Chapter One: Institutions

Institutions
Introduction
This chapter attempts to introduce the basic concepts of institution and institutional economics.
To facilitate future discussions, this chapter provides alternative definitions of institution that are
suggested by various scholars, mainly in the field of economics. Like many other social science
terms, providing a single universally accepted definition of social capital is usually difficult.
Thus, instead of providing a single definition, the material discusses important elements
embedded in each alternative definition. In order to help you to make sense of institutions, I
provide you some key elements of institution. The chapter then briefly discuss how institutions
matter in determining economic performance. Then outline a theory of institutional change not
only to provide a framework for economic history, but also to explain how the past influences
the future, the way incremental institutional change affects the choice set at a moment of time,
and the nature of path dependence.
Note that this is just to help you understand the essence of institutions. In-depth discussions on
this issue will be made in the last two chapters. The chapter finally attempts to provide an
overview of the origin and evolution of New Institutional Economics (NIE).
1.1. Definition of Institutions?
Like many terms in the areas of social sciences, there is no universally accepted definition for
institution, but institutions are different from organizations. Institutions are the rules of the game
in the economy, and ‘organizations’ (‘the players of the game’) arise in response to the
institutional structure. North (1993) explains: ‘It is the interaction between institutions and
organizations which shapes the institutional evolution of the economy.’ The meaning of
institution in the sense of economics is much wider, complex and abstract than its literally known
meaning.
Definitions of institution from the perspective of Old Institutionalists
Institutions are "settled habits of thought common to the generality of men." (Veblen, 1919).
Institutions are understood as essential “collective action in control of individual action”
(Commons 1934, 69). Institutions are "way of thought or action of some prevalence and
permanence, which is embedded in the habits of a group or the customs of a people." (Hamilton,
1934).
Notably, in the “old” institutionalism, the concept of habit plays a central role both in its
definition of an institution, as in its picture of human agency.
It is belied that, the New Institutional Economics merged with Coas’s 1937 article “ The Nature
of the Firms” even though Oliver Williamson coined the phrase “New Institutional Economics
(NIE)” to distinguish it from the “old institutional economics” (Coases, 2000). In the NIE
approach institutions emerge to minimize transaction costs and to facilitate the market exchange
and the unit of analysis is the transaction rather than the price, assumes that exchange itself is
costly (Eleni, 2001).

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The old institutional school argued that institutions were a key factor in explaining and
influencing economic behavior, but with little analysis rigor of neo-classical economics while
neo-classical economics on the other hand, refuse to notice the role of institutions. However,
under NIE the importance of institutions is acknowledged under the analysis framework of neo-
classic economics i.e. some of the unrealistic assumptions of neo-classical economics such as
perfect information, zero transaction costs, full rationality are relaxed with holding the other
assumptions such as self-seeking individuals attempt to maximize an objective function subject
to constraints still holds (Kherallah and Kirsten, 2002). With its conceptual and theoretical
innovations, NIE attempts to make neoclassical economics more realistic. The prime example of
this is the revision of the assumption of human behavior into a conception of ‘bounded
rationality’, which is perceived to be more in line with actual human behavior. With the
introduction of ‘transaction costs’, in combination with the focus on property rights, NIE also
takes economics in a more social direction, allowing for and explaining both historical evolution
and different economic systems than the market, as well as pointing to the necessity of
institutional and state support for the market to work. Having opened up these avenues of
theoretical elaboration, ‘institutions’ has become the key concept in indicating the need for a
more realistic, social, historical approach to economics.
Institutions from the perspective of New Institutionalists
In the words of the founding father: ‘Modern institutional economics should study man as he is,
acting within the constraints imposed by real institutions’ (Coase,1984). Institutions are “the
humanly devised constraints that shape human interaction” (North, 1990). This definition seems
to exclude conventions, habits and even some norms that are not the product of human design
but that just arise autonomously. To include norms and conventions, North provide an alternative
definition: Institutions are “the rules of the game” (North, 1994).
Following to North (1992), Institutions are the ‘rule of the game’ in a society i.e. they are
humanly devised constrains that shape human interaction, consisting of formal rules (laws,
contract, markets, political system, organizations, etc), informal constraints (such as norms of
behavior, conventions, and self-impose codes of conduct, etc), and enforcement characteristics of
both, as institutional setting depends on the effectiveness of enforcement. This enforcement is
carried out by the first party (self-imposed codes of conduct), by the second party (retaliation),
and/or by a third party (social sanctions or coercive enforcement by the state). Rules also affect
beliefs and preferences and provide a signal for agents to uncalculated action.
Ostrom (1990) provides a similar definition: Institutions refer to the rules, norms, and strategies
used by humans in repetitive interactions. According to World Bank (2002) Institutions are
‘rules, enforcement mechanisms and organizations’. Two key terms in the above definitions
need to be clarified: rules and norms.
Rules refer to shared prescriptions (must, must not, or may) that are mutually understood and
enforced in particular situations in a predictable way by agents responsible for monitoring
conduct and for imposing sanctions. In this case institutional may be the product of deliberate
design. Some legitimate authority (parliament, an entrepreneur, a team, etc.) acting with
complete rationality, may be able to introduce a particular institutional structure (formal rules)
that it deems appropriate.

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Norms are considered to be shared prescriptions known and accepted by most of the participants
themselves. They involve intrinsic costs and benefits rather than material sanctions or
inducements. Social norms such as “customary law” can in some cases be superior to
administrative or judicial dispute resolution among people with close social ties. Since social
norms effectively work among member of a closed social group, they inherently lack
universality. In other extreme, institutions are said to arise “spontaneously” (as a spontaneous
order, in the extreme: a set of informal norms) on the basis of the self-interest of individuals. In
such a case, they may organize themselves “without any agreement, without any legislative
compulsion, even without any consideration of public interest” using the term evolutionary
rationalism to describe the situation here.
The adherence of rules is largely due to explicit enforcement while adherence of norms is largely
due to acceptance. Rules and norms thus differ by virtue of the different ways they influence
behavioral patterns. In the former case, the rules are guaranteed by third parties (e.g., legally
enforced), in the later by self-enforcement. Self-enforcement can be justified rationally by use
of game-theoretic equilibrium concepts. Finally, only self-enforcing institutions are
(comparatively) stable.
Note that rules that are not enforced or norms that are not adhered to cannot be considered as
institutions. That is, we only refer to rules-in-use rather that rules-in-form. For instance, laws
about child labor will be considered as institution in so far as it shapes the behavior of actors in
the labor markets. Similarly, those norms that often prevail in the public rhetoric as the
embodiment of a specific community may not pass critical scrutiny. It is thus crucial to scrutinize
the extent to which the said norms order social interactions.
In the case of food products, for example, even if rules regarding food safety, grades, and
standards are specified in regulations, they cannot influence the behavior of agents in the food
market if they are not enforced by a relevant organization.
Generally, institutions enable ordered thought, expectation, and action by imposing form and
consistency on human activities. Institutions both constrain and enable behavior. The existence
of rules implies constraints. However, such a constraint can open up possibilities: it may enable
choices and actions that otherwise would not exist.
In addition, it is important to understand the boundaries of rules and norms. Norms that apply in
the interaction between members of a group may apply in the interaction between members and
non-members in an equal and similar way. For instance, a community may have a norm that
considers thieving from one’s own community member as bad behavior (and hence the
community ostracizes it). But that same community may have also have a norm that considers
that same action (theft) as an acceptable act or even a heroic act when the action is done on the
member of another community, especially from rival communities. The same action may not
even carry the same meaning. Thus, behavioral regularities have to be seen within the
framework of relevant social groups.
The other point is that distinctions about rules are made as formal and informal. Formal rules
are consciously designed by humans and often codified in written form –examples are
constitutions, laws and regulations. They are also often enforced by some external authority.
The police and the courts, for instance, enforce the rule of law. Enforcement requires enforcing

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organizations. The rules, the enforcement mechanisms, the organizations and the way these
influence behavioral patterns together are considered as formal institutions.
Informal rules evolve spontaneously and unintentionally over time through human interaction,
and take the form of unwritten conventions, routines, customs, codes of conduct and behavioral
norms (Menger, 1963). For instance, the norms to honor promises, to protect private property, or
to speak Somali in Somalia can be considered as informal rules. The ways these informal rules
are adhered to and their effect on behavioral patterns can be considered as informal institution.
Generally, non-compliance with informal rules is sanctioned through decentralized, spontaneous
social feedback.
Institutions include any form of constraint that human beings devised to shape human
interaction. Are institutions, formal or informal? They can be either, and we are interested both
in formal constraints – such as rules that human beings devise- and informal constraints- such as
conventions and codes of behavior. Institutions may be created, as was the Ethiopian
Constitution; or they may simply evolve over time, as does the common law (such as Idir and
Ekub). We are interested in both created and evolving institutions, although for purposes of
analysis, we may want to examine them separately. Many other attributes of institutions also will
be explored.
Institutional constraints include both what individuals are prohibited from doing and, sometimes,
under what conditions, some individuals are permitted to undertake certain activities. As defined
here, they therefore are the framework within which human interaction takes place. They are
perfectly analogous to the rules of the game in a competitive team sport. That is, they consist of
formal written rules as well as typically unwritten codes of conduct that underlie and supplement
formal rules, such as not deliberately injuring a key player on the opposing team. And as this
analogy would imply, the rules and informal codes are sometimes violated and punishment is
enacted. Therefore, an essential part of the functioning of institutions is the costliness of
ascertaining violations and the severity of punishment.
Institutions reduce uncertainty by providing a structure to everyday life. They are a guide to
human interaction, so that when we wish to greet friends on the street, drive an automobile, buy
oranges, borrow money from a business, bury our dead, or whatever, we know (or can learn
easily) how to perform these tasks. We would readily observe that institutions differ if we were
to try to make the same transactions in a different country.
Perhaps the following key features of institutions help you to understand what institutions are:
All institutions involve the interaction of agents, with crucial information feedbacks; All
institutions have a number of characteristic and common conceptions and routines; Institutions
sustain, and are sustained by, shared conceptions and expectations; Institutions have distinct
social boundaries in which they effectively work; Unenforced rules are not component of
institutions; Institutions generally are thought to serve collectively valued purposes but
sometimes institutions may exist without collective intentionality e.g. merely by virtue of shared
conventions and habits or by virtue of sustained enforcement by certain groups; Although they
are neither immutable nor immortal, institutions have relatively durable, self-reinforcing, and
persistent qualities-rules that change all the times are harder to know and are less effective in
ordering people’s actions. Rules therefore are stable, conforming with the age-old, conservative
saying that ‘old laws are good laws’. The advantage of stable institutions is that people have
adjusted to old institutions to the best of their advantage and have acquired a practice of
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following them almost instinctively and hence facilitates human interaction; and Institutions
incorporate values, and processes of normative evaluation. In particular, institutions reinforce
their own moral legitimation: that which endures is often-rightly or wrongly-seen as morally just.
1.2. Economic institutions
Economic institutions are a set of constraints that govern the relations among individuals or
groups in economic activities. The economic activity could be production, allocation, distribution
or exchange. Economic institutions make up the economic system (may be command or
authoritarian economic system, developmental state economic system, mixed economic system,
free market/capitalist economic system) – the framework that regulates economic activity.
Economic institutions as understood as proving the incentive structure that encourages agents to
behave in a certain way instead of another way. Institutions are, therefore, critical to determining
economic performance by influencing the cost of production, the mode of allocations and the
costs of transactions.
They may be broadly grouped into two categories: those that define the forms of ownership of
the means of production, and those that define the mechanisms for resource allocation and
coordination of economic activity. Markets can thus be considered as one form of institutions
coordinating economic activities.
In the economic exchange of goods and services, then, institutions act as a set of constraints that
govern the relations among individuals or groups in the process of economic exchange. For
instance, institutions facilitate sharecropping economic activity by create stable and predictable
behavioral patterns by providing a set of constraints and incentive structures. Institutions thus
help human beings to form expectations of what other people will do. Markets are only one type
of social device for settling the terms of transactions.
Institutional economics offers a theoretical framework for studying institutions and
organizations prevailing in an economy and the way these institutions emerge, evolve and impact
the behavior of individuals. When we seek to examine the role of “social, cultural, political, and
economic institutions” on “economic behavior and performance” we have cut a very large slice
of cake to chew on. NIE has not tried to focus on all institutions that might fit under this
umbrella. Nor has it focused on all aspects of economic performance. Whilst the field has been
reasonably inclusive, it has also been reasonably well-focused. To better understand the (perhaps
soft) boundaries of NIE it is useful to work from a more expansive description of the full range
of relevant institutions, and the relationships between them, and then to identify the subset of
institutions upon which research in NIE has focused. The most useful framework to work from is
the one proposed by Oliver Williamson (2000) a two decade ago. I will make use of
Williamson’s analytical framework here. Williamson’s framework identifies four interrelated
levels of social or institutional analysis.
Level 1: Embeddedness, or Social or Cultural Foundations. The highest level of the
institutional hierarchy encompasses informal institutions, customs, traditions, ethics and social
norms, religion, and some aspects of language and cognition. This level provides the basic
foundations for a society’s institutions. These basic social and cultural institutional foundations
change very slowly over time, with adaptation periods of as long as a thousand years and no
shorter than a hundred years, it is studded base on the social capital theory.

