
without, however, concealing that many questions revolving around the
relevance of institutions have not yet been answered convincingly. Having read
this book, you might feel that the NIE is an important field and that you could
also contribute something to its development. We offer just two or three
suggestions that are topics that you could possibly find interesting.
 By now, the NIE has turned mainstream. This implies that many important
contributions are carried by many different journals in economics, but also in
political science and other disciplines. But if you are interested in
methodological issues regarding the NIE, then there is a specialized journal that
you might want to consult, namely the Journal of Institutional Economics. The
contributions found in that journal originate from very different authors and it is
easy to grasp what a lively field of research the NIE is engaged in by thumbing
through the last couple of issues of this journal. The journal likes to be referred
to as JOIE, implying that it is, indeed, a pleasure to read it.
In the 1990s, a group of institutional economists who wanted to promote
the NIE founded the International Society for the New Institutional Economics,
ISNIE in short. Institutional economists with very different interests assembled
under the ISNIE umbrella, including those who are interested in the choice of
governance structures (as described in Chapter 3), and those interested in the
growth effects of institutions (as described in Chapter 5). A number of years
back, the society renamed itself as the Society of Institutional and Organizational
Economics (SIOE) and my impression is that those primarily interested in the
choice of governance structures clearly prevail. Almost simultaneously, a new
annual conference was established. It was also given a nice acronym, namely
WINIR for World Interdisciplinary Network for Institutional Research.
Compared to SIOE, its initiators seem less strict regarding the approaches of the
papers admitted to their conference.

Further Reading
Voigt (2019) is a survey on “Institutions and Transition.” It spells out the most
important issues and briefly summarizes the most important empirical findings.
 Camerer et al. (2005) is a very early overview of neuro economics. A very
accessible survey of how economists have begun to incorporate “ideas” into
their models is Rodrik (2014).
For a long time, the non-availability of data might have inhibited studies
that take personal characteristics of leaders explicitly into account. Currently, a
number of attempts to collect individual traits of political leaders are underway.
The Archigos dataset introduced by Goemans et al. (2009) is one such attempt,
the LEAD dataset by Ellis et al. (2015) another one. Outside the realm of
research motivated by economic and political inquiry, the individual traits of
judges has been the subject of intensive analysis for a number of years in
literature dealing with legal issues. Segal and Spaeth (2002) is one of the most
important contributions to this line of research.
Rodrik’s (2011) Globalization Paradox is a fascinating account of the
inherent tensions and incompatibilities involved in globalization. In particular,
he describes what he calls the “fundamental political trilemma of the world
economy” arguing that democracy, national determination, and economic
globalization cannot be achieved simultaneously.
The journal, as well as the conferences mentioned in Section 10.7, can be
easily found in the web. Here are their addresses:
http://journals.cambridge.org/action/displayJournal?jid=JOI; www.sioe.org/;
http://winir.org/. Finally, throughout this book, I have often referred to the work
of Daron Acemoglu and James Robinson. They run their own blog. You might
find it enlightening to follow their blog if you are interested in current
discussions. The blog is called whynationsfail.com.

1Hayek’s The Sensory Order (1952) is an early attempt at utilizing this

association for economic analysis.

2 For a similar argument, see Denzau and North (1994, 14f.).

 References

Acemoglu, D. (2003). Why Not a Political Coase Theorem? Social Conflict,

Commitment, and Politics. Journal of Comparative Economics 31: 620–652.

Acemoglu, D. (2008). Introduction to Modern Economic Growth. Princeton

University Press.

Acemoglu, D., D. Cantoni, S. Johnson, and J. Robinson (2011). The

Consequences of Radical Reform: The French Revolution. American Economic
Review 101: 3286–3307.

Acemoglu, D. and S. Johnson (2005). Unbundling Institutions. Journal of

Political Economy 113: 949–995.

Acemoglu, D., S. Johnson, and J. Robinson (2001). The Colonial Origins of

Comparative Development: An Empirical Investigation. American Economic
Review 91: 1369–1401.

Acemoglu, D., Johnson, S., and Robinson, J. A. (2002). Reversal of Fortune:

Geography and Institutions in the Making of the Modern World Income
Distribution. Quarterly Journal of Economics 117: 1231–1294.

Acemoglu, D., S. Johnson, and J. Robinson (2005a). Institutions as the

Fundamental Cause of Long-Run Growth. In P. Aghion and S. Durlauf (eds.),
Handbook of Economic Growth, Vol. 1A. Amsterdam: Elsevier, pp. 385–472.
Acemoglu, D., S. Johnson, and J. Robinson (2012). The Colonial Origins of
Comparative Development: An Empirical Investigation: Reply. American
Economic Review 102: 3077–3110.

Acemoglu, D., S. Johnson, J. Robinson, and P. Yared (2005b). From Education

to Democracy? American Economic Review 95: 44–49.

Acemoglu, D., S. Naidu, P. Restrepo, and J. Robinson (2014). Democracy Does

Cause Growth. Working Paper No. 20004. Cambridge, MA: National Bureau of
Economic Research.

Acemoglu, D. and J. Robinson (2005). Economic Origins of Dictatorship and

Democracy. Cambridge University Press.

Acemoglu, D. and J. Robinson (2012). Why Nations Fail: The Origins of Power,
Prosperity, and Poverty. New York: Crown Business.

Acemoglu, D., J. Robinson, and R. Torvik (2013). Why Do Voters Dismantle

Checks and Balances? Review of Economic Studies 80: 845–875.

Aghion, P. and R. Holden (2011). Incomplete Contracts and the Theory of the
Firm: What Have We Learned over the Past 25 Years? Journal of Economic
Perspectives 25: 181–197.

Ahern, K., D. Daminelli, and C. Fracassi (2015). Lost in Translation? The Effect
of Cultural Values on Mergers around the World. Journal of Financial
Economics 117: 165–189.

Aidt, T. S. (2016). Rent Seeking and the Economics of Corruption.

Constitutional Political Economy 27: 142–157.

Akerlof, G. A. (1970). The Market for Lemons: Quality Uncertainty and the
Market Mechanism. Quarterly Journal of Economics 84: 488–500.

Akerlof, G. A. and R. E. Kranton (2010). Identity Economics: How Identities

Shape Our Work, Wages, and Well-Being. Princeton University Press.

Albouy, D. Y. (2012). The Colonial Origins of Comparative Development: An

Empirical Investigation – Comment. American Economic Review 102:
3059–3076.

Alchian, A. (1950). Uncertainty, Evolution, and Economic Theory. Journal of

Political Economy 58: 211–221.

Alchian, A. (1984). Specificity, Specialization, and Coalitions. Journal of

Institutional and Theoretical Economics 140: 34–39.

Alchian, A. and H. Demsetz (1972). Production, Information Costs, and

Economic Organization. American Economic Review 72: 777–795.

Alchian, A. and S. Woodward (1988). The Firm is Dead; Long Live the Firm: A
Review of Oliver E. Williamson’s ‘The Economic Institutions of Capitalism’.
Journal of Economic Literature 26: 65–79.

Aldashev, G., Chaara, I., Platteau, J. P., and Wahhaj, Z. (2012). Using the Law to
Change the Custom. Journal of Development Economics 97: 182–200.

Alesina, A. and P. Giuliano (2015). Culture and Institutions. Journal of

Economic Literature 53: 898–944.

Alesina, A., P. Giuliano, and N. Nunn (2013). On the Origins of Gender Roles:
Women and the Plough. Quarterly Journal of Economics 128: 469–530.

Alesina, A. and E. Spolaore (2005). The Size of Nations. Cambridge, MA: MIT
Press.

Alessi, L. de (1980). The Economics of Property Rights: A Review of the

Evidence. Research in Law and Economics 2: 1–47.

Algan, Y. and P. Cahuc (2014). Trust, Growth, and Well-Being: New Evidence
and Policy Implications. In P. Aghion and S. Durlauf (eds.), Handbook of
Economic Growth, Vol. 2. Amsterdam: Elsevier, pp. 49–120.

Allen, D. (1998). Transaction Costs, and Coase: One More Time. In S. Medema
(ed.), Coasean Economics: Law & Economics and the New Institutional
Economics. Boston, MA: Kluwer, pp. 105–118.

Allen, D. (2000). Transaction Costs. In B. Bouckaert and G. de Geest (eds.),

Encyclopedia of Law and Economics, Volume I: The History and Methodology of
Law and Economics. Cheltenham: Edward Elgar, pp. 893–926.

Allen, D. (2011). The Institutional Revolution: Measurement and the Economic

Emergence of the Modern World. University of Chicago Press.

