INSTITUTIONAL

ECONOMICS
DR. S IYUN JIA NG
B IE JA N-2 02 5
S ES SION 3 -4
Rules of Public Speaking Sessions
90-second speech for ten students, TIMED
Come to the podium and wait in a queue

The speaker:
◦ Sharing a piece of news that relates to the course themes
◦ Sharing cultural, political, or societal events in your country that are significant
or impactful
◦ Expressing your criticism of a policy, event, or trend
◦ Responding to the previous speakers, challenging what others have said,
adding your perspective or additional information
◦ Sharing updates about your group’s events, initiatives, or achievements.
Creating Rules of Public Speaking Session
➢Goal: Give you a chance to practice public speaking in class
➢Starting Point:
➢Due to size of the class and time constraints, 90 seconds per person, max 10 per class
➢Max 5% of the grade
➢Question 1: Should it be mandatory?
➢If yes, how many times? Max 2 times. If not, could it end up being monopolized?

➢Question 2: How to motivate participants within each class and across classes?
➢Question 3: How to decide participants if there are multiple volunteers?
➢Question 4: How to compare performance across different topics?
How is Cooperation Possible?
The central focus of the field is on the problem
of human cooperation, specifically that which
allows economies to capture gains from trade.

Prisoner's Dilemma highlights how individual

wealth-maximizing behavior can lead to
outcomes that are not optimal for the group.
◦ A discouraging perspective on the problems
of human cooperation and coordination

Spoiler alert: Institutions

play a crucial role by
creating an environment conducive to
cooperative solutions for complex exchange.
Assumptions of the Standard Behavioral
Model of Economics
The neoclassical model assumes that
individuals act to maximize their preferences.
Completely rational individuals possess “the
ability to foresee everything that might
happen and to evaluate and optimally choose
among available courses of action.”
The model posits a world where there are no
costs associated with using the market. Prices
become the sufficient mechanism for
allocating resources to their highest value
uses, because the market functions perfectly.
Limitations of Standard Behavioral Model
of Economics
Violations of the assumptions:
◦ transitivity
◦ framing effects
◦ preference reversals
◦ problems in the formulation, manipulation, and
processing of subjective probabilities in
uncertain choices.

In real-world scenarios, exchanges are not

repeated, reducing the incentive to cooperate
Impersonal exchange involves large numbers of
participants and limited information about them.
The Condition for Game Theoretic
Cooperation
This line of literature further explores conditions under
which cooperation can be sustained.
Wealth-maximizing individuals will usually find it
worthwhile to cooperate with other players when the play
is repeated, when they possess complete information
about the other players' past performances, and when
there are small numbers of players.

But why, both throughout history and in most of the

present world economies, the potential gains from trade
have not been realized, as well as to why the modern
Western world has realized (at least partially) this economic
potential?
IE’s Modifications to the Standard
Behavioral Model
Assume bounded rationality instead Consider the costs of economic
of perfect rationality exchange
Traditionally, it was assumed that individuals Traditionally, economists assumed that such
attempt to maximize their utility in a perfectly exchange is costless.
rational manner.
Institutional economists emphasize that
Institutional economists emphasize that economic exchange entails
Individuals act on incomplete information and ◦ information costs
with subjectively derived models of the world
that may be erroneous. ◦ search costs
◦ negotiation costs
The mind's ability to process information is ◦ fulfillment costs
limited, leading to the evolution of rules and
procedures to simplify interactions The level of each depending on the type of
institutions in effect.
Transaction Cost: Costs of Using the
Market
The classical model posits a world where there
are no costs associated with using the market.
Therefore, institutions are irrelevant and play no
role in economic performance because they are
not needed to facilitate exchange.

Ronald Coase: But if using hierarchies (firms) is

costly whereas the use of markets is costless,
there is no reason for firms to exist.
For some activities, the costs of using the
market are higher than the costs of using
hierarchies like firms.
When it is costly to transact, institutions matter.
Transaction Cost: Costs of Using the
Market
The costliness of information is key to the
costs of transacting, which includes the costs
of measuring valuable attributes and
enforcing agreements.
Recognizing that production costs include
transaction costs, it requires a new
microeconomic framework.
The higher the transaction costs, the lower
the number of transactions. A lower number
of transactions implies a lower degree of
specialization and, at the end of the day, less
income.
Measurement Cost
When we engage in an exchange, we are not simply
trading generic goods or services. Instead, we are
concerned with the diverse attributes that make a
product valuable.
It requires resources (time, effort, expertise) to
measure these attributes accurately.
Sellers often know more about the valuable attributes
of a good or service than buyers, leading to
information asymmetry.
Measurement costs arise because it's expensive to
ascertain the valuable attributes of goods, services, or
the performance of agents.
Enforcement Cost I
Enforcement is typically imperfect due to the cost of
measuring contract performance and and the fact that Chart 1

enforcement is carried out by agents.