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Level 2: Basic Institutional Environment. This second level of the institutional hierarchy
encompasses the basic institutional environment or what Williamson calls “the formal rules of
the game.” At this level are defined constitutions, political systems, and basic human rights;
property rights and their allocation; laws, courts, and related institutions to enforce political,
human rights and property rights, money, basic financial institutions, and the government’s
power to tax; laws and institutions governing migration, trade, and foreign investment rules; and
the political, legal, and economic mechanisms which facilitate changes in the basic institutional
environment. The nature of the basic institutional environment at any point in time reflects,
among other things, the attributes of a society’s basic social and cultural foundations.
In a society in a dynamic equilibrium, a given set of basic institutions at this level will be
compatible with the society’s social foundations at any particular point in time. Changes in the
basic institutional environment occur more quickly than changes in the cultural or social
foundations (Level 1), but change is still relatively slow and partially constrained by the slow
rate of adaptation of the underlying social and cultural foundations, with response times as short
as ten years but as long as a hundred years.
Level 3: Institutions of Governance. This third level of the institutional hierarchy encompasses
what Williamson calls “the play of the game.” Given the basic institutional environment, choices
are made about the institutional (governance) arrangements through which economic
relationships will be governed given the attributes of the basic institutional environment. The
basic structural features of the institutions (e.g. competitive markets), through which individuals
trade goods, services, and labor are defined; the structure of contractual or transactional
relations, the vertical and horizontal structure of business firms, and the boundaries between
transactions mediated internally and those mediated through markets; corporate governance, and
financial institutions that support private investment and credit, are defined at this level.
The choice of governance arrangements is heavily influenced by the basic institutional
environment as well as by a country’s basic economic conditions (e.g. natural resource
endowments) at any point in time. Changes in governance arrangements also take place more
quickly than do changes in the basic institutional environment. Williamson suggests a change
time frame of one to ten years. Two important concepts in New Institutional Economics are the
institutional environment and institutional arrangements.
Level 4: Short-term Resource Allocation (Neoclassical Market Economics). This level refers
to the day-to-day operation of the economy given the institutions defined at the other three
levels. Prices, wages, costs, and quantities bought and sold are determined here as are the
consequences of monopoly, oligopoly, and other neoclassical market imperfections.
1.3. Institutions matter?
One person cannot interact with another without some shared understanding about how the other
will respond and some sanction if the other responds arbitrarily and contrary to agreement.
Private individuals and businesses can only buy, sell, employ labour, invest and explore
innovations if they can have some confidence that their expectations will be met. Much of the
exchange between individuals and firms is based on repetitive operations, and we prefer these to
be predictable because that reduces frictions and uncertainties.

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Just imagine, if your next bill at the check-out in the supermarket came to ten times what you
paid for the same basket of goods at the last visit! or if the bank where you deposited your
savings suddenly refused in economic life, depend on some sort of trust which is based on an
order that is facilitated by rules banning unpredictable and opportunistic behavior. We call these
rules ‘institutions’.
In our daily lives we interact with numerous people and organizations whom we scarcely know,
but in whose predictable behaviour we place great faith. We hand over our hard-earned money to
a teller clerk, while face we may not remember five minutes later in a bank about whose reserves
and management we know nothing. We allow ourselves to be operated upon by surgeons we
have hardly met, in hospitals we had never seen from the inside before. We prepay for the
delivery of a car made in a foreign country by workers we will never meet. Yet, in all these
situations, we trust that we will get worthwhile service and that promises to deliver will be kept.
Why? Because all these people have specialized knowledge and skills to offer and because they
are bound by institutions- - constraints on their opportunistic temptations not to deliver or to
short-change us. We are able to assume that selfish breaches of the contracts into which we enter
will incur sanctions of one sort or another. Come to think of it, modern economic life depends
rather precariously on numerous written and unwritten rules. If they are widely violated – as
when society collapses after a lost war or in internal chaos – many of the human interactions on
which we depend for our wellbeing are no longer possible; living standards and the quality of
life, then plummet. The institutions which normally prevent this are thus the very foundations of
our living standards and our sense of security and community.
Effective institutions of economic exchange play the following role: coordinate exchange,
facilitate low cost exchange (transaction costs) and provide the necessary incentives for agents.
Coordination roles – institutions coordinate exchange at several levels. At its most basic level,
coordinated exchange involves the reliable bringing together of buyers and sellers. Facilitative
roles – institutions facilitate efficient exchange by reducing information problems and by
limiting opportunistic actions. The idea is as transaction costs increases, the potential gains from
economic exchanges declines and hence economic activities decline. Allocative roles –
institutions providing the incentive structure affect the pattern of allocation of economic
resources. If, as mentioned earlier, the institutions provide incentive to piracy, more resources
will be devoted to capture the economic gains from piracy. If on the other hand institutions
make production a profitable activity, then it provides agents to invest their resources on
productive activities. If institution (the rules system, the belief, culture, etc.) enforce and protect
private property rights, then agents will have the incentive to accumulate private property which
affects the extent of economic activity, saving, investment and so many other economic
variables.
Agricultural development requires the development of institutions that incentive economic
activities, that reduce costs of transactions, that protect and enforce property rights and that
coordinate management of public good investments. In sum, institutions matter for economic
development. In the past, development was conceived as a matter of investment on
infrastructure, education, and technology dissemination. Though these investments are
necessary, cannot bring the intended effect on economic development if institutions fail to
provide the necessary incentives structure, if they fail to protect and enforce property rights and
if they fail to reduce transaction costs. The question to most developing countries is then ‘how to
get institutions right’.

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Unfortunately, getting institutions right is not an easy task. It is not something that can be
achieved in an overnight campaign. Rather it requires continuous efforts and results of
evolutionary process. It is not something that can be achieved just by government intervention. It
rather requires the commitments of all actors. It is not something achieved by through
intervention on a given organization or sector. Rather it requires overall organizational, social
and cultural transformation. In a nut shell, there is no short cut to get institutions right. But the
good news is, once institutional change begins, the change is then incremental.
1.4. Institutions vs. Organizations
A crucial distraction in the study of institutional economics is made between institutions and
organizations. Like institutions, organization provide a structure to human interaction. Indeed,
when we examine the costs that arise as a consequence of the institutional framework we see
they are a result not only of that framework, but also of the organizations that have developed in
consequence of the framework. Conceptually, what must be clearly differentiated are the rules
from the players. The purpose of the rules is to define the way the game is played. But the
objective of the team within that set of rules is to win the game – by a combination of skills,
strategy, and coordination; by fair means and sometimes by foul means. Modeling the strategies
and the skills of the team as it develops in a separate process from modeling the creation,
evolution, and consequences of the rules.
These two terms are often used interchangeably in everyday language. In the context of
institutional analysis, however, institutions are complexes of rules, norms and behavioral
patterns. Organizations are made up of groups of individuals bound together by some common
purpose to achieve certain objectives. Examples of organizations include political bodies
(political parties, a city council, a regulatory agency), economic bodies (firms, trade unions,
family farms, cooperatives), social bodies (churches, clubs, athletic associations), and
educational bodies (schools, universities). The complex of formal rules, regulations, code of
conducts, norms, conventions, etc. that determine the behavioral pattern of actors in these
organizations could be thought as institution. But institution go beyond the boundary of the
organization.
Many institutions are organization (for example household, firms and co-operatives) on other
hand; other types of institutions are not organization for instance money or the law. Likewise,
there are organizations at grass-root level which are not institutions (Kherallah and Kirsten,
2002). Although, Meramveliotakis and Milomakis (2010) emphasized that organization and
institutions are interlinked or vested within one another, therefore they are not entirely separable.
Institutions operate on different level of business environment such as macro, meso and micro
level, and the relevance of it is bound to vary according to the context in which the inter-firm
relation is embedded. According to (Kautonen and Kohtamäki, 2006), the micro level analysis
inter-firm relation such as formal and informal institutions and their source can be roughly
mapped on the continuum of meso and macro levels of the business environment in which the
inter-firm relation in embedded.
The meso level analysis comprises of formal norms, standards and regulation imposed by local
authorities specific to an industry sector or business association (Bachmann, 2001) as well as
informal institutions that are specific to an identified category of actors such as members of a
professional association in certain industry sector or region. The other on is the macro level

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institution which operate to any member of a society disregarding membership in any specific
region and sector. The basic unit on the macro level is the national state, which share one
framework of legal norms and judicial system as well as it shares broad cultural norms, albeit
regional variations (Kautonen and Kohtamäki, 2006).

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 Chapter Two: Institutional Economics and Neoclassical Economics
Introduction
This chapter extends the previous introduction by going into the basic elements defining
institutional economics as a paradigm in the field of economics. In this line, it attempts to
discuss the behavioral aspects that depart institutional economists from neo-classical economists.
In addition, the chapter also discuss the contribution of NIE in broadening our understanding of
economics and in addressing real economic problems.
2.1. Behavioral Patterns in the Neoclassical economics and NIE
Economics is thought as the theory of choice. It studies how agents behave in response to
changes in economic incentives. Behavioral economics is then the study of the key behavioral
attributes governing the choice decision pattern of people. The primary focus of the behavioral
economics is to understand the constraints with regard to time, information, and cognitive
abilities people face when they make choice decisions. In addition, it also attempts to understand
the motives driving the preference of people and the circumstances that changes preferences.
While neoclassical economics takes a stringent behavioral assumption as a starting points, NIE
recognize from the outset the limitations of these behavioral assumptions and attempt to explain
behavioral patterns within the framework of institutions.
Neoclassical economics takes the following assumptions as a starting point. It begins by
assuming decision makers to have perfect knowledge. It also assumes to self-interested rational
individuals attempt to maximize their utility.
Neoclassical economics uses an ideal perfect competition as a benchmark against which to
develop and extend the theories to consider real world situations and problems. The first step to
understand neoclassical economics is to understand the core assumptions of perfect competition.
The next step will then be to question whether one or more of these core assumptions do hold in
real world situation or not.
Core assumptions of the perfect competition model are: Profit and utility maximization; Perfect
information; Homogenous products; Ease of entry and exit; Large numbers of firms and buyers
(price takers); No production externalities; No economies of scale; Complete set of markets.
The major thrust of neoclassical economics has always been the extension of its analysis to
address conditions in which some of these assumptions do not hold. Thus, a number of theories
have attempted within the neoclassical economics framework to relax these stringent
assumptions. All these theories developed in the framework neoclassical economics are intended
to consider real world situations by relaxing one or more of these stringent assumptions.
Other market structures (outside competitive market) such as monopolistic competition
oligopoly, duopoly, monopoly are all to relax the stringent assumptions underlying the perfect
competitive markets. Game theories (to analyze the outcomes of the interaction of few agents);
the concepts of externalities and public goods (that arise due to the difference between
social and private costs and benefits); risk and uncertainties; the concept of information