Alston, L. (2008). The “Case” for Case Studies in New Institutional Economics.
In E. Brousseau and J.-M. Glachant (eds.), New Institutional Economics: A
Guidebook. Cambridge University Press, pp. 103–121.

Angrist, J. and A. Krueger (1999). Empirical Strategies in Labor Economics. In

O. Ashenfelter and D. Card (eds.). Handbook of Labor Economics, Vol. 3A.
Amsterdam: North Holland, pp. 1277–1366.

Angrist, J. and J.-S. Pischke (2009). Mostly Harmless Econometrics: An

Empiricist’s Companion. Princeton University Press.

Arruñada, B. (2007). Pitfalls to Avoid when Measuring Institutions: Is Doing

Business Damaging Business? Journal of Comparative Economics 35: 729–747.

Arthur, B. (1989). Competing Technologies and Lock-in by Historical Small

Events. Economic Journal 99: 116–131.

Audi, R. (2010). Epistemology: A Contemporary Introduction to the Theory of

Knowledge. London: Routledge.

Axelrod, R. (1970). Conflict of Interest: A Theory of Divergent Goals with

Applications to Politics. Chicago: Markham.

Axelrod, R. (1984). The Evolution of Cooperation. New York: Basic Books.

Axelrod, R. (1986). An Evolutionary Approach to Norms. American Political

Science Review 80: 1095–1111.

Baker, G., R. Gibbons, and K. Murphy (2002). Relational Contracts and the
Theory of the Firm. Quarterly Journal of Economics 117: 39–84.

Barro, R. and D. Gordon (1983). Rules, Discretion, and Reputation in a Model

of Monetary Policy. Journal of Monetary Economics 12: 101–121.

Barzel, Y. (1977). Some Fallacies in the Interpretation of Information Costs.

Journal of Law and Economics 20: 291–307.

Barzel, Y. (1987). The Entrepreneur’s Reward for Self-Policing. Economic

Inquiry 25: 103–116.

Beck, U. (2000). What is Globalization? Trans. Patrick Camiller. Cambridge:

Polity Press.

Becker, G. (1968). Crime and Punishment: An Economic Approach. Journal of

Political Economy 76: 169–217.
Becker, G. (1976). The Economic Approach to Human Behavior. University of
Chicago Press.

Becker, G. (1983). A Theory of Competition among Pressure Groups for

Political Influence. Quarterly Journal of Economics 98: 371–400.

Becker, S., K. Boeckh, C. Hainz, and L. Woessmann (2016). The Empire Is

Dead, Long Live the Empire! Long‐Run Persistence of Trust and Corruption in
the Bureaucracy. The Economic Journal 126: 40–74.

Becker, S. and L. Woessmann (2009). Was Weber Wrong? A Human Capital

Theory of Protestant Economic History. Quarterly Journal of Economics 124:
531–596.

Benham, A. and L. Benham (2000). Measuring the Costs of Exchange. In C.

Menard (ed.), Institutions, Contracts, and Organizations. Cheltenham: Edward
Elgar, pp. 367–375.

Berggren, N. and C. Bjørnskov (2011). Is the Importance of Religion in Daily

Life Related to Social Trust? Cross-Country and Cross-State Comparisons.
Journal of Economic Behavior & Organization 80: 459–480.

Berkowitz, D., K. Pistor, and J. Richard (2003). Economic Development,

Legality, and the Transplant Effect. European Economic Review 47: 165–195.

Besley, T. and A. Case (1995). Incumbent Behavior: Vote-Seeking, Tax-Setting,

and Yardstick Competition. American Economic Review 85: 25–45.

Besley, T., J. G. Montalvo, and M. Reynal-Querol (2011). Do Educated Leaders

Matter? The Economic Journal 121: F205–F227.
Besley, T., R. Pande, and V. Rao (2005). Political Selection and the Quality of
Government: Evidence from South India. CEPR Discussion Paper 5201.
London: Centre for Economic Policy Research.

Binmore, K. (1994). Game Theory and the Social Contract, Vol. 1: Playing Fair.
Cambridge, MA: MIT Press.

Bisin, A. and T. Verdier (2008). Cultural Transmission. In S. Durlauf and L.

Blume (eds.), The New Palgrave Dictionary of Economics. Basingstoke:
Palgrave Macmillan.

Bjørnskov, C. (2010). How Does Social Trust Lead to Better Governance? An

Attempt to Separate Electoral and Bureaucratic Mechanisms. Public Choice 144:
323–346.

Block, W. (ed.) (1991). Economic Freedom: Toward a Theory of Measurement.

Vancouver: The Fraser Institute.

Blume, L., J. Müller, and S. Voigt (2009). The Economic Effects of Direct
Democracy: A First Global Assessment. Public Choice 140: 431–461.

Blume, L. and S. Voigt (2013). The Economic Effects of Constitutional Budget

Institutions. European Journal of Political Economy 29: 235–251.

Bollard, A. (1994). New Zealand. In J. Williamson (ed.), The Political Economy

of Policy Reform. Washington, DC: Institute for International Economics, pp.
73–110.

Bolton, P. and M. Dewatripont (2005). Contract Theory. Cambridge, MA: MIT

Press.

Boserup, E. (1970). Women’s Role in Economic Development. London: Allen &

Unwin.

Bowles, S. and H. Gintis (2011). A Cooperative Species: Human Reciprocity and

Its Evolution. Princeton University Press.

Boyd, R. and P. Richerson (1994). The Evolution of Norms: An Anthropological

View. Journal of Institutional and Theoretical Economics 150: 72–87.

Boyd, R. and P. Richerson (2005). The Origin and Evolution of Cultures. Oxford
University Press.

Brennan, G. and A. Hamlin (2000). Democratic Devices and Desires.

Cambridge University Press.

Brewer, M. and R. Kramer (1986). Choice Behavior in Social Dilemmas: Effects

of Social Identity, Group Size and Decision Framing. Journal of Personality and
Social Psychology 3: 543–549.

Brousseau, E. and J.-M. Glachant (eds.) (2008). New Institutional Economics: A

Guidebook. Cambridge University Press.

Brunetti, A., G. Kisunko, and B. Weder (1998). Credibility of Rules and

Economic Growth. The World Bank Economic Review 12: 353–384.

Buchanan, J. (1959). Positive Economics, Welfare Economics, and Political

Economy. Journal of Law and Economics 2: 124–138.

Buchanan, J. (1975). The Limits of Liberty: Between Anarchy and Leviathan.

University of Chicago Press.

Buchanan, J. (1978). A Contractarian Perspective on Anarchy. In J. Roland

Pennock and John W. Chapman (eds.), Anarchism. New York University Press,
pp. 29–42.

Buchanan, J. M. (1987). The Constitution of Economic Policy. American

Economic Review 77: 243–250.

Buchanan, J. and R. Congleton (1998). Politics by Principle, Not Interest:

Toward Nondiscriminatory Democracy. Cambridge University Press.

Buchanan, J. and G. Tullock (1962). The Calculus of Consent: Logical

Foundations of Constitutional Democracy. Ann Arbor, MI: University of
Michigan Press.

Camerer, C., G. Loewenstein, and D. Prelec (2005). Neuroeconomics: How

Neuroscience Can Inform Economics. Journal of Economic Literature 43: 9–64.

Cameron, L. (1999). Raising the Stakes in the Ultimatum Game: Experimental

Evidence from Indonesia. Economic Inquiry 37: 47–59.

Cantoni, D. (2015). The Economic Effects of the Protestant Reformation:

Testing the Weber Hypothesis in the German Lands. Journal of the European
Economic Association 13: 561–598.

Carlsson, F. and S. Lundström (2002). Economic Freedom and Growth:

Decomposing the Effects. Public Choice 112: 335–344.

Chaudhuri, A. (2011). Sustaining Cooperation in Laboratory Public Goods

Experiments: A Selective Survey of the Literature. Experimental Economics 14:
47–83.

Cheibub, J., J. Gandhi, and J. Vreeland (2010). Democracy and Dictatorship

Revisited. Public Choice 143: 67–101.
Clague, C., P. Keefer, S. Knack, and M. Olson (1999). Contract-Intensive
Money: Contract Enforcement, Property Rights, and Economic Performance.
Journal of Economic Growth 4: 185–211.

Coase, R. H. (1937). The Nature of the Firm. Economica 4: 386–405.

Coase, R. H. (1960). The Problem of Social Cost. Journal of Law and

Economics 3: 1–44.

Coase, R. H. (1964). The Regulated Industries: Discussion. American Economic

Review 54: 194–197.

Coase, R. H. (1988). The Firm, the Market, and the Law. University of Chicago
Press.

Coase, R. H. (1992). The Institutional Structure of Production. American

Economic Review 82: 713–719.

Coleman, J. (1987). Norms as Social Capital. In G. Radnitzky and P. Bernholz

(eds.), Economic Imperialism. New York: Paragon House Publishers, pp.
133–155.

Coleman, J. (1990). Foundations of Social Theory. Cambridge, MA: Belknap

Press.

Colman, A. (1982). Game Theory and Experimental Games: The Study of

Strategic Interaction. Oxford: Pergamon Press.

Congleton, R. D., A. L. Hillman, and K. A. Konrad (2008). Forty Years of

Research on Rent Seeking, 2 vols. Heidelberg: Springer.

Cooter, R. and T. Ulen (2012). Law and Economics, 6th edition. New York:
Addison-Wesley.

Costa, S. (2013). Do Freedom of Information Laws Decrease Corruption?

Journal of Law, Economics, & Organization 29: 1317–1343.

Dahlman, C. (1979). The Problem of Externality. Journal of Law and Economics

22: 141–162.

Dahrendorf, R. (1968). Essays in the Theory of Society. Stanford University

Press.

Darity, W. (ed.) (2007). International Encyclopedia of the Social Sciences.

London: Macmillan Library Reference

David, P. (1994). Why Are Institutions the ‘Carriers of History’? Path

Dependence and the Evolution of Conventions, Organizations, and Institutions.
Structural Change and Economic Dynamics 5: 205–220.

Davis, D. and C. Holt (1993). Experimental Economics. Princeton University

Press.

Davis, L. (1986). Comment. In R. Gallman (ed.), Long-Term Factors in

American Economic Growth. University of Chicago Press, pp. 149–161.

Dawkins, R. (1989). The Selfish Gene. Oxford University Press.

De Soto, H. (1990). The Other Path: The Invisible Revolution in the Third
World. New York: Harper & Row.

Demsetz, H. (1967). Toward a Theory of Property Rights. American Economic

Review 57: 347–359.

Demsetz, H. (1969). Information and Efficiency: Another Viewpoint. Journal of

Law and Economics 12: 1–22.

Denzau, A. and D. North (1994). Shared Mental Models: Ideologies and

Institutions. Kyklos 47: 3–31.

Diamond, J. M. (1998). Guns, Germs and Steel: A Short History of Everybody

for the Last 13,000 Years. New York: Random House.

Dixit, A. (1996). The Making of Economic Policy: A Transaction-Cost Politics

Perspective. Cambridge, MA: MIT Press.

Dixit, A. and B. Nalebuff (1991). Thinking Strategically: The Competitive Edge

in Business, Politics, and Everyday Life. New York: W. W. Norton.

Dreher, A., M. J. Lamla, S. M. Lein, and F. Somogyi (2009). The Impact of

Political Leaders’ Profession and Education on Reforms. Journal of
Comparative Economics 37: 169–193.

Dreher, A., H. Mikosch, and S. Voigt (2015). Membership Has its Privileges:
The Effect of Membership in International Organizations on FDI. World
Development 66: 346–358.

Duesenberry, J. (1960). Comment on “An Economic Analysis of Fertility.” In

Report of the National Bureau of Economic Research, Demographic and
Economic Change in Developed Countries. New York: Columbia University
Press, pp. 231–234.

Durante, R. (2010). Risk, Cooperation and the Economic Origins of Social Trust:
An Empirical Investigation. Available at http://papers.ssrn.com/sol3/papers.cfm?
abstract_id=1576774.

Duverger, M. (1954). Political Parties. London: Methuen.

Easterly, W. and R. Levine (2003). Tropics, Germs, and Crops: How
Endowments Influence Economic Development. Journal of Monetary
Economics 50: 3–39.

Easton, S. and M. Walker (eds.) (1992). Rating Global Economic Freedom.

Vancouver: Fraser Institute.

Eggertsson, T. (1990). Economic Behavior and Institutions. Cambridge

University Press.

Elkins, Z. and B. Simmons (2005). On Waves, Clusters, and Diffusion: A

Conceptual Framework. Annals of the American Academy of Political and Social
Science 598: 33–51.

Ellickson, R. (1986). Of Coase and Cattle: Dispute Resolution among Neighbors

in Shasta County. Stanford Law Review 38: 623–687.

Ellickson, R. (1991). Order Without Law. Cambridge, MA: Harvard University

Press.

Ellickson, R. (1994). The Aim of Order Without Law. Journal of Institutional

and Theoretical Economics 150: 97–100.

Ellis, C. M., M. C. Horowitz, and A. C. Stam (2015). Introducing the LEAD

Data Set. International Interactions 41: 718–741.

Elster, J. (1984). Ulysses and the Sirens: Studies in Rationality and Irrationality,
revised edition. Cambridge University Press.

Elster, J. (1989a). The Cement of Society: A Study of Social Order. Cambridge

University Press.
Elster, J. (1989b). Social Norms and Economic Theory. Journal of Economic
Perspectives 3: 99–117.

Ensminger, J. (1997). Changing Property Rights: Reconciling Formal and

Informal Rights to Land in Africa. In J. Drobak and J. Nye (eds.), The Frontiers
of the New Institutional Economics. San Diego, CA: Academic Press, pp.
165–196.

Ensminger, J. (1998). Fairness in Cross-Cultural Perspective: Evidence from

Experimental Economics in a Less Developed Society. Paper presented at the
second annual conference of the International Society for the New Institutional
Economics, Paris, September.

European Council (2004). A Comparative Analysis of Regulatory Impact

Assessment in Ten EU Countries: A Report Prepared for the EU Directors of
Better Regulation Group, Dublin. Available at
www.betterregulation.ie/attached_files/Pdfs/Report%20on%20RIA%20in%20the%20EUa.pdf

Evans, L., A. Grimes, B. Wilkinson and D. Teece (1996). Economic Reform in

New Zealand 1984–1995: The Pursuit of Efficiency. Journal of Economic
Literature 34: 1856–1902.

Falk, A. and J. Heckman (2009). Lab Experiments are a Major Source of

Knowledge in the Social Sciences. Science 326: 535–538.

Fehr, E. (2009). On the Economics and Biology of Trust. Journal of the

European Economic Association 7: 235–266.

Fehr, E., S. Gächter, and G. Kirchsteiger (1997). Reciprocity as a Contract

Enforcement Device: Experimental Evidence. Econometrica 65: 833–860.
Fehr, E., L. Götte, and C. Zehnder (2009). A Behavioral Account of the Labor
Market: The Role of Fairness Concerns. Annual Review of Economics 1:
355–384.

Fehr, E. and K. M. Schmidt (1999). A Theory of Fairness, Competition, and

Cooperation. Quarterly Journal of Economics 114: 817–868.

Feld, L. and S. Voigt (2003). Economic Growth and Judicial Independence:

Cross Country Evidence Using a New Set of Indicators. European Journal of
Political Economy 19: 497–527.

Ferejohn, J. and F. Rosenbluth (2014). Arms and Men: Technology’s Shadow

over Democracy. Yale Global Online. Available at
http://yaleglobal.yale.edu/content/arms-and-men-technology%E2%80%99s-
shadow-over-democracy.

Ferguson, A. (1995 [1767]). An Essay on the History of Civil Society. Ed. F. Oz-
Salzberger. Cambridge University Press.

Fernández, R. (2010). Does Culture Matter? Working Paper No. 16277.

Cambridge, MA: National Bureau of Economic Research.

Fontaras, G. and Z. Samaras (2007). A Quantitative Analysis of the European

Automakers’ Voluntary Commitment to Reduce CO2 Emissions from New
Passenger Cars based on Independent Experimental Data. Energy Policy 35:
2239–2248.

Frank, R. (1988). Passions Within Reason: The Strategic Role of the Emotions.
New York: W. W. Norton.

Frey, B. (1997). A Constitution for Knaves Crowds Out Civic Virtues. The
Economic Journal 107: 1043–1053.

Friedman, D. (1991). The Swedes Get It Right. Reason Magazine: 1–4.

Friedman, M. (1953). The Methodology of Positive Economics. In M. Friedman,

Essays in Positive Economics. University of Chicago Press, pp. 3–44.

Fudenberg, D. and E. Maskin (1986). The Folk Theorem in Repeated Games

with Discounting or with Incomplete Information. Econometrica 54: 533–545.

Furubotn, E. and S. Pejovich (1972). Property Rights and Economic Theory: A

Survey of Recent Literature. Journal of Economic Literature 10: 1137–1162.