10
asymmetry (that arise due to information balance between agents); and others moral
hazard and adverse selection problems are all attempts to explain real world economic
phenomena by relaxing the assumptions underlying the perfectly competitive market.
In a static neoclassical economic theories, institutions are largely taken as given. Even
dynamic analyses, institutions are considered as to have only frictional role. The neoclassical
tradition places less emphasis on institutions but focuses on the analysis of efficiency, often
abstracting from particular institutional contexts. One of the contribution of NIE is explicit
consideration of institutions as they play a central role in explaining real world economic
problems.
NIE explore institutional structures at different levels and examine efficiency and welfare with
respect to these structures. NIE draws on the theoretical and empirical tools of neoclassical
economics in analyses of both the evolution of institutions and their effects on economic
behavior and outcomes in different circumstances. But, in addition to this, it is also important to
note that NIE draws on a variety of schools of thought in other social sciences.
We structure our discussions of the various behavioral issues under the following sub-topics:
Knowledge problems, cognitive burden and rationality; self-interest and opportunism and
altruism and review of game theories.
2.2.1. Self-interest, opportunism and altruism
The basic behavioral assumption in the neoclassical economic theory is that agents are self-
interested. That is the intrinsic motive driving economic agents in their decision making is self-
interest. But this does not mean egotistic behavior – a behavior that puts the self-first but
consider oneself better and more important than others. Self-interest has no negative or positive
attitudinal implications about others. It only means that when agents make decisions, they only
choose that action that maximize their self-interest without having any interest to benefit or harm
the interest of others. It is rather neutral to others.
Self-interest should not also be confused with selfishness which may implicitly take the
happiness (or for that matter the misery) of other people as a part of one’s satisfactions. The
theorem of self-interest is not morally loaded, since it states only that agents behave in
accordance with their own preferences. The fundamental presumption is that individuals know
best what is right for them (consumer sovereignty) regardless of how good or bad it may be to
others. The utility function entering in the choice decision is only the utility function of the
individual; it doesn’t include the utility (or disutility) function of others.
While some scholars, especially in the field of sociology, attack this assumption as immoral and
others argue as it does not represent human being who is a product and at the same time whose
motive is social. Others in the field of economics also attack the self-interest assumption based
on the argument that allowing everyone to promote self-interest in every economic activity will
have undesirable consequences on the society at large. The fact that self-interest could have
undesirable consequences on the society doesn’t make the assumption invalid. Contrary to the
generalization made by Adam Smith ‘when individuals are left to pursuit their self-interest, they

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promote an end which was no part of their intension”. This does not allow for any conflict
between individual interest and social interest. But theories have successfully demonstrated a
condition where self -interest outcomes that differ from the societal interest. Especially in the
areas of public goods, letting everyone to promote his self-interest results an outcome that
departs from the societal interest.
In general, NIE takes the self-interest assumption as valid. But it adds opportunism as an
important possible behavior too.
Opportunism, according to Williamson (1996), is “self-interest seeking with guile” - agents
who are skilled at dissembling realize transactional advantage. Individuals may well be
motivated to capture gain by taking such opportunistic actions as fraud, betrayal, deception,
defection, breaching contract, etc. Opportunism includes but is scarcely limited to more blatant
forms, such as lying, stealing, and cheating. Opportunism more often involves subtle forms of
deceit. Both active and passive forms and both ex ante and ex post types are included. Ex ante
and ex post opportunism are recognized in the insurance literature under the headings of adverse
selection and moral hazard, respectively. More generally, opportunism refers to the incomplete
or distorted disclosure of information, especially to calculated efforts to mislead, distort,
disguise, obfuscate, or otherwise confuse. It is responsible for real or contrived conditions of
information asymmetry, which vastly complicate problem of organization.
Even if the motive behind are still assumed to be self-interest, it is not just seeking self-interest
with honest behavior. Rather it is an attempt to seek self-interest with contrived effort to capture
gains. The consequences are that it makes economic activities risky and uncertain. The
consequence can go to the extent to block economic exchanges. Williamson (1995) argues that
human being, when assessed with respect to his transactional characteristics, is a subtler and
devious creature, than the usual self-interest seeking assumption reveals. Inclusion of
opportunistic behavior modifies the neoclassical assumption. The possibility of opportunistic
behavior means that actors will be uncertain about each other’s behavior. This limit transactions
and economic activities in general. Institutions thus emerged to limit such opportunistic actions.
Some argue that trust as an important means that discourage opportunism. But can such trust
arise in a vacuum? It requires institutions that encourage trustworthiness and that discourage
opportunism and malfeasance. Institutions thus provide the incentive and constraint structure so
that actors will act in a predictable and stable way. Such institution can range from those that
promote self-restraint behavior to second-party retaliation to third-party constraints. Multiple of
informal and formal institutions can incentivize trust and discourage opportunism.
Altruism is an aspect of moral philosophy in which it is argued that moral decisions should be
based upon the interests or well-being of others rather than on self-interest. This basis can range
from only taking the interests of others into consideration to simply taking them into account a
little bit. Though such behavioral assumptions are taken as valid by school of thoughts,
especially in the areas of collective actions, they have no much ground in economics in general.
Altruism as a behavioral attribute is still controversial.

12
Some even argue that those that appears altruistic, and hence considered as a deviation from self-
interest behavior, are still far-sighted calculative self-interest behavior.
2.1.2. Knowledge problem, cognitive burden and rationality
In neoclassical economic theory, agents are assumed to have perfect knowledge. Actors know
about the market, each other’s behavior, nature of good/service they transacting, the best
available technology, even about the future and the like. Even if one does not know about these,
the actor is assumed to access the information without incurring any cost. In reality actors incur
a lot of cost in order to gather, process and disseminate information. But even then actors still
lack information about the various attributes of actors, products, technology, and the like.
Neoclassical economics accepts the possible existence of information problem but considers the
problem as frictional in that information market will emerge. It takes agents are more
calculative given the existing information. NIE on the other hand assume less calculative in the
capacity to receive, store, retrieve, and process information. The presence of information
problem means that there is a gain that can be captured by reducing information problem.
What caused the booming of information technology: internet, telephone, television companies,
advertising firms, various consultancy firms, quality assurance and standardizing firms, etc.
These market emerged to capture economic gain by gathering, supplying and processing
information. Theories, within the framework of neoclassical economics, are developed to
explain these real world situations. These theories explain much of the missing markets and
market imperfections especially in the areas of insurance and credit markets. One of the
contribution of NIE is it has integrated these theories through the concept of transaction costs.
Some of these will be discussed in the coming chapters. For now, we will consider the
implication of information problem behavioral patterns and institutions.
One aspect of information is even if it was costless to access the required information, human
agency has limited capacity to process the available information. The natural cognitive and
computational capacity of human being is limited. In addition, the future is surrounded by
uncertainties. So far, the best technology cannot tell about the future with certainty. This will
have implication on the validity of the assumption of rationality. In neoclassical theory, self-
interested actors are also assumed to be rational. Rationality refers to the power of being able
to exercise one's reason. The instrumental rationality postulate of neoclassical theory assumes
that the actors possess information necessary to evaluate correctly the alternatives and in
consequence make choices that will achieve the desired ends. But as discussed above agents
always lack information and the choice decisions may not enable them achieve they are intended
to achieve. NIE thus introduced a concept of bounded rationality – intendedly rational but
only limitedly so. Simon (1957) who proposed the concept of bounded rationality argue that if
institutions play active role in constraining the choices of actors and in reducing information
problem, then bounded rationality must be the building block of economic theory.
When we see the process of decision making, actors before they make decision, they need to
have complete information. But the world is such it cannot grant one with complete information.
The feasible option is to use the available information however it may be incomplete. Using this

13
information, actors use a certain model to process the available information. Given the
computational capacity, actors often use a simplified subjective model and correct this model
through information feedback about the correctness of initial model.
When we examine this process of decision making, it used incomplete information, it processed
the incomplete information with an imprecise model (because it is subjective and simplified).
But the process of correcting it is also imperfect because the information feedback will also be
incomplete. A decision maker can thus rarely attain what he/she intended to by processing
incomplete information with imprecise model. Thus decision makers are considered as
boundedly rational even if they are intended to be rational.
In terms of transaction, other barriers also exist. Knowledge of actors about each other’s
behavior, each other’s language, culture, belief, tradition, etc. also matter. Can a person get a
job without knowing the working language of a given organization? The institution of language
has a bearing in impeding or facilitating transactions.
They are more calculative in that they are given to opportunism. Taken together, that appears to
correspond more closely with human nature as we know it. Still, it is plainly a narrow
prescription. It makes little provision for attributes such as kindness, sympathy, solidarity, and
the like. Indeed, to the extent that such factors are acknowledged, their costs, rather than their
benefits, are emphasized.
Taken together, the behavioral assumptions of NIE appears to correspond more closely with
human nature as we know it. But it should be noted that it still is plainly a narrow prescription.
It makes little provision for attributes such as kindness, sympathy, solidarity, and the like.
Indeed, to the extent that such factors are acknowledged, their costs, rather than their benefits,
are emphasized.
2.2. Game Theory and Institutions
Theory of Games has progressively permeated all fields of economics (industrial organization,
labor, financial and international economics) and extended its influence on the other social
sciences (politics, sociology, and law). It has become an essential tool for studying interpersonal
relationships and provides a rigorous and useful methodology for modeling and analyzing
strategic decisions. Game theory methodology has also incited profound and far reaching
changes in the way markets, organizations, and institutions are viewed; it has contributed to
better understanding the rationale of many private and public institutions, such as contracts,
franchising, insurance, certification agencies, and standardization committees.
Institutions are defined as generally known rules that apply in a community. They constrain
possible opportunistic behavior in human interactions and always carry some sanction for
breaches of the rules (North, 1990). As we said in chapter one, rules without obligatory
sanctions are useless. When sanctions are no longer applied institutions collapse. It should also
be noted that institutions are man-made, not physical, constraints on human action. Institutions
may basically be characterized in two ways. They can, first, be defined as the set of fundamental
political, social, and legal ground rules that establish the bases for production, exchange, and

14
distribution (Davis and North1971). From this perspective, institutions appear as the rules of the
game imposed on all economic actors. Yet, an institution may also be considered in a more
endogenous manner, in being defined as a player who can interact with the game’s other
strategic players, albeit with a specific status since it can influence or modify the rules of the
game and directly affect the outcome, for example by helping players to coordinate their
strategies or select an equilibrium. This section will adopt the latter approach in order to examine
how institutions may be modeled within strategic games and what can be learned about the role
of institutions.
For this purpose, it is helpful to define what exactly a strategic game is: a strategic game is
characterized by its players (number of players, their features), the set of strategies assigned to
each player, players’ information set and payoff function (or utility function), and, lastly, by the
sequence of moves (and scope of the game).
In perfectly competitive markets both buyers and sellers are assumed to very large and both
group of actors are assumed to have perfect knowledge. Thus the decision of actors can be
assumed as independent. The analysis of equilibrium is based on decisions of active and
independent individuals. But in reality, actors may be few enough that action of one will have
effect on the other and vise versa. In such situations the choice decision of one agent will be
interdependent with the choice decision of one of more rival agents. Similarly, transacting parties
in the neoclassical theory are assumed to have perfect knowledge about each other’s actions.
But in reality, transacting parties may not fully know about the behavior (trustworthiness,
opportunistic behaviors) of partner. For example, you want to lend money to a person but you
may not know with certainty about the repayment capacity and the intension of the borrower and
possible hidden actions (to avoid repayment) the borrower may take. In such situations, the
welfare of one party is dependent, in part, on the decision of the other party. Game theory is the
analysis of equilibrium among two or more interacting parties or agents “in the game”.
One approach for examining strategic behavior of competing agents or transacting parties is to
study how people play “games”. Self-enforcing properties of contracts, credible commitments,
the private production of public goods, externalities, and models of negotiation use game
theoretic models.
The following section is just to brief review the common games. You are thus strongly advised
to refer back the basics of game theory.
Prisoners’ Dilemma
Institutions –and in particular the sanctions attached to them –allow people to make credible
commitments that promises made will indeed be fulfilled. Human nature is such that self-seeking
individuals will often make promises but later forget or shirk delivering on them. Our instincts
play a big role in such opportunistic acts, and institutions support the control of our innate
instincts in the interest of longer-term effective coordination. Cooperation between people thus
normally requires the framework of institutions to discourage this sort of instinctual opportunism
by increasing the risks of shirking and to reinforce habits of cooperation for reciprocal benefit.

15
The fact that when people cooperate they are often better off than when they do not cooperate
has been explored by game theory under the label of ‘prisoner’s dilemma’. The term relates to
the case of two prisoners who are not permitted to communicate (cooperate). When interrogated,
each prisoner faces a dilemma in not knowing whether to remain silent, hoping that no guilt can
be established, or whether to speak out with the intent of putting all responsibility on the other
prisoner and claiming mitigating circumstances. Both prisoners face this dilemma, as long as
they cannot cooperate with one another. Both would be better off when cooperating and making
credible commitments to each other, for example promising that both will remain silent. When
they cannot communicate but speak out in self-defense, they incriminate each other and are both
worse off. What is at stake here can be clarified by the matrix in Figure 2.1. such prisoners’
dilemmas arise frequently when people cannot cooperate reliably. Intuitions are there to
enhance the chances of mutually beneficial cooperation.
Figure 2.1 The prisoners’ dilemma
Prisoner A
Remains silent Speaks out
Prisoner B Remains silent Both go free B is found guilty
Speaks out A is found guilty Both are found guilty

An instructive example that demonstrates the advantages of cooperation based on appropriate

institutions is the history of the Cold War and the strategic arms limitation agreements that
fallowed in the 1970s and 1980s. as long as the two powers did not cooperate, they were tied into
a costly arms race the danger of a nuclear holocaust. It was increasingly realized on both sides
that both would be better off with some of cooperation. They entered into negotiations for rules,
monitoring procedures and sanctioned retaliations for rule violations; eventually they
established credibility, making the cooperation possible that solved their prisoners’ dilemma and
allowed the de-escalation of the nuclear threat.
Cooperation is, however, not always desirable. Various suppliers of a product may find it
beneficial to free themselves from the prisoners’ dilemma of having to complete by forming a
cartel that fixes high prices. But, in this instance, the prisoners’ dilemma of the suppliers served
a good purpose from the standpoint of potential buyers and the community at large, just as the
prisoners’ dilemma serves a good purpose from the viewpoint of the interrogated. Whether to
facilitate or impede cooperation by appropriate institutions thus depends on circumstances and
on whose interests are included in the evaluation.
The "original" prisoners’ dilemma game goes something like the following.
Two individuals are arrested under suspicion of a serious crime (murder or theft). Each is known
to be guilty of a minor crime (say jay walking), but it is not possible to convict either of the
serious crime unless one or both of them confesses. The prisoners are separated. Each is told that

16
if he testifies about the other's guilt that he will receive a reduced sentence for the crime that he
is known to be guilty of. The equilibrium of this game is that BOTH TESTIFY (CONFESS).
To see this, consider the following game matrix (Figure 2.2) representing the payoffs to each of
the prisoners:
Prisoner B
Testify Don’t testify
Prisoner A Testify (10, 10) (1, 12)
Don’t testify (12, 10) (2, 2)

Each cell of the game matrix contains payoffs, for A and B, in years in jail (a bad). Each
individual will rationally attempt to minimize his jail sentence. Regardless of what Prisoner B
does, Prisoner A is better off testifying. Suppose B testify, A will serve 10 years in jail but still
better because if he doesn’t testify he will serve 12 years. Likewise, if B doesn’t testify, A will
be better if he testify. Because, if he testifies, he will serve 1 year in jail but 2 years if he doesn’t.
Note that the same strategy yields the lowest sentence for Prisoner B regardless of what Prisoner
A does. If A testifies, then by also testifying B can reduce his sentence from 12 to 10years. If A
does not testify, then B can reduce his sentence from 2 to 1 year by testifying. Since one prisoner
cannot be sure that the other will not testify, each will find the ‘testify’ option the best choice.
The dominant strategy is then that both prisoners will choose the ‘testify’ option. The (testify,
testify) strategy pair yields 10 years in jail for each. This is said to be the Nash equilibrium to
this game because given that the other player has testified, each individual regards his own
choice (testifying) as optimal. No player has an incentive to independently change his own
strategy at a Nash equilibrium.
It is a dilemma because each prisoner would have been better off if neither had testified. If both
didn’t testify, both would serve only 2 years in jail (Pareto optimal results) as compared to 10
years (Nash equilibrium). Independent rational choices do not always achieve. Note that the
Pareto optimality condition is considered in terms of the collective outcomes for the two
prisoners. If the situation is viewed in terms of society at large, we may regard this particular
dilemma as optimal insofar as two dangerous criminals are punished for real crimes.
The central message of the above game is since players do not know each other’s choice decision
with certainty, each attempt to minimize the jail period by taking all possible scenario with equal
probability. If suppose A fully trust B that he will not testify, whether A will testify or not
depend on his commitment to be honest to B. If A is a kind of person that reciprocate honesty
with honesty (tit-for-tat strategy), A will be committed to shoulder the burden of serving one
additional year in jail by testifying. But if B is an opportunistic person that takes advantage of
A’s trustworthiness, B will not testify just to reduce the period in jail by one year. The facts that
A trusts B and A is committed to bear the cost of serving one additional year by testifying are not
sufficient enough for A to be safe. For A to be safe, B must not only fully trust A, or be certain
that A will not testify, but B must also be committed to bear the cost of serving an additional one

17
year in jail by testifying. The fact that you trust me does not guarantee that I will be trustworthy.
It is just your perception of me. The same holds if we start by supposing that B fully trust A.
In the above game we find a pair of strategies such that player A’s strategy is optimal for A
given B’s strategy and moreover B’s strategy is optimal for B given A’s strategy, we are at an
equilibrium. Neither player can gain by a unilateral switch to a non-equilibrium strategy. The
lesson is that for Pareto optimal outcome to occur i.e. for both Prisoners to choose (don’t testify,
don’t testify), it not only require for one player (prisoner) to trust the other and be committed
to bear the costs associated with his choice decisions, the other must also do the same (trust the
other and be committed to bear the costs).
2.3. New institutional economics vs standard neoclassical economics
Neoclassical economics construct competitive market model largely based on clearly articulated
assumptions. To relevantly use the theory to real world economic problems, it extends one or
more of these assumptions. Assumptions are important tools in scientific enquiry, because they
allow analysts to focus on one set of issues at a time.
You must have now recognized that the emergence of institutions are in response to the
nonfulfillment of assumptions underlying the perfectly competitive markets. Contributes of NIE
to provide broader explanation to real world within the framework of neoclassical economic
theories.
However, the particular focus and contribution of NIE approaches have been their emphasis on
(1) the problems that economic actors face as a result of imperfect information in transactions
and (2) the role of institutions in addressing (or exacerbating) such problems. NIE becomes the
building block upon which various theories, proposed within the framework of neoclassical
economics, in order to address market failures associated with the nonfulfillment of key
assumptions underlying perfectly competitive markets. Theories in the areas of information
(moral hazard and adverse selections, principal-agency problem, associated with information
asymmetry), property right theories; organizational theory; transaction cost theories; and the like.
NIE is not a replacement of neoclassical economic theories but an attempt to complement it in
order to relevantly apply neoclassical economic theories to real world problems.
Yet NIE has made slight modifications of behavioral assumptions (mainly bounded rationality
and self-interest with guile which is the basis of opportunistic behaviors), explicit recognition the
non-fulfilment of stringent assumptions underlying perfectly competitive markets (mainly the
assumption of perfect knowledge).
2.4. But NIE is not neoclassical economics
The primary decision making unit in neoclassical economics is the individuals (individual
households, worker, firms, markets, etc.) and broaden the scope by aggregating the outcomes of
individual decisions. Contrary to this, NIE assess the complex interplay between the individual
and the institutional environment.

18
While neoclassical economics assess the real world economic problems in the lens of perfectly
competitive markets to the inefficiency gaps, NIE usually use other alternative institutional
arrangements as reference point to find any intervention points. In addition, efficiency play a
central role in neoclassical economics and normative analysis are largely based on this
fundamental objective. NIE on the other hand refrain from taking any single objective as
fundamental.
Neoclassical economics takes perfectly competitive markets as a reference point and build other
theories upon it. It takes institutions as frictional. NIE on the contrary takes perfectly
competitive markets just as one form of institution along the continuum of institutional
arrangements. While mathematical and econometric models play a dominant role in building
theories and undertaking empirical analysis, NIE utilize case studies and empirical evidences as
an important tool. It attempts to blend mathematical and econometric models with other social
theories to explain real economic problems. Moreover, historical and evolutionary aspects play
important roles in understanding the existing problems.

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20
 CHAPTER THREE: TRANSACTION COST ECONOMICS
This chapter thus deal with the concept of Transaction Cost Economics (TCE). The chapter
begin by introducing the concept of transaction costs in general. Here we will explain the
implications of recognizing positive transaction costs on neoclassical economic theory. We will
then attempt to explain the connection between transaction cost economics with institutions in
particular and NIE in general. Before we go to the relevance of transaction cost economic theory
for agricultural development, we will try to identify the various sources of transaction costs.
3.1. What are transaction cost
It was Ronald Coase who brought the concept of transaction costs in to economic theory in his
influential paper “The Problem of Social Costs” (1960). He took two neighboring farms –
rancher and crop producer whose increase in production by one are assumed to inflict external
cost on the other. Based on these hypothetical case, he showed that, independent of the initial
assignment of property rights, the rancher and the farmer could rearrange a property rights
regime that would increase their overall benefits if it was costless for the two owners to bargain.
The issues are as follow:
There are neighboring rancher and crop producer. Increase in cattle production requires
reduction in crop production as cattle damages crops. Each have alternative options in front of
them. If for instance the price for cattle in the market rise, the rancher may find profitable to
expand cattle productions. What he can do? The rancher can pay crop producer to damage the
crop; the rancher can pay for fence to contain the crop damage; the rancher can pay the farmer
for abandoning crop production; or the rancher can just rent or buy the crop land.
Similarly, the farmer can pay the rancher to reduce cattle; the farmer can pay for fence to protect
crop damage from cattle encroachment; or the farmer can rent or buy the ranchland. Given these
alternative options are open to each, both can strike a bargain that would maximize the total
production. He thus showed, if it was costless for the two to bargain, both could agree to choose
one of the above alternatives depending on the liability laws and the relative values of land,
crops, and cattle. The main economic outcome is that voluntary exchange would have produced
efficient outcome, independent of the initial assignment of property rights, if the voluntary
bargaining does not involve some costs.
Whether the agreement occur and at what cost if it does depend on: the social environment (the
norms, the social bond, the culture and belief of society), the knowledge of agents about each
other’s behavior (the level of trust and malfeasance, their mental model, the power balance), the
political environment, the legal environment, the depth of the market, etc.
Assuming the transaction occurred with positive costs, would the outcome be the same as the
costless transactions? What possible implications does this transaction costs will have on the
efficiency the outcome? What implications the presence of positive transaction cost has on the
way society respond to basic economic questions: production, allocation, and distribution. Since
the resources devoted to facilitate these transactions are dead-weight losses as they constitute
neither the producer surplus nor consumer surplus. The outcome will be suboptimal if the

21
transaction involves positive cost. This is because the time, energy, and other resources to
facilitate these transactions would have been used in productive somewhere else in the economy.
If making such transaction is nearly costless, the outcome from reallocation would have been
efficient regardless of the initial assignments of property rights.
Thus transaction costs refer to the costs originating from the various actions taken to reduce the
risk of transaction failure. Transaction costs therefore the value of resources devoted to (1)
establish and enforce exclusive property rights and/or (2) define and enforce the attributes of the
good or service being exchanged and (3) the losses incurred because of failure to (a) enforce
exclusive property rights, (b) enforce required attributes, or (c) complete the transaction.
The point we want to show in the above hypothetical case is that most transactions from simple
purchase of good to complex contracts involve positive transaction costs. The ‘real world’ is
beset by positive transaction costs on which account the assignment of property rights and choice
of governance structures do matter. Assuming that positive transaction costs are not so great as to
block the assignment of property rights altogether, then differential transaction costs will warrant
the assignment of property rights one way rather than another. Similarly, respect to organization:
except where positive transaction costs block the organization of some activities altogether,
differential transaction costs will give rise to discriminating alignment according to which some
transactions will (for efficiency purposes) align with one set of governance structures and other
transactions will align with others. In some, transaction costs will have a lot of bearing on the
allocation, production and distribution activities.
The concept of transaction costs is the foundation of New Institutional Economics. As Ronald
Choase pointed out, the organization of transactions, with the inevitable costs it incurs,
determines what goods and services are produced and the capacity of any economy to take
advantage of the division of labor and specialization – the two key concepts of economic theory
since Adam Smith. Thus, transaction costs profoundly influence not just individual firms but the
size and activities of the entire economy.
The extent of transaction costs thus determines the level and types of economic activities. The
extent of transaction costs then depends on the institutional environment that determine: the
degree of information problem (on prices, new technologies, and other potential market players),
the extent of opportunism, the strength of defining and enforcing property rights and contract and
the level of risks posed by exogenous shocks.
3.2. Sources of transaction costs
Given the above example, we can identify transaction activities that involve costs. Although
there are many other cost involving transaction activities, we will discuss the most common one.
3.2.1. Information and search costs
As we discussed in earlier chapters, in perfectly competitive markets economic agents are
assumed to have perfect knowledge. The presumption is they can access whatever information
they need without incurring considerable costs. But in reality information are not only imperfect
but also involve costs. In addition, human being has limited ability to gather and process