Furubotn, E. and R. Richter (1998). Institutions & Economic Theory: The

Contribution of the New Institutional Economics. Ann Arbor, MI: University of
Michigan Press.

Gächter, S., E. Kessler, and M. Königstein (2011). Do Incentives Destroy

Voluntary Cooperation? Working Paper, University of Nottingham.

Galanter, M. (1981). Justice in Many Rooms: Courts, Private Ordering, and

Indigenous Law. Journal of Legal Pluralism and Unofficial Law 19: 1–47.

Garrouste, P. and S. Saussier (2008). The Theories of the Firm. In E. Brousseau

and J.-M. Glachant (eds.), New Institutional Economics: A Guidebook.
Cambridge University Press, pp. 23–36

Gibbons, R. (2005). Four Formal(izable) Theories of the Firm? Journal of

Economic Behavior & Organization 58: 200–245.

Glaeser, E., R. La Porta, F. Lopez-de-Silanes, and A. Shleifer (2004). Do

Institutions Cause Growth? Journal of Economic Growth 9: 271–303.
Goderis, B. and M. Versteeg (2014). The Diffusion of Constitutional Rights.
International Review of Law and Economics 39: 1–19.

Goemans, H. E., K. S. Gleditsch, and G. Chiozza (2009). Introducing Archigos:

A Dataset of Political Leaders. Journal of Peace Research 46: 269–283.

Göhlmann, S. and R. Vaubel (2007). The Educational and Professional

Background of Central Bankers and its Effect on Inflation: An Empirical
Analysis. European Economic Review 51: 925–941.

Gould, S. J. (1985). The Flamingo’s Smile: Reflections in Natural History. New

York: W. W. Norton.

Greif, A. (1992). Institutions and International Trade: Lessons from the

Commercial Revolution. American Economic Review 82: 128–133.

Greif, A. (2006). Institutions and the Path to the Modern Economy: Lessons
from Medieval Trade. Cambridge University Press.

Greif, A. and D. Laitin (2004). A Theory of Endogenous Institutional Change.

American Political Science Review 98: 633–652.

Greif, A., P. Milgrom, and B. Weingast (1994). Coordination, Commitment, and

Enforcement: The Case of the Merchant Guild. Journal of Political Economy
102: 745–776.

Guiso, L., P. Sapienza, and L. Zingales (2004a). Cultural Biases in Economic

Exchange. Working Paper No. 11005. Cambridge, MA: National Bureau of
Economic Research.

Guiso, L., P. Sapienza, and L. Zingales (2004b). The Role of Social Capital in
Financial Development. American Economic Review 94: 526–556.
Guiso, L., P. Sapienza, and L. Zingales (2006). Does Culture Affect Economic
Outcomes? Journal of Economic Perspectives 20: 23–48.

Guiso, L., P. Sapienza, and L. Zingales (2008). Long Term Persistence. Working
Paper No. 14278. Cambridge, MA: National Bureau of Economic Research.

Güth, W. and M. Kocher (2014). More than Thirty Years of Ultimatum

Bargaining Experiments: Motives, Variations, and a Survey of the Recent
Literature. Journal of Economic Behavior & Organization 108: 396–409.

Güth, W., R. Schmittberger, and B. Schwarze (1982). An Experimental Analysis

of Ultimatum Bargaining. Journal of Economic Behavior & Organization 3:
367–388.

Gwartney, J. and R. Holcombe (1999). Economic Freedom, Constitutional

Structure, and Growth in Developing Countries. In M. Kimenyi and J. Mbaku
(eds.), Institutions and Collective Choice in Developing Countries. Aldershot:
Ashgate, pp. 33–59.

Gwartney, J., R. Lawson, and W. Block (1996). Economic Freedom of the

World: 1975–1995. Vancouver: Fraser Institute.

Gwartney, J., R. Lawson, and J. Hall (2017). Economic Freedom of the World:
2017 Annual Report. Vancouver: Fraser Institute.

Haan, J. de and J. E. Sturm (2000). On the Relationship between Economic

Freedom and Economic Growth. European Journal of Political Economy 16:
215–241.

Hamilton, A., J. Madison, and J. Jay (1961 [1788]). The Federalist Papers.
Introd. Clinton Rossiter. New York: Mentor.
Hardin, G. (1968). The Tragedy of the Commons. Science 162: 1243–1248.

Hardin, R. (1989). Why a Constitution? In B. Grofman and D. Wittman (eds.),

The Federalist Papers and the New Institutionalism. New York: Agathon Press,
pp. 100–120.

Harrison, G. and J. List (2004). Field Experiments. Journal of Economic

Literature 42: 1009–1055.

Hart, O. (1989). An Economist’s Perspective on the Theory of the Firm.

Columbia Law Review 89: 1757–1774.

Hayek, F. A. (1952). The Sensory Order: An Inquiry into the Foundations of

Theoretical Psychology. University of Chicago Press.

Hayek, F. (1964). Kinds of Order in Society. New Individualist Review 3: 3–12.

Hayek, F. (1973). Law, Legislation and Liberty, Vol. 1: Rules and Order.
University of Chicago Press.

Hayek, F. (1976). Law, Legislation and Liberty, Vol. 2: The Mirage of Social
Justice. University of Chicago Press.

Hayo, B. and S. Voigt (2008). Inflation, Central Bank Independence and the
Legal System. Journal of Institutional and Theoretical Economics 164: 751–777.

Heiner, R. (1983). The Origin of Predictable Behavior. American Economic

Review 4: 560–595.

Henisz, W. (2000). The Institutional Environment for Economic Growth.

Economics and Politics 12: 1–31.
Henrich, J. (2000). Does Culture Matter in Economic Behavior? Ultimatum
Game Bargaining Among the Machiguenga of the Peruvian Amazon. American
Economic Review 90: 973–979.

Henrich, J., R. Boyd, S. Bowles, C. Camerer, E. Fehr, H. Gintis, and R.

McElreath (2001). In Search of Homo Economicus: Behavioral Experiments in
15 Small-Scale Societies. American Economic Review 91: 73–78.

Henrich, J., R. Boyd, S. Bowles, C. Camerer, E. Fehr, H. Gintis, R. McElreath,

et al. (2005). “Economic Man” in Cross-Cultural Perspective: Behavioral
Experiments in 15 Small-Scale Societies. Behavioral and Brain Sciences 28:
795–855.

Herrmann, B., C. Thöni, and S. Gächter (2008). Anti-Social Punishment across

Societies. Science 319: 1362–1367.

Hirschman, A. (1970). Exit, Voice and Loyalty: Responses to Decline in Firms,

Organizations, and States. Cambridge, MA: Harvard University Press.

Hobbes, T. (1982 [1651]). Leviathan. Harmondsworth: Penguin Classics.

Hodgson, G. (1998). The Approach of Institutional Economics. Journal of

Economic Literature 36: 166–192.

Holcombe, R. (2016). Advanced Introduction to Public Choice. Cheltenham:

Edward Elgar.

Hume, D. (1987 [1777]). Essays: Moral, Political, and Literary. Ed. E. F. Miller.
Indianapolis, IN: Liberty Classics.

Hume, D. (1990 [1740]). A Treatise of Human Nature. Ed. L. A. Selby-Bigge.

Oxford: Clarendon Press.
Jensen, M. and W. Meckling (1976). Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure. Journal of Financial Economics 3:
305–360.

Johansson, P.-O. (1991). An Introduction to Modern Welfare Economics.

Cambridge University Press.

Jolls, C., C. Sunstein, and R. Thaler (1998). A Behavioral Approach to Law and
Economics. Stanford Law Review 50: 1471–1550.

Jones, B. and B. Olken (2005). Do Leaders Matter? National Leadership and

Growth since World War II. Quarterly Journal of Economics 120: 835–864.

Kahneman, D. (2011). Thinking, Fast and Slow. New York: Farrar, Straus &
Giroux.

Kahneman, D., J. Knetsch, and R. Thaler (1986). Fairness as a Constraint on

Profit Seeking: Entitlements in the Market. American Economic Review 76:
728–741.

Kant, I. (1991 [1797]). The Metaphysics of Morals. Ed. Mary Gregor.

Cambridge University Press.

Kennedy, P. (1987). The Rise and Fall of the Great Powers. New York: Vintage.

Keefer, P. and M. Shirley (1998). From the Ivory Tower to the Corridors of
Power: Making Institutions Matter for Development Policy. Paper presented at
the second annual conference of the International Society for the New
Institutional Economics. Paris, September.

Kirchgässner, G. (2008). Homo Oeconomicus: The Economic Model of

Behaviour and its Applications in Economics and Other Social Sciences.
Dordrecht: Springer.

Kirstein, R. and S. Voigt (2006). The Violent and the Weak: When Dictators
Care About Social Contracts. American Journal of Economics and Sociology 65:
863–890.

Kiwit, D. and S. Voigt (1995). Überlegungen zum institutionellen Wandel unter

Berücksichtigung des Verhältnisses interner und externer Institutionen. ORDO:
Jahrbuch für die Ordnung von Wirtschaft und Gesellschaft 46: 117–148.

Klerman, D., P. Mahoney, H. Spamann, and M. Weinstein (2011). Legal Origin

or Colonial History? Journal of Legal Analysis 3: 379–409.

Knack, S. and P. Keefer (1995). Institutions and Economic Performance: Cross-

Country Tests Using Alternative Institutional Measures. Economics and Politics
7: 207–227.

Knack, S. and P. Keefer (1997). Does Social Capital Have an Economic Payoff?
A Cross-Country Investigation. Quarterly Journal of Economics 112:
1251–1288.

Knight, F. (1922). Risk, Uncertainty, and Profit. Boston, MA: Houghton-Mifflin.

Knight, J. (1992). Institutions and Social Conflict. Cambridge University Press.

Knorr, A. (1997). Das ordnungspolitische Modell Neuseelands. Ein Vorbild für

Deutschland? Tübingen: Mohr Siebeck.

Korobkin, R. and T. Ulen (2000). Law and Behavioral Science: Removing the
Rationality Assumption from Law and Economics. California Law Review 88:
1051–1143.
Kovač, M. and R. Spruk (2016). Institutional Development, Transaction Costs
and Economic Growth: Evidence from a Cross-Country Investigation. Journal of
Institutional Economics 12: 129–159.

Kreps, D. (1990). A Course in Microeconomic Theory. Princeton University

Press.

Kreps, D. (1996). Corporate Culture and Economic Theory. In P. J. Buckley

(ed.), Firms, Organizations and Contracts. Oxford University Press, pp.
221–275.

Kreps, D. (1998). Bounded Rationality. In S. Durlauf and L. Blume (eds.), The

New Palgrave Dictionary of Economics, 2nd edition. Basingstoke: Palgrave
Macmillan, pp. 168–173.

Kreps, D., P. Milgrom, J. Roberts, and R. Wilson (1982). Rational Cooperation

in the Finitely Repeated Prisoners’ Dilemma. Journal of Economic Theory 27:
245–252.

Krueger, A. (1974). The Political Economy of the Rent-Seeking Society.

American Economic Review 64: 291–303.

Kydland, F. and E. Prescott (1977). Rules Rather than Discretion: The

Inconsistency of Optimal Plans. Journal of Political Economy 85: 473–491.

La Porta, R., F. Lopez-de-Silanes, and A. Shleifer (2008). The Economic

Consequences of Legal Origins. Journal of Economic Literature 46: 285–332.

La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R. Vishny (1997). Trust in

Large Organizations. American Economic Review: Papers and Proceedings 87:
333–338.
La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R. Vishny (1998). Law and
Finance. Journal of Political Economy 106: 1113–1155.

La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R. Vishny (1999). The

Quality of Government. Journal of Law, Economics, and Organization 15:
222–279.

Ledyard, J. (1995). Public Goods: A Survey of Experimental Research. In J.

Kagel and A. Roth (eds.), The Handbook of Experimental Economics. Princeton
University Press, pp. 111–194.

Levitt, S. and J. List (2009). Field Experiments in Economics: The Past, the
Present, and the Future. European Economic Review 53: 1–18.

Levy, B. and P. Spiller (1994). The Institutional Foundations of Regulatory

Commitment: A Comparative Analysis of Telecommunications Regulation.
Journal of Law, Economics & Organization 10: 201–246.

Lewis, D. (1969). Convention: A Philosophical Study. Cambridge, MA: Harvard

University Press.

Lewis-Beck, M. and M. Stegmaier (2019). Economic Voting. In B. Grofman, R.

Congleton, and S. Voigt (eds.), The Oxford Handbook of Public Choice. Oxford
University Press.

Libecap, G. (1978). Economic Variables and the Development of the Law: The
Case of Western Mineral Rights. Journal of Economic History 38: 338–362.

Liebowitz, S. and S. Margolis (1989). The Fable of the Keys. Journal of Law
and Economics 33: 1–25.

Lipset, S. M. (1959). Some Social Requisites of Democracy: Economic

Development and Political Legitimacy. American Political Science Review 53:
69–105.

Littlechild, S. and J. Wiseman (1986). The Political Economy of Restriction of

Choice. Public Choice 51: 161–172.

Macher, J. and B. Richman (2008). Transaction Cost Economics: An

Assessment of Empirical Research in the Social Sciences. Business and Politics
10: 1210.

Macneil, I. (1974). The Many Futures of Contracts. Southern California Law

Review 47: 691–816.

Majeski, S. (1990). Comment: An Alternative Approach to the Generation and

Maintenance of Norms. In K. Coo and M. Levi (eds.), The Limits of Rationality.
University of Chicago Press, pp. 273–281.

Martynova, M. and L. Renneboog (2008). Spillover of corporate Governance

Standards in Cross-Border Mergers and Acquisitions. Journal of Corporate
Finance 14: 200–223.

Massell, G. (1968). Law as an Instrument of Revolutionary Change in a

Traditional Milieu: The Case of Soviet Central Asia. Law and Society Review 2:
179–214.

Matsusaka, J. G. (2005). Direct Democracy Works. Journal of Economic

Perspectives 19: 185–206.

McCloskey, D. (1998). The So-Called Coase Theorem. Eastern Economic

Journal 24: 367–371.

Meltzer, A. and S. Richard (1981). A Rational Theory of the Size of

Government. Journal of Political Economy 89: 914–927.

Milgrom, P., D. North, and B. Weingast (1990). The Role of Institutions in the
Revival of Trade: The Law Merchant, Private Judges, and the Champagne Fairs.
Economics & Politics 2: 1–23.

Milgrom, P. and J. Roberts (1992). Economics, Organization, and Management.

Englewood Cliffs, NJ: Prentice Hall.

Milinski, M., D. Semmann, H. J. Krambeck, and J. Marotzke (2006). Stabilizing

the Earth’s Climate is Not a Losing Game: Supporting Evidence from Public
Goods Experiments. Proceedings of the National Academy of Sciences 103:
3994–3998.

Mill, J. S. (2006 [1845]). The Claims of Labour. In J. S. Mill, The Collected

Works of John Stuart Mill, Vol. 4: Essays on Economics and Society 1824–1845.
Indianapolis, IN: Liberty Fund.

Moe, T. (1990). Political Institutions: The Neglected Side of the Story. Journal
of Law, Economics, & Organization, 6: 213–253.

Montesquieu, C. de (1989 [1748]). The Spirit of the Laws. Cambridge University

Press.

Moselle, B. and B. Polak (2001). A Model of the Predatory State. Journal of

Law, Economics, & Organization 17: 1–33.

Mueller, D. (1986). Rational Egoism versus Adaptive Egoism as Fundamental

Postulate for a Descriptive Theory of Human Behavior. Public Choice 51: 3–23.

Mueller, D. (1998). Redistribution and Allocative Efficiency in a Mobile World

Economy. Jahrbuch für Neue Politische Ökonomie 17: 172–190.
Mueller, D. (2003). Public Choice III. Cambridge University Press.

Mueller, D. (2015). Public Choice, Social Choice, and Political Economy. Public
Choice 163: 379–387.

Nelson, R. and S. Winter (1982). An Evolutionary Theory of Economic Change.

Cambridge, MA: Harvard University Press.

Niskanen, W. A. (1971). Bureaucracy and Representative Government. New

Brunswick, NJ: Transaction Publishers.

Niskanen, W. A. (1997). Autocratic, Democratic, and Optimal Government.

Economic Inquiry 35: 464–479.

North, D. (1981). Structure and Change in Economic History. New York: W. W.

Norton.

North, D. (1990a). Institutions, Institutional Change and Economic

Performance. Cambridge University Press.

North, D. (1990b). A Transaction Cost Theory of Politics. Journal of Theoretical

Politics 2: 355–367.

North, D. (1993). Institutions and Credible Commitment. Journal of Institutional

and Theoretical Economics 149: 11–23.

North, D. (1994). Economic Performance through Time. American Economic

Review 84: 359–368.