22
information. The implications are that economic agents devote a lot of resources to gather
information. In the above example, determining the amount of payment require a lot of
information such as future relative prices, the level of payments in other areas for similar
agreements (if there is), estimation of each other’s potential gains, and the like. More
importantly, each agent must collect information about each other’s trustworthiness, reputations,
past history, social status, network, and the like. Searching appropriate partner (if there are two
or more alternative partners) also require a lot of efforts. All these tasks involve costs that would
otherwise been used for productive activities elsewhere in the economy.
3.2.2. Bargaining and decision costs
Having equipped with the required information, the transacting parties must make a lot of
bargaining in order to reach at profitable terms of agreement. Depending on the complexity of
the transaction, this can involve a lot of resources – lobbying, financing meetings, payment for
third party mediating the bargaining, and the like. To achieve favorable terms and avoid possible
risks, parties will have to devote time and resource in the bargaining. Once agreement is reached
on general and key issues, drafting, reviewing and signing the agreement is not a simple task. It
can involve a lot of cost.
3.2.3. Supervision and enforcement costs
Once the agreement is signed, each party need to monitor the other. Still this can take a lot of
surveillances, supervision, hiring consultants or forming an independent organ, etc. Enforcing
when there are deviations could also involve a lot of costs. This can be through legal court or
through informal ways. In short we can find these three classes of transaction costs in many
economic exchanges. For instance, hiring a worker require finding a suitable worker, examining
potential applicants, bargaining on the wage rate, assessing the prevailing wage rates, metering
performances (marginal contributions), designing appropriate incentive structure, penalizing
shirking and malfeasances, and the like.
Why firms need supervisors? It is because workers may shirk, underperform, abuse firm’s
resources, and the like. The various resources to devoted for management activities can be
considered as transaction costs that would have been used for other productive activities.
The magnitude of these costs depend on a number of factors. Dimensions of transaction cost and
nature of the transactions.
3.3. Dimensions of transaction cost
TC are not replacements neoclassical cost theory. The neoclassical production cost theory still
holds. In the NIE sense then, costs are neoclassical production costs plus transaction costs.
3.3.1. Behavioral patter of the transacting parties
As explained earlier, TCE is founded on two of the key behavioral assumptions that are spring
from self-interest assumption: bounded rationality and opportunism. Economic agents are
assumed to center their own interest when they make decisions. An economic agent is assumed

23
to be self-interest seeking with guile. First, even if the intentions of agents is to promote self-
interest, their level of realization is limited. This is due to information problem: access to
information and limited computational and cognitive capacity. Thus they cannot be purely
rational but boundedly rational.
Second, agents are assumed to seek their self-interest with guile. Constructing economic theory
based on simple self-interest seeking (without including guile) imply that transacting parties will
act in farsighted and responsible way. For instance, even if there are opportunities that maximize
short-term gains at the cost of substantial reduction of future mutual gains, individuals are
assumed to be committed not to take such opportunities. Simple self-interest seeking behavior
when coupled with (perfect) rationality, also imply that parties precisely know the adverse
effects of taking myopic opportunistic actions. That is such adverse effects can be avoided by
asking parties to act responsibly. Contrary to this, TCE modify the self-interest-seeking by
including guile. This guile coupled with bounded rationality help to alert agents to avoidable
dangers of reneges, commitment failures, and the like. As a result, TCE takes opportunism as
important behavioral assumption. Agents attempts to meet their self-interest by taking advantage
of opportunities. Whether agents can realize the advantage or not depend on the environment the
transacting parties are in. Thus, agents are generally assumed to be opportunistic.
Take a simple example. Suppose you lend someone money to be repaid after three years. You
lend the money without interest. The reason you did this is just to assist the person to enter into
business and in the hope that the person will reciprocate by doing some favor in the future. But
you made the agreement verbally. Secondly, under the current circumstances, you have all the
power to force him repay the loan if he fails to do so. Suppose you lost that power for some
reason. Can you be sure that the person will pay his loan? It depends. Your current condition
has provided the borrower an opportunity to refuse to repay the loan. That is the person can act
opportunistically. What will be the outcome of this behavioral condition on the confidence of
people to lend money to others? Since the future is always unknown, people in such
environment will not be interested to take such risks - risk cost that block the development of
credit market. Such ex post hazards of opportunism arise in when such long-term and
incomplete contracts are implemented such environment fraught with uncertainties.
There are three options to constrain this opportunistic behavior: self-enforcement, second party
enforcement and third party enforcement. Self-enforcement requires psychological conviction
that such behavior is bad. The traditional belief that a person who did bad actions on someone
will face bad luck in the future and this bad luck can even pass on to her family member.
Similarly, a feeling by opportunist person or his children that sometime in the future can fall in
the hand of the victim will also create a psychological restraint from being opportunist. The
emergence of the institutions of religion of various forms, norms of trust, keeping promise, oath,
swearing in the name of God, and the like are society’s attempt to restrain opportunistic
behavior. These institutions are intended to impose some psychological cost (guilty feeling) so
that the person will not act opportunistically. If we closely scrutinize our culture, belief,
conventions and traditions, we can learn that many of them are to facilitate transactions by
creating self-restraint on behavior people.

24
The other mechanism is second-part retaliation. If a person acts opportunistically, the victim can
retaliate. The type of retaliation the victim will take depend on the various factors: the power
balance of the two (political, social and economic power), the norm of retaliation, the legal
framework, etc. If the victim is more strong (socially, economically, or politically) than the
defector, he can force the defector, give ultimatum for impending retaliation, or he can take very
sophisticated actions that will bring the defector at the mercy of the victim. Even if the victim is
weaker, fear of retaliation may not be effective.
The last option is third party enforcement. Institutions have evolved to provide many third party
enforcement mechanisms. The victim can use social groups to take some actions on the
opportunist person. This can take the form of social sanction, ostracism, use of powerful close
person to retaliate, calling for local leaders (administrative and religious leaders) and other social
connections. These alternatives require strong social connections. Unfortunately, it is those
economically powerful who are likely to have more of this. Society also provide the weaker
members other alternatives. The weak can use witchcraft/sorcery and other supernatural power
to do the job. These institutions provide strong and invisible instrument to the wider society.
Strong belief on sorcery/witchcraft in most traditional societies of Africa could be thought as
institutional response to the problems of opportunism. These above assume the absence of
formal institutions. When there are formal institutions, people can use to enforce contracts and
discourage opportunism legal rules.
These and many other culture, traditions, conventions and beliefs can be thought as an
institutional response by society to provide alternative enforcement and constraints: first-party,
second-party and third-party constraints.
When all these three enforcement mechanisms fail to create credible commitment, one option for
the lender (in our previous example) will be to refuse to engage in such long-term transactions.
A second option will be to adjust the price of the transaction to reflect the expected hazard. A
third and deeper response would be to explicitly recognize the potential hazard of opportunism
and to create ex ante safeguards (credible commitments) that mitigate opportunism. Transaction
cost economics advises agents to devise (give and receive) credible commitments. Farsighted
agents who give and receive credible commitments will thus outperform myopic agents who are
grabby.
In fact, in an environment where formal institutions are weak, these and other informal
institutions will play important roles in reducing transaction costs. But mostly such institutions
are not as efficient as some social scientists attempt to portray. Enforcement through informal
institutions can involves a lot of costs. In addition, handling complex transaction that go beyond
the narrow social boundaries require strong formal institutions. This is one of the reasons
markets thin and many markets are missing in societies where formal institutions are weak and
thin. Note that these informal institutions were also common in advanced countries in the early
stage of their development. It is difficult to imagine all the complex transactions we seen now in
advanced countries would have been possible without complex formal institutions. Yet it must
also be recognized that formal institutions can be panacea for all problems of opportunism.
Informal institutions still play some roles even in advanced countries too.

25
In sum, one of the reasons for the emergence of diverse informal and formal institutions is to
reduce opportunistic behavior of agents and information problems associated with transactions.
The general hypothesis of transaction-cost economics (TCE) is that institutions are transaction-
cost–reducing arrangements that may change and evolve with changes in the nature and sources
of transaction costs.
3.3.3. Nature of the transactions
The three dimensions of transaction costs are: uncertainties, frequency and asset specificity. The
extent to which these dimension determine the actual level of transaction costs depend on the
behavioral pattern and the extent of information problem existing in the transacting environment.
Uncertainty
TCE recognize two sources of uncertainties: behavioral uncertainties and uncertainties posed by
the transaction environment.
The two behavioral assumptions (bounded rationality and opportunism) means that when two
parties transact, it poses a lot of uncertainties. That is, transacting parties lack information about
each other’s behavioral attributes, attributes of the exchange (attributes of the goods or service),
and the environment they are in. This generally pose a lot of risks and uncertainties. To
minimize risk costs, transacting parties have to devote resources to collect information about the
attributes just mentioned above. These costs are generally referred to as search costs. But one
agent after devoting resources to gather, interpret, and process information, still the agent cannot
have perfect information about the behavior of the transacting party, the attributes of the
exchange and attributes of the environment. Agents then still assume some risk premium. The
search costs plus the risk premium provide the total transaction that arise from uncertainty. In
addition to the uncertainties that arise from transacting parties, strategic interaction of firms can
also pose uncertainties. Rival firms can mislead information, take costly strategic moves and the
like. Uncertainty of a strategic kind is attributable to opportunism and will be referred to as
behavioral uncertainty.
Even if there are no behavioral uncertainty, exogenous shocks from the environment can still
pose a lot of uncertainties. The stability and predictability of the macroeconomic environment,
the stability of the legal environment, the social and cultural environment that determine the
preferences, the political stability and the like pose a lot of uncertainties. The extent of these
uncertainties determine the level of economic transactions and their profitability. These
transaction cost could be so high as to block the transaction altogether. The technological level
together with the institutions determine the level of the transaction cost.
If there are efficient institutions that transmit information efficiently and with small costs, if the
institutions are efficient in constraining opportunistic behaviors and if the overall environment is
stable and predictable, then the transaction costs tend to be small. That is if the future is certain
and agents have perfect information as conceptualized in the perfectly competitive markets, then
there is no resource devoted to realize the transaction. But in reality, transactions involve costs.

26
Institutions thus arise to economize transaction costs. If society is successful in minimizing this
cost, people will have the incentive to capture the gains from exchange.
Notice that this concept can also apply in political and social arena. The level of transaction costs
plays important role in determining political and social exchange.
Frequency
The frequency of transaction determines the level of transaction costs. Frequency is the number
of times the transaction takes place within a given period of time. Frequency can range from
making a one- time transaction to making frequent transaction with a given firm. The frequency
of the transaction affects the costs involved to make the exchange.
Suppose there are two honey buyers: buyer A and buyer B. Buyer A is a honey trader and buyer
B is a consumer who buys honey once in a season. The frequency of transactions are higher for
buyer A than buyer B. Buyer A is likely to incur smaller costs for each unit of transactions than
buyer B. Why? The reason is Buyer A incur smaller search costs, lower uncertainties, lower
bargaining costs and the like. If you are a frequent buyer, you will have the chance to retaliate for
any malfeasance behaviors by sellers. It is like comparison on the outcomes between original
Prisons dilemma (PD) game and repeated games. Cooperation instead of opportunistic behavior
is likely to be higher in latter than the former. In addition, if you are a frequent buyer, you will
have better information about the trustworthiness of sellers. If you are frequent buyer, you will
also develop skill in bargaining, measuring the quality of the product, the behavior of transacting
parties. In sum, TCE predicts that transaction costs tend to be lower as the frequency of
transactions increases.
Asset specificity
Investments on assets are of two types. Some investments are special purpose and others are
general purpose. A specific purpose asset has little or no alternative use. Contracting around
specific assets can be risky in that the specialized assets cannot be redeployed without sacrifice
of productive value if contracts should be interrupted or prematurely terminated. Asset
specificity arises in an intertemporal context. General purpose investments do not pose the same
difficulties. For instance, one party may invest on durable specific assets on the agreement that a
contracting party will use the specific assets. Once the investment is made and if the contracting
party terminated its contract, then the specific asset will have no value as it cannot be redeployed
for some other purpose. This situation can provide the contracting party the incentive to threaten
the party who invested on the specific asset. The cost savings afforded by the specific assets
must justify strategic hazards that arise as a consequence of then on salvageable character of
specific assets.
Such contract hazard is called hold-up problem and the costs that arise from such risk are called
maladaptation costs. The most-often-discussed example of maladaptation is the ‘holdup’
problem associated with relationship-specific investments. Investment in such assets exposes
agents to a potential hazard: If circumstances change, their trading partners may try to
expropriate the rents accruing to the specific assets. The more the asset is specific, the more

27
likely for its contracts to suffer from the hold-up problem and the higher risk costs tend to be.
Hold-up problem leads to the risk of underinvestment. Changing the allocation of asset
ownership between the trading parties may partially solve the hold-up problem. Overall, several
governance structures may be employed. TCE holds that parties tend to choose the governance
structure that best controls the underinvestment problem, given the particulars of the relationship.

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 CHAPTER FOUR: INFORMATION ASYMMETRY AND INSTITUTIONS
In this chapter, we will discuss the case of asymmetric information. Specifically, we will discuss
the two twin problems associated with asymmetric information: moral hazard and adverse
selections and the associated transaction cost implications. We then discuss the role of
institutions in reducing these problems.
4.1. Information problems, moral hazard and adverse selection
Information problems can arise due to information imbalance between the transacting parties
which we call information asymmetries. Asymmetric information is a condition that exists in a
transaction between two parties in which one party knows the material fact that the other party
does not. The most informed party may exploit the less informed party. For example, the worker
(the agent) knows more about her skill and knowledge than the employer (the principal) does.
The worker also knows more about the actual efforts she is putting toward achieving the goal of
her employer or immediate supervisor.
But in addition to the uncertainties that arise due to information asymmetry between party’s ex
ante the transaction, ex post transaction uncertainties in the process. For instance, even if the
information between parties is symmetrical at the beginning of transaction, a party may not
perfectly know about the future changes in the business environment and the behavioral
responses of another party. Thus, not only the bounded rationality of decision makers (about the
transacting parities) pose uncertainties, but also opportunistic behavior of agents could entail
additional costs of transactional uncertainties. The behavioral sources of all these information
problems are bounded rationality and opportunism. These information problems entail
transactional costs that would otherwise doesn’t exist if transacting parties were unboundedly
rational and non-opportunistic.
4.1.1. Hidden Action and Moral Hazard
What is moral hazard? What transaction problems does it pose? Moral hazard is opportunism
characterized by an informed person taking advantage of a less-informed person through
unobservable action.
Moral hazard is an institutional failure where institutions fail to constrain one party from taking
an opportunistic action that would leave another party bear the consequences of the actions.
Because institutions fail to force an individual to take the full consequences and responsibilities
for its actions, the individual may have a tendency to act less carefully that it otherwise would.
This will leave the other party to hold the consequences of the actions of the individual. To
minimize such problems, a transacting party devote resources in an attempt to make sure the
other transacting partner is taking appropriate actions and not taking inappropriate actions. Even
then, a boundedly rational transacting party may face transaction risks associated with moral
hazard. The monitoring costs added to the risk costs give rise the transaction costs associated
with moral hazard.
Moral hazard can occur in many transactions. For example, you wanted to buy a semi processed
food product. How can you be sure that what you buy is a quality product or poor quality product

29
(what Akerolf (1970) called it a lemon). To what extent the product the seller has not adulterated
the product with foreign materials? In a condition where you don’t know what actions has taken
in processing the product, you cannot be sure that what you buy is a good quality.
Another common example is the problem observed in the insurance markets. For example,
insured people (the agents), feeling that they will claim the necessary indemnity payment, may
engage in risky behaviors that increase the probability of large claims against insurance
companies, or they fail take reasonable precautions that would reduce the likelihood of such
claims. Similarly, an insured homeowner may fail to remove fire hazards. A person who is
unable to pay his debt on time may not be able to build capital goods in order to just appear that
he is really poor. But in some cases individuals may go beyond such less careful act and can
intentionally take sophisticated and unobservable actions in order to capture some benefits from
other parties inappropriately. In some circumstances, individuals can even take observable
opportunistic actions. If an ordered institutional environment turns out to anarchic for some
reasons, the situation may provide the individuals the incentive to openly refuse to pay their debt.
All these pose risk and uncertainty on a transacting party and hence raise the transaction costs.
The implication of the rise in transaction costs is clear, it constrains the markets from attaining
efficient outcomes. If the transaction costs are high, it can entirely block the emergence of these
transactions. Livestock and crop insurance, for example, gives farmers an incentive not to invest
in the prevention of crop failure but rather to rely on cash income from the insurance proceeds of
the failed crop.
4.1.2. Hidden Information and Adverse Selection
What is adverse selection? What transaction problems does it pose? Adverse selection is
opportunism characterized by an informed person’s benefiting from trading or otherwise
contracting with a less informed person who does not know about an unobservable
characteristic of the informed person.
A trading party may select an individual who is opportunistic and can face transaction costs.
Adverse selection problem is associated with the difficulty of one party in selecting honest and
trustworthy transacting partner. In circumstances where the seller knows more about the
product it is selling, the buyer cannot be sure what standard the quality of the product is. In such
conditions, buyer devote a lot of resources in searching a reliable seller. Even then, a boundly
rational still face transaction risks of selecting adverse seller. The search cost added to the risk
provide the transaction costs associated with adverse selection.
For example, farmers who buy insurance policies for their livestock could be better informed
about livestock health risks than a prospective livestock insurance company does. The
consequence of this is that it is those farmers whose livestock are in greater risk willing to buy
insurance policy than those farmers whose livestock are relatively in less risk condition. Since
the insurer does not perfectly know about the risk distribution, it tends to raise the insurance
premium to minimize the costs. In effect, the market for livestock insurance may be sub-optimal.
For research purpose, this can be tested assessing the positive correlation between insurance
coverage and risk occurrence.

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4.1.3. Implications of asymmetric information
The presence of asymmetric information is the major causes of many of the market failures:
market imperfections and missing markets. The fact that one transacting party has better
information over the other means that the better informed party can exploit the less informed
party. To minimize this unnecessary exploitation, the less informed party will devote a lot of
resources in searching a reliable party.
We have seen that the monitoring costs plus the risk costs give rise to transaction costs
associated with moral hazard. Similarly, the search costs plus the risk costs give rise to
transaction costs associated with adverse selection. Depending on the observability of the
actions a transacting party may take and the observability of the behavioral attributes of party,
moral hazard and adverse selection can involve large transaction costs. Many of the transactions
in the rural areas suffer from one or both of these information problems.
The critical issue constraining the agricultural sector in sub-Sahara African country is
information problem. The primary reason for the slow adoption of agricultural technologies by
African farmers is that the market fails to provide the right incentive for quality products.
Because the market fail to discriminate the good quality product from poor quality product, both
poor and good quality products will receive very similar prices. In such circumstance, devoting
resources and efforts to improve quality will not pay. Thus farmers will not have the incentive to
improve quality. As a result, all farmers will tend to produce the lemon.
This is also the main factor constraining the agricultural export markets. As long as these
countries fail minimize the information asymmetry between exporters and importers about the
quality of agricultural products they are buying and about the reliability of exporters, these
countries cannot exploit the full potential of the benefits of exports.
4.1.4. Alternative institutional responses to asymmetric information
In response to transaction costs problems, transacting parties and society at large take a lot of
measures to reduce information asymmetry. The extent of the information problems and the
associated transaction costs depend on the efficiency of institutions. Given the technological
levels, set of institutional responses to the above transaction cost problems can be taken at two
levels: organizational level and societal levels. While the strategic responses of the principal are
discussed under organizational theory (along Williamson approach). The latter are discussed
from the perspective of the institutional environment and its evolution (along North’s approach).
Here we will discuss the most common alternative responses.
Information sharing: Firms to economize information cost can design some way of sharing and
pooling information. For instance, banks can easily pool borrowers profile and history. This
information sharing will help banks to reject borrower who failed to pay their debt in another
bank. It will help banks to reduce default risks that arise from adverse selection problems.

31
Equalizing information: These are strategic responses to reduce information differences
between the principal and the agent. The following are some of the strategies.
Screening - Uninformed people may try to eliminate their disadvantage by screening to gather
information on the hidden characteristics of informed people. If the originally uninformed
people obtain better information, they may refuse to sign a contract or insist on changes in
contract clauses or in the price of a good. Insurance companies’ request for health certificate for
life insurance policy seekers is to economize transaction costs of adverse selections.
In addition, insurance companies also collect information up to the point at which the marginal
benefit from extra information equals the marginal cost of obtaining. Over time, insurance
companies have increasingly concluded that it pays to collect information about whether
individuals exercise, have a family history of dying young, or engage in potentially life-
threatening activities. If individuals but not insurance companies know about these
characteristics, individuals can better predict whether they'll die young, and adverse selection
occurs.
Signaling - Signaling is used primarily by informed parties to try to eliminate adverse selection.
The agent can create a condition where agents provide signal. Likewise, potential employees
use a variety of signals to convince firms of their abilities. Only people who believe that they
can show that they are better than others want to send a signal. In addition, the principal can
also identify which attributes that signal the right customer. For example, insurance companies
intentionally put their offices at the top floor of many story building without lift. The purpose is
to examine the physical fitness of the individual as it climbs to the office. To what extent this
reduce adverse selection depend on the accuracy of the signaling.
Universal coverage – adverse selection can be prevented if informed people have no choice. For
example, a government can avoid adverse selection by providing insurance to everyone or by
mandating that everyone buy insurance. Many states require that every driver carry auto
insurance. They thereby reduce the adverse selection that would arise from having a
disproportionate number of bad drivers buy insurance.
Laws to prevent opportunism – product liability laws protect consumers from being stuck with
non-functional or dangerous products. Moreover, many state supreme courts have concluded
that products are sold with an implicit understanding that they will safely perform their intended
function. If they do not, consumers can sue the seller even in the absence of product liability
laws. If consumers can rely on explicit or implicit product liability laws to force a manufacturer
to make good on defective products, they need not worry about adverse selection.
Third-party comparisons – Some non-profit organizations, such as consumer groups and
nonprofit firms publish expert comparisons of brands. To the degree that this information is
credible, it may reduce adverse selection by enabling consumers to avoid buying low-quality
goods.
Standards and Certification - The government, consumer groups, industry groups and others
provide information based on a standard: a metric or scale for evaluating the quality of a

32
particular product/service. For example, numerous attributes related to body size and cup test are
used to standardize coffee types into different brands and grade levels. This is to equalize the
information about quality of the coffee between the buyer and the seller. In addition to providing
access to market information can help consumer learn about coffee quality levels.
When one or more of the above institutional responses inexpensively and completely inform
consumers about the relative quality of all goods/services and reliability of the trader without
restricting the competitive environment, the institutions will be considered efficient and their
outcome socially desirable. Not only these activities involve a lot of costs from societal point of
view, in some conditions, such programs can also have harmful effects. The efficiency of such
institution thus depend on the extent to which they minimize transaction costs. Remember that
we conceptualize transaction costs in terms of societal cost. Thus, the transaction costs existing
in a given institution should not only include the opportunity costs of realizing the rules, it
should also include the adverse effects of its existence. This second cost, however difficult, can
be judged by comparing the outcome it would otherwise be in the next best institutional
arrangement.
For instance, standard and certification programs that provide degraded information, for
instance, may mislead consumers. Many standards use only a high- versus low-quality rating
even though quality varies continuously. Such standards encourage the manufacture of products
that have either the lowest possible quality (and cost of production) or the minimum quality level
necessary to obtain the top rating. If standard and certification programs restrict salable goods
and services to those that are certified, such programs may also have anticompetitive effects.
Many governments license only professionals and crafts people who meet some minimum
standards. People without a license are not allowed to practice their profession or craft.
Society may align governance structure in a cost minimizing ways. Yet the level of transaction
costs could be so high as to make no alternative governance structure, given the current
institutional context, economically feasible. Particularly the institutional context in the rural
areas of sub-Sahara African countries are such that generally create great information asymmetry
between transacting parties. The fragmented and scattered settlement pattern, the infrastructural
problems, the legal systems, the social structure and the small individual farmers (in terms of
individual effective demand and marketed supply) pose special challenges to improve
institutions. In addition to these micro-contexts, it is also common to observe macroeconomic,
political and institutional (formal) instability. Such political instability may provide parties
incentive to take opportunistic actions. Due to this institutional failures, many markets that
require long-term commitments that are critical for development are missing in these countries.
Thus, institutions are very important in reducing such costs and creating stable and predictable
business environment.
In such cases, if the transactions have to occur, parties use create some forms of institutions that
economize transaction costs. In most local agricultural markets of sub-Sahara African countries
various social institutions to minimize information asymmetry.