North, D. (2005). Understanding the Process of Economic Change. Princeton

University Press.
North, D., J. Wallis, and B. Weingast (2009). Violence and Social Orders: A
Conceptual Framework for Interpreting Recorded Human History. Cambridge
University Press.

North, D. and B. Weingast (1989). Constitutions and Commitment: The

Evolution of Institutions Governing Public Choice in Seventeenth-Century
England. Journal of Economic History 49: 803–832.

Nunn, N. (2009). The Importance of History for Economic Development.

Annual Review of Economics 1: 65–92.

Nunn, N. (2014). Historical Development. In P. Aghion and S. Durlauf (eds.),

Handbook of Economic Growth, Vol. 2A. Amsterdam: Elsevier, pp. 347–402.

OECD (2003). Voluntary Approaches for Environmental Policy: Effectiveness,

Efficiency and Usage in Policy Mixes. Paris: OECD.

OECD (2004). Regulatory Impact Assessment (RIA) Inventory – Note by the

Secretariat. Paris OECD. Available at www.oecd.org/gov/regulatory-
policy/35258430.pdf.

Olson, M. (1965). The Logic of Collective Action. Cambridge, MA: Harvard

University Press.

Olson, M. (1982). The Rise and Decline of Nations. New Haven, CT: Yale
University Press.

Olson, M. (1996). Big Bills Left on the Sidewalk. Journal of Economic

Perspectives 10: 3–24.

Olsson, O. and D. A. Hibbs Jr. (2005). Biogeography and Long-Run Economic

Development. European Economic Review 49: 909–938.
Oosterbeek, H., R. Sloof, and G. van de Kuilen (2004). Cultural Differences in
Ultimatum Game Experiments: Evidence from a Meta-Analysis. Experimental
Economics 7: 171–188.

Ordeshook, P. (1992). Constitutional Stability. Constitutional Political Economy

3: 137–175.

Ostrom, E. (1986). An Agenda for the Study of Institutions. Public Choice 48:
3–25.

Ostrom, E. (1990). Governing the Commons: The Evolution of Institutions for

Collective Action. Cambridge University Press.

Ostrom, E. (1996). Incentives, Rules of the Game, and Development. In M.

Bruno (ed.), Annual World Bank Conference on Development Economics.
Washington, DC: World Bank, pp. 207–234.

Ostrom, E. (2000). Collective Action and the Evolution of Social Norms.

Journal of Economic Perspectives 14: 137–158.

Ostrom, E. (2010). Beyond Markets and States: Polycentric Governance of

Complex Economic Systems. Transnational Corporations Review 2: 1–12.

Pejovich, S. (ed.) (2001). The Economics of Property Rights II. International

Library of Critical Writings in Economics. Cheltenham: Edward Elgar.

Pénard, T. (2008). Game Theory and Institutions. In E. Brousseau and J.-M.

Glachant (eds.), New Institutional Economics: A Guidebook. Cambridge
University Press, pp. 158–179.

Pistor, K. (2002). The Demand for Constitutional Law. In S. Voigt and H.-J.
Wagener (eds.), Constitutions, Markets and the Law. Cheltenham: Edward Elgar,
pp. 65–82.

Platteau, J. P. (2000). Institutions, Social Norms, and Economic Development.

Mahwah, NJ: Psychology Press.

Plott, C. and V. Smith (2008). Handbook of Experimental Economics Results,

Vol. 1. Amsterdam: North Holland.

Polanyi, M. (1998 [1952]). The Logic of Liberty. Indianapolis, IN: Liberty

Classics.

Popper, K. R. (1959). The Logic of Scientific Discovery. London: Hutchinson.

Przeworski, A. and F. Limongi (1993). Political Regimes and Economic Growth.

Journal of Economic Perspectives 7: 51–69.

Putnam, R. (1993). Making Democracy Work: Civic Traditions in Modern Italy.

Princeton University Press.

Rawls, J. (1971). A Theory of Justice. Cambridge, MA: Belknap Press.

Riker, W. (1975). Federalism. In F. I. Greenstein and N. Polsby (eds.), The

Handbook of Political Science, Volume V: Government Institutions and
Processes. Reading, MA: Addison-Wesley, pp. 93–172.

Rodrik, D. (2011). The Globalization Paradox: Democracy and the Future of the
World Economy. Cambridge University Press.

Rodrik, D. (2014). When Ideas Trump Interests: Preferences, Worldviews, and

Policy Innovations. Journal of Economic Perspectives 28: 189–208.

Rodrik, D., A. Subramanian, and F. Trebbi (2004). Institutions Rule: The

Primacy of Institutions over Geography and Integration in Economic
Development. Journal of Economic Growth 9: 131–165.

Rousseau, J.-J. (1992 [1755]). Discourse on the Origin of Inequality.

Indianapolis, IN: Hackett.

Rutherford, M. (1994). Institutions in Economics: The Old and the New

Institutionalism. Cambridge University Press.

Sachs, J. and P. Malaney (2002). The Economic and Social Burden of Malaria.
Nature 415: 680–685.

Salsburg, D. (2001). The Lady Tasting Tea: How Statistics Revolutionized

Science in the Twentieth Century. New York: Holt Paperbacks.

Sappington, D. (1991). Incentives in Principal–Agent Relationships. Journal of

Economic Perspectives 5: 45–66.

Schelling, T. (1960). The Strategy of Conflict. Cambridge, MA: Harvard

University Press.

Schermerhorn, J. (2012). Management, 11th edition. Hoboken, NJ: Wiley.

Schlicht, E. (1990). Rationality, Bounded or Not, and Institutional Analysis.

Journal of Institutional and Theoretical Economics 146: 703–719.

Schneider, F. and D. Enste (2007). The Shadow Economy: An International

Survey. Cambridge University Press.

Schoeck, H. (1987). Envy: A Theory of Social Behavior. Indianapolis, IN:

Liberty Fund.

Segal, J. A. and H. J. Spaeth (2002). The Supreme Court and the Attitudinal
Model Revisited. Cambridge University Press.
Shelanski, H. and P. Klein (1999). Empirical Research in Transaction Cost
Economics: A Review and Assessment. In G. R. Carroll and D. J. Teece (eds.),
Firms, Markets, and Hierarchies: The Transaction Cost Economics Perspective.
Oxford University Press, pp. 89–118.

Shirley, M., W. Ning, and C. Menard (2014). Ronald Coase’s Impact on

Economics. Journal of Institutional Economics 11: 1–18.

Simon, H. (1955). A Behavioral Model of Rational Choice. Quarterly Journal of

Economics 69: 99–118.

Sinn, H.-W. (1997). The Selection Principle and Market Failure in Systems
Competition. Journal of Public Economics 66: 247–274.

Smith, A. (1983). Nationalism and Classical Social Theory. British Journal of

Sociology 34: 19–38.

Smith, V. (1994). Economics in the Laboratory. Journal of Economic

Perspectives 8: 113–132.

Sokoloff, K. L. and Engerman, S. L. (2000). Institutions, Factor Endowments,

and Paths of Development in the New World. Journal of Economic Perspectives
14: 217–232.

Spamann, H. (2010). The “Antidirector Rights Index” Revisited. Review of

Financial Studies 23: 467–486.

Stone, A., B. Levy, and R. Paredes (1996). Public Institutions and Private
Transactions: A Comparative Analysis of the Legal and Regulatory Environment
for Business Transactions in Brazil and Chile. In L. Alston, T. Eggertsson, and
D. North (eds.), Empirical Studies in Institutional Change. Cambridge
University Press, pp. 95–128.

Studenmund, A. (2010). Using Econometrics: A Practical Guide, 6th edition.

Harlow: Pearson.

Sugden, R. (1986). The Economics of Rights, Co-operation and Welfare. Oxford:

Basil Blackwell.

Sumner, W. G. (1992 [1906]). Folkways. In R. C. Bannister (ed.), The Essential

Essays of William Graham Sumner. Indianapolis, IN: Liberty Press, pp.
357–372.

Sutter, D. (1995). Potholes along the Transition from Authoritarian Rule.

Journal of Conflict Resolution 39: 110–128.

Tabellini, G. (2010). Culture and Institutions: Economic Development in the

Regions of Europe. Journal of the European Economic Association 8: 677–716.

Teerikangas, S. and P. Very (2006). The Culture–Performance Relationship in

M&A: From Yes/No to How. British Journal of Management 17: S31–S48.

Thaler, R. and C. Sunstein (2008). Nudge: Improving Decisions about Health,

Wealth, and Happiness. New Haven, CT: Yale University Press.

Tiebout, C. (1956). A Pure Theory of Local Expenditures. Journal of Political

Economy 64: 416–424.

Tilly, C. (1992). Coercion, Capital, and European States, AD 990–1992. Oxford:

Basil Blackwell.

Tocqueville, A. de (2003 [1840]). Democracy in America. London: Penguin

Classics.
Tullock, G. (1967). The Welfare Costs of Tariffs, Monopolies, and Theft.
Economic Inquiry 5: 224–232.

Tullock, G. (1987). Autocracy. Dordrecht: Kluwer.

Twight, C. (1992). Constitutional Renegotiation: Impediments to Consensual

Revision. Constitutional Political Economy 3: 89–112.

Ullmann-Margalit, E. (1977). The Emergence of Norms. Oxford University

Press.

Uslaner, E. M. (2002). The Moral Foundations of Trust. Cambridge University

Press.

Vanberg, V. (1992). Innovation, Cultural Evolution, and Economic Growth. In U.

Witt (ed.), Explaining Process and Change: Approaches to Evolutionary
Economics. Ann Arbor, MI: University of Michigan Press, pp. 105–121.

Vanberg, V. (1994). Rules & Choice in Economics. London: Routledge.

Voigt, S. (1993). Values, Norms, Institutions and the Prospects for Economic
Growth in Central and Eastern Europe. Journal des Économistes et des Études
Humaines 4: 495–529. Reprinted in S. Pejovich (ed.), The Economics of
Property Rights II: The International Library of Critical Writings in Economics.
Cheltenham: Edward Elgar (2001), pp. 303–337.

Voigt, S. (1999a). Explaining Constitutional Change: A Positive Economics

Approach. Cheltenham: Edward Elgar.

Voigt, S. (1999b). Improving Welfare by Seeking Rents. Or: On the Ambivalence

of Rent Seeking for Explaining Constitutional Change. Jena: Max-Planck-Institut
zur Erforschung von Wirtschaftssystemen.
Voigt, S. (2011). Positive Constitutional Economics II: A Survey of Recent
Developments. Public Choice 146: 205–256.

Voigt, S. (2013). How (Not) to Measure Institutions. Journal of Institutional

Economics 9: 1–26.

Voigt, S. (2019). Institutions. In R. Kollmorgen, W. Merkel, and H.-J. Wagener

(eds.), Handbook of Transformation Research. Oxford University Press.

Voigt, S., M. Ebeling, and L. Blume (2007). Improving Credibility by

Delegating Judicial Competence: The Case of the Judicial Committee of the
Privy Council. Journal of Development Economics 82: 348–373.

Voigt, S., J. Gutmann, and L. Feld (2015). Economic Growth and Judicial
Independence, a Dozen Years On: Cross-Country Evidence Using an Updated
Set of Indicators. European Journal of Political Economy 38: 197–211.

Voigt, S. and D. Kiwit (1998). The Role and Evolution of Beliefs, Habits, Moral
Norms, and Institutions. In H. Giersch (ed.), The Merits of Markets: Critical
Issues of the Open Society. Berlin: Springer, pp. 83–108.

Voigt, S. and S. M. Park (2013). Not a Quick Fix: Arbitration is No Substitute

for State Courts. Journal of Development Studies 49: 1514–1531.

Walker, M. (1988). Freedom, Democracy, and Economic Welfare. Vancouver:

Fraser Institute.

Wallis, J. and D. North (1986). Measuring the Transaction Sector in the

American Economy, 1870–1970. In S. Engermann and R. Gallman (eds.), Long-
Term Factors in American Economic Growth. University of Chicago Press, pp.
95–148.
Weber, M. (1964 [1922]). The Theory of Social and Economic Organization. Ed.
T. Parsons. New York: Free Press.

Weber, M. (1993 [1920]). The Sociology of Religion. Trans. E. Fischoff. New

York: Beacon Press.

Weber, M. (2011). Methodology of Social Sciences. Trans. and ed. E. A. Shils

and H. A. Finch. New Brunswick, NJ: Transaction Publishers.

Weibull, J. W. (1997). Evolutionary Game Theory. Cambridge, MA: MIT Press.

Weimann, J. (1994). Individual Behaviour in a Free Riding Experiment. Journal

of Public Economics 54: 185–200.

Weingast, B. (1993). Constitutions as Governance Structures: The Political

Foundations of Secure Markets. Journal of Institutional and Theoretical
Economics 149: 286–311.

Weingast, B. (1995). The Economic Role of Political Institutions: Market-

Preserving Federalism and Economic Development. Journal of Law, Economics,
& Organization 11: 1–31.

Weingast, B. (2014). Second Generation Fiscal Federalism: Political Aspects of

Decentralization and Economic Development. World Development 53: 14–25.

Whinston, M. D. (2003). On the Transaction Cost Determinants of Vertical

Integration. Journal of Law, Economics, & Organization 19: 1–23.

Wicksell, K. (1896). Finanztheoretische Untersuchungen. Jena: Fischer.

Williamson, C. R. and R. L. Mathers (2011). Economic Freedom, Culture, and

Growth. Public Choice 148: 313–335.
Williamson, J. (ed.) (1994). The Political Economy of Policy Reform.
Washington, DC: Institute for International Economics.

Williamson, O. E. (1975). Markets and Hierarchies: Analysis and Antitrust

Implications. New York: Free Press.

Williamson, O. E. (1985). The Economic Institutions of Capitalism. New York:

Free Press.

Williamson, O. E. (1996). The Politics and Economics of Redistribution and

Efficiency. In O. E. Weingast, The Mechanisms of Governance. Oxford
University Press, pp. 195–216.

Williamson, O. E. (2002). The Theory of the Firm as Governance Structure:

From Choice to Contract. Journal of Economic Perspectives 16: 171–195.

Williamson, O. E. (2010). Transaction Cost Economics: The Natural

Progression. Journal of Retailing 86: 215–226.

Wintrobe, R. (1998). The Political Economy of Dictatorship. Cambridge

University Press.

Wittman, D. A. (1995). The Myth of Democratic Failure: Why Political

Institutions are Efficient. University of Chicago Press.

Wydick, B. (2007). Games in Economic Development. Cambridge University

Press.

Zak, P. J. and S. Knack (2001). Trust and Growth. The Economic Journal 111:
295–321.

Zweigert, K. and H. Kötz (1998). Introduction to Comparative Law. Oxford:

Clarendon Press.
 Index
adverse selection, 66–67
agency costs, 66
Agrippa’s trilemma, 223
allocation, 39–45, 224–226, 242
allocation approach, 224
as if explanation, 88
asset specificity, 69
asymmetric information, 65–68

banking, regulation of, 131

bargaining power, 73, 174–176
behavioral assumptions, 68–70
behavioral economics, 103
Bertelsmann Transformation Index (BTI), 139
bivariate, 139
black box, 62
black market, 56, 131
black market exchange rates, 131
bureaucracy, 52, 105, 108, 126, 163, 216, 250
Business Environment Risk Intelligence (BERI), 138

Ceteris paribus, 57
cheap talk, 95, 200, 244
circular argument, 223
civil law, 171
civil society, 53, 146
climate, 101, 112, 214
Coase theorem, 39–45, 189
coefficient of determination, 156
cognition, 208, 257
collective action problem, 15–16, 81, 162, 168, 175–177, 183, 186–187, 190
collective decision-making, explicit process, 185
colonization, 117, 171–173, 184
commitment approach, 200
common law, 171
common pool problem, 161
common pool resources, 99
communication, 183, 200, 202, 244, 258
comparative institutional analysis, 22, 100, 250
conditional cooperation, 202
constitution, 91, 101, 103, 177
constitutional economics, 32–33, 83, 166, 227
constitutional ignorance, 233
constitutional level, 83
contestable markets, 250
contract, 16, 39, 65
neoclassical contracts, 72
nexus of contracts, 64
relational contracts, 72
contract theory, 32, 166
contract-intensive money (CIM), 124
contributions of NIE, 7
convention, 17, 24, 75, 95, 256
coordination approach, 225, 232
corporate culture, 75, 264
correspondence theory of truth, 222
corruption, 126
Corruption Perceptions Index (CPI), 139
counterfactual argument, 204
creative destruction, 251
crowding out effect, 102, 245, 250
culture, 119, 148

demand side, 184, 191

democracy, 170, 191
credible commitment, 177
economic growth and, 126, 153
market economy and, 131–135
measurement, 137
democratization, 159, 256–258
dilemma of the strong state, 86–91, 200, 239, 264
Doing Business, 151
dominant coalition, 178