33
Most of the formal regulatory institutions discussed above that reduce information asymmetry
are missing in the rural areas of sub-Sahara African countries. But even if they exist, the small
and infrequent size of individual transactions make the use of these institutions less economical.
As a result, parties attempt to use personal connections and social networks to economize
transaction costs. Clientelization, the use of family and social groups in transactions are all
different forms of social institutions used to constrain opportunistic behaviors and incentivize
commitments. Theories in the social capital theory argue that interpersonal connections and
social networks reduce transaction costs, some of these reductions were made at the expense of
limiting transactions within a narrow social boundary. To what extent these social institutions
are efficient in minimizing transaction costs and in expanding markets is an empirical question.
Recently, researches have attempted to evaluate the effectiveness and efficiency of social capital
in reducing transaction costs.
In an institutional environment where such social networks are less feasible, informal brokers
emerge to profit by economizing information costs. The use of brokers in the livestock markets
and interregional agricultural trade is common in these countries. In other contexts, parties also
attempt to minimize information asymmetry by signaling reputations. One of the important tasks
of institutional economics is to compare the existing institutional arrangements with feasible
alternative institutional arrangements.

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 CHAPTER FIVE: CONTRACTING AND AGENCY THEORY
In this chapter, we will discuss the implications of information imperfections on the long term
contract relationship between two (or more) parties designated as Principal and Agent. We will
emphasize the effects of institutions (which is the main subject areas of NIE) in governing the
relationships of these parties and the role it plays in reducing transaction costs that arise due to
the imperfect information. We will discuss the problems arising in long term contracts. This is
because, principal-agent problem arise in long term economic contract relationships.
5.1. Contracting
People in a modern society operate within a social network of legally binding and legally
nonbinding obligations into which they enter either voluntarily or through compulsion.
Contractual obligations are legally binding. There are voluntarily assumed obligations like the
obligation of the seller of a commodity to deliver the appropriate merchandise to the purchaser at
the agreed upon time and location and the obligation of the buyer to pay the purchase price in
timely fashion. Legally nonbinding, freely assumed obligations result, for example, from
agreements as to social engagements, the promise to visit one's friend, or the legally non-
enforceable ("moral”) obligation of a gambler to pay his gambling debts. Involuntarily incurred
obligations (non-contractual obligations) are legal liabilities that arise because of tortuous acts.
5.2. Types of Contract
One of the important concepts in governance structure and transaction cost economics is
contract. According to Peterson et al., (2001) and Williamson’s (1991) there are three types of
contract laws which includes: classical contract, neoclassical contract, relational contract,
formal cooperation, and vertical integration which varying from market mechanism (invisible
hand) into internal (hierarchical) control.

Market-based or spot market governance: support contracts that are classical in nature
(Williamson, 1991) and coordination intensity are low. To enter transaction parties, engage in
transaction only discovery price which is determined by the invisible-hand of the market and
make either a yes or no decision (Wysocki et al., 2003). In this governance structure safeguards
incase transaction fails, are missing. Market may be thick or thin but the classical markets are
thick, in which case there are large numbers of buyers and sellers on each side of the transaction
and identity is unimportant, because each can go its own way at negligible costs to the other, thin
markets are characterized by fewness, which is mainly due to asset specificity (Williamson’s,
1993).

35
The specification contract or neoclassical contract: coordination intensity is moderately low
or transaction control for people involved in the transaction is higher than that of the market and
contracts are based on the legally enforceable establishment of specific and detailed conditions
of exchange (Wysocki et al., 2003). The parties transacting exercise coordination control through
the ex-ante negotiation of contract specification and the parties exercise control through proper
monitoring of contract execution and related decisions to renew or renegotiate contract or ex post
transactions (Peterson et al., 2001). According to Williamson (1975) the middle between spot
market and vertical integration has been defined as hybrid governance structures.

Relation based contract: exhibit the following three characteristics: mutuality in objective
identification, mutuality in controlling decision making processes, as well as mutuality in sharing
risks and benefits (Martin et al., 1993). This types of governance structure is typically recurrent
and with long exchanges among partners as price plays a minor role in the transaction compared
to the market or partly market base organizations, here transaction consider relation-building as
the most important motivation factors (Milagrosa, 2007). For instance, marriage is an appropriate
example when we discuss relation-based alliance as partners find means to resolve internal
differences and concerns.

Equity-based alliance: is the fourth position continuum which includes a seemingly old mixture
of organizational forms that include joint ventures, partial ownerships and other organizational
forms that involve some level of shared equity capital between the actors in an exchange
relationship, for instance agricultural cooperatives and private firms who form a joint venture lie
at this point of the continuum. The distinguishing feature between this continuum and relation
based alliance is the presence of a formal organization that conduct the coordination of
transaction (Peterson et al., 2001).

According to Williamson’s (1991) the remaining polar continuum which is opposite to the spot
market (where transactions are solely determined by prices) is the vertical integration where all
transaction are carried out under one ownership and the characteristics of invisible hand co-
ordination of spot transaction are here replace by the characteristics of manage co-ordination.
Except most of developing countries including Ethiopia, developed countries like the US
agricultural industries like poultry are almost fully vertically coordinated and also the EU,
contract arrangements have been encourage under the EU common Agricultural Policy, to

36
vertically coordinate the highly perishable products such as dairy and poultry (Costales and
Catelo, 2008).

5.3. Contract incompleteness

Contractual incompleteness exposes the contracting parties to certain risks. We will discuss these
costs under ex ante and ex post transaction costs.
Ex ante problems
Transaction costs of ex ante and ex post types are usefully distinguished. The first are the costs
of drafting, negotiating, and safeguarding an agreement. This can be done with a great deal of
care, in-which case complex document is drafted in which numerous contingencies are
recognized, and appropriate adaptations by the parties are stipulated and agreed to in advance. Or
the document can be very incomplete, the gaps to be filled in by the parties as the contingencies
arise.
The adverse selection problem where one party to the trade has private information that it can
choose selectively to disclose, which asymmetry the other party cannot overcome except at great
cost. The condition is a manifestation of a more general problem that is responsible for
measurement difficulties, namely, idiosyncratic information.
Ex post problems
Information asymmetries of two kinds can be distinguished at the contract execution stage. The
more familiar is where one party to the trade has more knowledge over the particulars than does
the other. A second, less widely recognized type of asymmetry takes the form of discussed by
Alchian and Demsetz (1972) about shirking of workers. Here each party to the transaction
knows the full truth of what has occurred, but it is costly to disclose the facts to anyone other
than an on-site observer. Even if workers know each other’s contributions in a given cooperative
work activity, they will prefer the supervisor do the assessment.
Ex post costs of contracting take several forms. These include (1) the maladaption costs incurred
when transactions drift out of alignment in relation to what Masahiko Aoki refers to as the
"shifting contract curve"(1983), (2) the haggling costs incurred if bilateral efforts are made to
correct ex post misalignments, (3) the setup and running costs associated with the governance
structures (often not the courts) to which disputes are referred, and (4) the bonding costs of
effecting secure commitments.
Monitoring and enforcing costs depends on many factors: the complexity of the agreement, the
uncertainties arise from exogenous shocks (macroeconomic, sociocultural, political and legal
environment) and behavioral pattern of parties, specificity of the asset, the repetitiveness of their
agreement.
5.4. Principal-Agent Problem

37
The principal agent problem is associated with the principal’s difficulty of knowing the right
agent and the actions agent takes in a long-term contract. To be clear, we will discuss this by
taking an insurance contract as an example. An agent is a designated economic actor who, acts
for, on behalf of, or as representative for other economic actor designated as principal. Agency
relationship is then the relationship between the principal and agent in a particular domain of
decision problems. The relationship between employer (principal) and manager (agent); the
manager (principal) and workers (agents) can both be considered as agency (principal-agent)
relationships differing in the domain of decisions.
Compared to business in other sectors, business activities in the agricultural sector are fraught
with a lot of risks – natural and market risks. Thus, insurance markets are especially more
important in the agribusiness than other business activities. Yet the insurance market suffers
from these two agency problems: adverse selections and moral hazards. Unlike other
transactions, insurance transactions require long-term contracts that require long-term
commitment. The two principal-agent problems - moral hazard and adverse selection – pose
transaction challenge. Ex ante problems are that the insurer (principal) cannot specify
appropriate term as it cannot determine the individual’s (agent) risk level. Theoretically the
insurer may not need to know the individual risk level if the distribution of insurance seekers
follows the actual distribution of risk levels in the population. In this case, the insurer can specify
some average premium in such a way that the likely claim of the high-risk individuals offsets the
low-risk individuals. But in reality, not only the insurer may not perfectly know the distribution
of the risk, the distribution of the insurance seekers may not follow actual distribution. Rather, it
is argued the high -risk individuals are more likely to be willing to buy insurance compared to
low-risk individuals. In such cases, the insurer can set a high premium for all insurance seekers.
This will discourage the low-risk individuals because the high-premium is not proportional to
their individual risk levels. Even if we ignore the problem the above strategy will create on low
risk individuals, it still poses a problem because the insurer doesn’t also know how high is the
risk level of the high-risk individuals. It can be that only those individuals whose risk level are so
high as to be justified by the ‘high premium’. To determine an appropriate premium and to make
sure that it is not selecting only the adverse insurance seekers, it will have to collect a lot of
information. The search cost will be high. For example, the insurance company may demand
health certificate for livestock to determine the health risk. This will involve cost. Similarly, the
insurance company need to collect a lot of information. Even after doing all these, a boundedly
rational insurer will still face uncertainty. The information cost plus the risk cost give the
transaction costs posed by adverse selection.
But in addition to this, the insurer also faces another information problem. Once, the individual
bough the insurance policy can take hidden action that entail additional cost on the insurer. It
may be very difficult to monitor the actions of livestock herders. Livestock herder can slaughter
the livestock and still claim insurance payment for deaths whose causes are not in the policy.
Moreover, the insured livestock herder may not take the necessary precautionary actions to avoid
the hazard. It can rather take risky actions. To minimize these uncertainties, the insurance
company incurs monitoring costs. Yet, a boundedly rational monitor can till face uncertainty.

38
The monitoring costs added to this uncertainty costs give rise to transaction costs posed by moral
hazard.
The transaction costs posed by the adverse selection plus the transaction costs that arise due to
moral hazard give rise to total transaction costs. Depending the institutional environment and the
technology level, this transaction costs could be so high as to block insurance transactions.
Exactly the same argument can be made for credit services. Principal-Agent problems also pose
a similar transaction costs issue in the labor market. The employer may not exactly know the
distribution of individual abilities of job applicants. In addition to the costs the searching, testing,
selection, bargaining and agreement tasks, the employer may still cannot be certain that
incompetent individuals are not recruited. It is to minimize this most employers assign probation
period before they approve the recruitment. But even after all these efforts, an employer cannot
just leave for the workers to manage themselves. The employer will have to devote a lot of
resources to monitor and measure the performances of the worker. Even then, hidden actions
such as shirking, using principal’s asset for personal use, and the like that whose costs are born
by the principal but whose benefits accrue to the agents (workers). All these are transaction
costs that arise due to information problems. The theory can be extended into numerous long-
term contracts.