econometrics, 30, 132, 152, 154

economic analysis of law, 5, 32–33
economic behavioral model homo economicus, 5
Economic Freedom Index, 127, 135, 138
economic freedom rights, 150
economic growth, 132, 146
economic growth theory, 238
endogenous growth theory, 108
economic theory of politics, 170
economies of scale, 167
egoism, adaptive, 211
endogenization, 21, 255
endogenous, 21, 156
enforcement, 13–18
organized private, 16
organized state, 16
self-commitment, 15
self-enforcing, 14–15, 244
spontaneous societal enforcement, 16
equilibrium, 24, 26, 92, 95, 202–203, 209
evolutionary approach, 199–202
biased transmission, 201
gene-culture-coevolution, 201
natural selection, 201
unbiased transmission, 201
ex post opportunism, 75, 244
exit, 182–184, 246
exogenous, 20, 68
experiment, 28–29, 46
explanandum, 158
explanans, 158
exploitation theory, 165
export regulation, 131
external effect, 40
externality, 40, 67, 87, 161, 197–198, 203
network, 188

failed states, 170

fallacy
functionalist, 13, 185
 instrumentalist, 223
naturalistic, 223
falsification, 222
Fertile Crescent, 115
firm, 61–65, 72–75
fixed costs, 74
Folk theorem, 92, 202
Fraser Institute, 127
Freedom House, 137
freedom of contract, 38–39, 221
freedom-of-information act, 239
free-ride, 63, 187
free-rider problem, 98, 198

Gallup World Poll, 145

game theory, 23–27, 92
coordination game, 15, 23–24, 57, 93, 195, 209
dominant strategy, 15, 26, 54, 209, 244
information set, 24
mixed-motive game, 23, 25, 174
Nash equilibrium, 24, 91
payoff function, 24
player, 23
prisoner’s dilemma, 25–27, 63, 81, 91–96, 202, 208–209, 244–246
zero-sum game, 23
GDP, 107, 127, 132
geography, 112, 119
Germany, economic development in East and West, 111
Global Attitudes Project, 146
Global Competitiveness Report, 132, 138
globalization, 182, 257, 263, 265, 267
governance, 61, 163, 266
hybrid, 68
governance structure, 70
governing the commons, 100
government failure, 225
growth theory, 108

Habsburg Empire, 216–217

hidden action, 68
hidden information, 68
homo economicus, 5, 7, 20, 28, 46, 207
homo sociologicus, 197
honeymoon hypothesis, 253
human action, 14
human capital, 69, 75, 150, 238
hypothetical consensus, 226, 231, 236

ideology, 169
import regulation, 41, 131
import substitution policy, 247, 249
income distribution, 45
Index of Economic Freedom see Economic Freedom Index
inductive thinking, 31
inequity aversion, 205
infinite regress, 199
infinite regression, 223
inflation rate, 86, 125, 129–130, 140
informal sector, 56–57
information economics, 32
innovation, 29, 110, 168, 201
institutions, 17–20, 109
change of, 158, 185, 190
external, 17, 38, 122, 158
function of, 32, 188, 238
institutional competition, 184
internal, 17, 45, 75, 91, 142, 195, 242
relationship between external and internal, 19, 48, 50, 98
spatial diffusion, 184
interdependence cost calculus, 229
interdependence costs, 228
interdependent utility function, 205
internalization, 15, 161
International Country Risk Guide (ICRG), 126, 138

Judicial Committee of the Privy Council, 91

Korea, economic development in North and South, 112

labor, regulation of, 131

laboratory experiment, 28
latitude, 113
legal families, 171–172
legal origin, 150, 172, 184
legal structure, 52, 140
legal system, 129
limited access orders, 178
lock-in, 69

mandate hypothesis, 252

market failure, 225, 242, 250
measurement cost approach, 65
meme 200–202
methodological individualism, 7, 13, 185, 227
mobility, 131, 143, 182
monetary policy, 89
monitoring, 11, 15–16, 60, 82, 98, 100, 163, 213, 245, 250, 254
monopolist, discriminating, 167
moral hazard, 66–67
moral suasion, 242

naïve theory, 181, see also property rights, naïve theory

Nirvana approach, 225
non-tariff barriers, 131
norm, 6, 197, 199–202
justice and fairness norms, 46
meta norm, 198
procedural norm, 227
solidarity, 95
normative individualism, 227
normative theory, 221–222, 232
of institutions, 232

open access orders, 178

opportunism, 54, 68, 70, 78, 244
ordinary least squares, 154
organizability of interests, 183
organization, 61, 82, 90, 98, 165, 178, 249, 251, 264
organization costs, 60, 72, 74
ostracism, 97

Pareto criterion, 228, 230

Pareto optimum, 40, 230
parliament, 84, 104, 158, 185, 247, 251–252
path dependency, 53, 186, 188
patronage, 163
Pigou tax, 40
political business cycles, 86
political economy, 5, 160, 164–165, 192–193, 241, 256
political entrepreneur, 191, 251
political rights, 137
Political Risk Services Group, 138
Polity IV indicators, 137
preference, 6, 183
pretense of knowledge, 233
price stability, 89, 248
principal–agent theory, 65–68, 74, 87, 102, 168, 250
private autonomy see freedom of contract
problem of ultimate justification, 223
procedural law, 39, 129
prohibition, 39, 48
property rights, 11, 38–45, 87, 110
and economic growth, 124
and incentives, 38
and legal system, 129
development of property rights, 160–165
inefficient, 165, 168
naïve theory, 160
property rights approach, 73
property rights theory, 31, 33, 38, 73, 255
security of, 124, 140–141, 239
Protestant ethic, 121
public choice theory, 32, 83, 170
public good, 81–84, 91–102, 148, 175, 181, 183, 187, 198, 243, 262
linear public goods experiments, 93
non-excludability, 81
non-rivalry, 81
voluntary provision of public goods, 93
public sector, 55
punishment dilemma, 179

quasi rent, 69
QWERTY, 188

race to the bottom, 182

rational choice, 212
rational choice sociology, 197
rationality, 7
bounded, 8, 68, 186, 234, 237
satisficing behavior, 187
perfect, 7, 27
reciprocity, practical, 53
reference data, 7
relative power, 175, 186, 190
rent seeking, 84
reputation, 16, 77, 101, 199, 203
loss of, 97, 246
mechanism, 245
residual income, 64
reversal of fortune, 118
right
 residual, 73
risk, 8, 98, 126
risk aversion, 143
rule, 13–18
choice of rules, 7, 186
choice within rules, 186
constitutional rules, 32, 228
ethical rule, 15, 17, 20, 96, 195, 211, 244
regular behavoir, 203
rule breaking, 16, 18
rule of law, 85, 126, 139, 158, 179, 262
for elites, 178
Rule of Law Index, 139
rule system, 227

sanction, 13, 16, 49, 76, 96, 98, 198, 205, 246
secondary virtues, 95–96, 144
selective retention, 182
self-binding mechanisms, 88
separation of powers, 88
shadow economy, 56
social dilemma, 243, 246
social market economy, 250
social welfare function, 224, 226, 237
solidarity, 95
specific investment, see asset specificity
standard deviation, 130
state, 17, 20, 33, 48–50, 76, 81, 83, 165, 263
state control, 16
state representatives, 131
 state-owned enterprises, 129
subjective data, 126
subsidies, 40–41, 85, 127, 176, 241, 248–249
sunk costs, 69
supply side, 191

tacit knowledge, 189

taxation, 129–130, 167
time-inconsistency, 89–90
tit-for-tat, 96
tragedy of the common, 99
transaction cost economics, 31
transaction costs, 8–9, 68–72
alternative delineations of transaction costs, 11
estimation, 54–57
political, 11, 162, 186, 189, 192, 244
positive, 33, 60, 232, 235, 237
transaction industries, 55
transaction sector, 55
transactions, 37–47, 107
transfer payment, 127
transformation industries, 55
Transparency International, 139
trust, 142, 144, 146–148, 210, 214
two-party system, 251
two-stage behavioral model, 211

ultimatum game, 45–46

unanimity test, 231–232
uncertainty, 238
 institutions and, 13
parametric, 12
strategic, 12
unicameral system, 251
universalizability, 233
utility, 6
utility maximization, 8, 34, 89, 207, 259

value, 196
value judgment, 222
veil of ignorance, 231
veto player, 125

welfare economics, 224

Westminster model, 251
World Bank, 91, 139, 151, 240, 256
World Competitiveness Yearbook, 138
World Economic Forum, 138
World Values Survey, 145
Worldwide Governance Indicators, 139