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 Chapter Six: The Economics of Property Rights
This chapter discusses about one of key economic element: property rights. It starts with
comparison between property right theory neoclassical economists and new institutional
economists.
6.1. Neoclassical and NIE Theories on Property rights
Neoclassical economics assume private ownership of resources in most economic analyses.
When the unit of analysis is property rights itself, it predicts private ownerships as the most
efficient property rights arrangement. Thus, any departure from private property rights imply that
inefficient allocation of resources. That means, economic agents can gain from changing the
property right arrangements toward private ownership. The presence of this economic incentive
provides economic agent to modify the existing ownership toward private ownership. For
instance, given the economic losses that arise from common property rights, economic agents
attempt to minimize the losses by modifying the common property rights regime into private one
as soon as the private benefits of so doing outweigh the private costs. Changes in relative price
changes induced by technological changes or some other exogenous shocks may induce
adjustments in property rights. Neoclassical economics fail to deal the process by which property
rights institutions changes and stagnates.
NIE on the other hand analyze the efficiency of existing property rights institutions and the
process of their change in the wider context of institutional environment. Accordingly, NIE take
political institutions at the primary determinant of property right institutions that defines and
enforce property rights. And changes in the property right institutions comes as a political
process that involve negotiation and bargaining among immediate members or lobbying and
power friction at the higher levels of government. In this sense, however the existing property
rights institutions are inefficient from societal point of view, beneficial changes may not occur if
the distributional implications of the change compel influential parties to oppose it. Thus
inefficient property rights institutions can persist.
There are three lines of analysis in the New Institutional Economics about property rights:
Williamson’s work on contracts, in the lens of governance structures, demonstrated that property
rights are vulnerable to opportunistic predation and that private ordering is usually less costly
than the legal system in enforcing rights. The second line of works by Douglass North, in the
lens of historical and institutional evolution, show how differences in the distribution and quality
of enforcement of property rights affect the different ways societies develop. The third line of
work by Elinor Ostrom, in the areas of natural resource management and collective actions,
expanded the concept of property rights by analyzing how the damaging effects of poorly
defined and enforced private property rights can be avoided through community governance.
Though both theories emphasize the role of property rights in determining incentive structure,
neoclassical economic theories assume the evolution toward private property ownership as an
efficient long run outcome. In addition, neoclassical economics put heavy emphasis on private
property rights. On the contrary, NIE emphasize the role of institutions in securing property

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rights and the possibility that institutions perpetuate inefficient property rights. Moreover, NIE
recognize mixture of property rights in addition to private property ownerships.
6.2. Property rights
Property right is a societal issue. Property rights define the expectation one can hold in dealing
with others. The expectations can be explicitly stated in the laws in which case may be enforced
formally or they can simply imbedded in the norms, customs, and conventions of the society in
which case expected to be understood and accepted by the most of the members. Thus,
institutions define property rights. As we mentioned earlier, even if there are laws that define
rights of a given property, they cannot be considered as institutions if they are not enforced.
Property rights specify how persons may be benefited and harmed and, therefore, who must pay
who to modify the actions taken by persons. As in the case of the ranch owner and crop farmers,
if there is no a clearly defined land rights, the rancher may let its livestock to encroach and
damage the crops of the farmer.
Transactions in the market involve the exchange of two bundles of property rights: a bundle of
rights often attaches to a physical commodity or service and the value of the rights which
determines the value of what is exchanged. When you buy fruit, the seller is transferring the
right to use the fruit – the physical good – to you so that you can consume it, give it to someone
or feed your pet or you can through away. Once you bought, you can apply the bundle of rights
on the physical good as defined by the property rights institutions. On the other hand, when you
buy the fruit, you transfer the right on a given sum of money to the seller.
Property rights may be defined as: “the claims, entitlements and related obligations among
people regarding the use and disposition of a scarce resource” (Furubotn and Pejovich 1972).
Although exact definitions of these rights vary, there are several key elements. First, property
rights are fundamentally a social relation: they are not about the link between a person and a
thing (object of property), but rather about the relations between people with regard to a thing, or
more particularly, with regard to the benefit stream that is generated. Unless others respect one’s
property rights, they are meaningless. Thus, all property rights are associated with corresponding
duties of others to observe them. They are also frequently associated with specific duties of the
rights-holder to do certain things to maintain the right to the resource.
Depending on the existing institutional framework, society can provide different types of rights
on different types of resources and goods. The different types of resources include: 1) use rights
(usufruct) - controlling the use of the property; 2) extraction rights - the right to capture the
benefits from the property through, for example, mining or agriculture; 3) transfer rights - the
right to sell or lease the property to someone else; 4) exclusion rights - the right to exclude
someone from the property; 5) encumbrance rights - the right to use property as security or for
other purposes.
The property rights institutions thus define which of the above rights are assigned to whom and
which of the others are assigned to whom. Societies assign one or more of these rights to
individuals leaving the others to groups or state. Property rights are the social institutions that

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define or delimit the range of privileges granted to individuals of specific resources, such as
parcels of land or water. Private ownership of these resources may involve a variety of property
rights, including the right to exclude non-owners from access, the right to appropriate the stream
of economic rents from use of and investments in the resource, and the rights to sell or otherwise
transfer the resource to others. Property rights institutions range from formal arrangements,
including constitutional provisions, statutes, and judicial rulings, to informal conventions and
customs regarding the allocations and uses of property. Such institutions critically affect
decision making regarding resource use and, hence, affect economic behavior and economic
performance.
The types of the rights, the assignment of the rights, the time horizon for which the rights will be
effective, etc. depend on the existing the institutional environment and the type of the properties.
The efficiency of the exiting property rights can be judged based on the following three
important criteria: 1) universality—all scarce resources are owned by someone; 2) exclusivity —
property rights are exclusive rights; and 3) transferability—to ensure that resources can be
allocated from low to high yield uses.
Universality criteria imply that property rights for all scarce resources need to be clearly defined.
If property rights for some resources is clearly defined leaving others poorly defined or
undefined, the inefficiency in poorly defined resources can be transmitted into those properties
whose rights are clearly defined. For example, establishing a clear property rights on capital and
labor may not bring efficient utilizations of resources if for example the property rights for land
is poorly defined or left undefined. Moreover, property rights focus on physical resources
ignoring intangible property rights such as intellectual property rights. In a condition where
individuals cannot invest on their resource and effort if they cannot capture the benefits of their
inventions and creative works.
The other criteria is exclusivity. Non-exclusive right are rather meaningless. A given resource is
non-exclusive means anyone member outside those to whom the property is assigned can also
use the resource, appropriate the benefits, etc. Unless the right holder is able to exclude other
non-right holders, the mere assignment of the right on given property to an individual or group
will not provide the right incentive to exploit the full potential of the resource.
Transferability provide a great deal of incentive to the right holders. The fact that one resource
can be transferred means, it can be used for collateral, future security and the like. It thus
provides right holders the incentive to make long term investment to improve the resource. Land
it a good example. If the owner of land cannot transfer the land, it implies that the will have less
incentive to invest to improve the land. The result will be that the land will rapidly degraded.
Property rights can be assigned to individuals (firms), groups or government. Though mix of
these assignments always exist in any society, the extent at which most properties are assigned to
individual or collective (group, public or state) depend on the specific economic and political
setting of the country. In every society including advanced market economies, there are some
resources which are communally owned. The choice between individual rights and regulated

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common property would probably depend on such factors as transaction and enforcement costs,
environmental and technological factors, and distributional considerations.
The classifications of economies into market, command and mixed economic system is largely
based on the dominancy of private or common property rights and the allocation mechanism that
emanates from it. A market economic system can then simply be described as one where private
property rights and the market mechanism dominate, while a centrally planned economic system
is dominated by state or collective ownership and bureaucratic coordination. In the so-called
market economies for instance, the institutions of private property rights assign most of these
rights for most of the properties (including land) to individuals (or firms) and accordingly market
forces determine the allocation, the exchange and distribution processes.
One of the important contributions of NIE is it shows the role of property rights institutions in
determining the performance of economies across space and time. Property rights are a
fundamental institution governing who can do what with resources. Therefore, an essential part
of development policy is the creation of polities that will create and enforce efficient property
rights.
By economically efficient property rights are where the partitions of property rights are grouped
into appropriate bundles and assigned to the transacting party who is most capable of efficient
production (utilizing that bundle), and the property rights that compose those bundles will be
grouped so that appropriate economic incentives are created for owners of each bundle of
property rights. By assigning to valuable resources and by designating who bears the economic
rewards and costs of resource-use decisions, property rights institutions structure incentives for
economic behavior within the society. In effect, costs of making transactions will be lower and
help for the market to develop.
Since it is costly to measure all attributes of asset accurately, rights are never fully delineated,
and property is consequently in danger of appropriation by others due to adverse selection, free-
riding behavior, and shirking, among other reasons. The efficiency of property right institutions
is thus depending on their capacity to reduce these transaction costs. Even if property rights
institutions are efficient in this respect, exploiting the full potential of economic opportunities
require efficient long-term contract institutions. Consider rental contracts. Even where the rights
of the renter can be perfectly specified in advance, if the costs of monitoring compliance
(asymmetric information) and measuring the degree of that compliance (measurement costs) are
significant, the renter will be able to appropriate some economic benefits from the contractual
relationship despite perfect specification of property rights.
Setting aside the argument in favor or against private property rights, property rights need to be
clearly defined and enforced. One of the critical problems of developing countries in general and
sub-Sahara African countries in particular is that they lack institutions that enforce contracts
impartially and secure property rights over the long run. These countries even if they have
considerable resource base, the institutional environment is such that the gains from investment,
specialization, and trade are so small to provide economic agents sufficient incentive.
6.3. Property rights institutions and economic performance

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The role of property rights in determining economic performances by providing the basic
economic incentive system that shapes resource allocation was recognized. What has been
largely missing is why property rights take the form that they do. In this respect, important
literatures such as Anderson and Hill, 1975; Libecap, 1989; North, 1990 provide important
insights on the evolutionary perspective property rights institutions. These literatures show the
historical processes through which institutional choices are made. The concept suggest that the
potential distributional conflicts among contracting parties that arise from a given property rights
institutions can help to explain for the persistent of inefficient property rights regimes. Political
institutions in political and economic markets cause inefficient property rights institutions to
emerge, but the imperfect subjective models of the actors as they attempt to understand the
complexities of the problems they confront can lead to the persistence of inefficient property
rights.
One of the crucial institutional weakness in sub-Sahara African countries is that property rights
are poorly defined. Even most properties that are assigned as private property are poorly
enforced. The demarcation between common and private properties are not clear. In addition,
many of the common properties are open access properties. Land in most societies are either
communally owned by communities or owned by State.

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 Chapter Seven: Institutional Evolution and Economic Performance
This chapter discusses the relationships between institutions and economic performances through
time. The analysis is based on historical evolution of mainly Western countries. It draws on the
influential Book of Douglas North (1990) ‘Institutions, Institutional Change and Economic
Performance’.
7.1. Economic Performances and Institutions
Currently, we see a wide variation in the economic development of countries in the world. Some
countries are highly developed (most Western countries) while some others are less developed
but growing fast (East Asian and some Latin American countries). Still some other countries are
not only least developed, they can be much least developed in the future than they are now (most
countries in the tropics especially sub-Saharan countries). Still some other countries are wealthy
but less developed in terms of wider key socio-economic indicators. There are also wide
variations in the ways the economies of these countries are organized and function and in the
type and efficiency of institutions and organizations. Historical evidences indicate all these
countries were more or less similar, if not equal, before some 10 millennia.
In the past, development economics attempted to explain the wide gaps and divergences in terms
of capital and technological gaps and latter in terms of differentials in human capital. Given the
large potential capacity of less developed countries, the implications of the above theories are
that attracting capital, adopting Western technologies and investing on human capital
development will narrow the wide gaps. Despite the efforts made by most countries along these
lines, the success in most countries was not as it was expected. Many countries are falling far
behind the developed countries. Even if capital (physical and human) and technology play
decisive roles in the development of countries, history showed us that they do not create the
sufficient condition for development. Achieving development seems to be much more than
increasing capital stock, adopting technology and educating people. Moreover, increasing capital
stock and technology required unnecessary government interventions and complex
macroeconomic policies. This motivated development economists and foreign donors to make
one last attempt: through market deregulation. In the 1980s and 1990s, International Monetary
Fund (IMF) and World Bank insisted the governments of developing countries to adopt what is
called Structural Adjustment Program (SAP). Mainly to benefit from the conditionality loan that
was made available for implementation of SAP, most countries adopted the blanket
recommendations of IMF and the World Bank. As a result, key macroeconomic policy changes
were made to deregulate the domestic and foreign market and to privatize economic activities.
Since countries that fail to enact these programs were subjected to severe fiscal discipline,
governments unwillingly took different measures to implement SAP. Accordingly, measures
such as devaluation of local currency, reduction of trade barriers, privatizations, increase in tax
and reduction in government spending and lifting subsidies were taken. Even if there were policy
reversal in some of the countries, the program has changed the way economies were organized
and function. However the recent progresses of some countries can be partly considered as the
long term impacts of the program, its immediate adverse effects were evident. Many

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countries entered into serious macroeconomic shocks as a result of the program. The message
was, getting the price right is not enough to bring sustainable economic development.

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