◦ Ascertain Violations: It is often costly to discover if a
contract or agreement has been violated.
◦ Measure Violations: Measuring the extent of the violation
and the consequent damages is also costly.
◦ Apprehend Violators: Resources must be spent on
apprehending the violator and imposing penalties.

It is costly to measure and enforce agreements, then the

contracts may be self-enforcing if it is in the interest of
the parties to live up to the terms, which is often the
case when there is substantial knowledge between
parties and repeat dealings.
Enforcement Cost II
Agent costs arise when one party (the principal)
delegates tasks or responsibilities to another party
(the agent). These costs occur due to the fact that the
agent's goals and motivations may not perfectly align
with those of the principal.
Information asymmetry creates opportunities for
agents to act in ways that benefit themselves at the
expense of the principal.
Principals must incur costs to monitor the agent's
performance and enforce agreements.
The principal-agent issue is ubiquitous in hierarchical
organizations
What are Institutions?
Institutions are the rules of the game in a society or,
more formally, the humanly devised constraints that
shape human interaction.
Institutions, whether formal or informal, function as
constraints that limit the set of choices available to
individuals.
They structure incentives in human exchange,
whether political, social, or economic.
They can be created or evolve over time.
They define what individuals are prohibited from
doing and also specify the conditions under which
certain activities are permitted.
Institutions do not guarantee efficient outcomes.
Institutions that create monopolies, restrict
opportunities, or favor redistributive over productive
activity are common.
Why are Institutions Necessary?
Institutions reduce uncertainty by establishing a stable structure for human
interaction.
The importance of institutions arises from the costliness of measuring what is
valuable, protecting rights, and enforcing agreements.
◦ Resources may be allocated to activities that exploit information asymmetry rather than to
productive activities.
◦ Because of the cost of measuring all aspects of an exchange, most contracts will be
incomplete and require informal constraints to supplement them.
◦ As self-enforcement is insufficient in many situations, complex exchanges in an impersonal
world require third-party enforcement to ensure compliance.
Institutions affect the performance of the economy by their impact on the costs
of exchange and transformation (production).
Informal Constraints I
Trade Map showing Clam shell beads, black oak acorns, dried sage, pine nuts,

Informal constraints include conventions, codes of obsidian and salt were just a few of the items traded among the tribes and other
groups that traveled to and from Yosemite to trade.

conduct, and norms of behavior.

Culture defines how individuals process
information and thus affects how informal
constraints are specified.
In the absence of formal rules, kinship ties often
form the basis of social order as insurance,
protection, and law enforcement mechanisms.
Enforcement: Members of a family may deter
other family members from engaging in harmful
behavior because the threat of a feud would be
harmful to all members.
Informal Constraints I
Informal constraints can include internally enforced
codes of conduct where individuals give up wealth
for some other value, such as altruism, fairness, and
justice.
Ideas, ideologies, and convictions can play a major
role in choices, especially when the cost of expressing
them is low.
Institutions can lower the cost individuals pay to
express their ideologies and convictions.
◦ Formal institutions can provide mechanisms that enable
individuals to express their views and influence
outcomes.
◦ For example, lifetime tenure for judges can allow them
to act on their own conviction, shielding individuals
from interest group pressures.
Formal Constraints
Formal constraints include rules and laws that are explicitly stated
and provide a framework for exchange.
Contracts are explicit frameworks to provide evidence about
forms of organization and to reflect ways to facilitate exchange.
◦ The need for a state to enforce agreements creates a dilemma
because the state can also act in ways that are harmful to economic
growth.
◦ But how does one get the state to behave like an impartial third
party?
Political institutions evolve to lower the costs of exchange among
legislators by establishing credible commitments for future
payoffs.
Formal rules alone are insufficient to explain outcomes because
they interact with informal norms and enforcement
characteristics.
Two Types of Research Questions
EFFECTS OF INSTITUTIONS ORIGINS OF INSTITUTIONS
Institutions are assumed to be Institutions are endogenized
exogenously given.
The origins of institutions and how
How institutions affect economically certain institutions develop
relevant variables.
For example, how do institutions affect
GDP growth and economic For example, how do economic growth
development? and inequality explain democratization?

Exogenous variables are variables Endogenous variables are determined

determined outside the model. within the model.
Goals and Challenges
➢Descriptive inference: the empirically founded relationship between the independent and
dependent variables, based on a number of observations, allows generalization over and beyond
the cases under review.
◦ Internal Validity: the degree to which descriptive or causal inferences from a given set of cases
are indeed correct for most, if not all, the cases under inspection.
◦ External Validity: the extent to which the results of the comparative research can be considered
to be valid for other more or less similar cases
➢Causality: if the variation in the dependent variable is evidently and systematically related to the
variation in (one of ) the independent variable(s)
➢The challenge of causal inference in social science:
We cannot control exposure to independent variables (treatments) because we cannot randomly
‘assign’ a country a type of regime or a level of social expenditures. Genuine experiments are rare in
comparative politics. There is always a chance that some third (confounding) variable is causing Y.
The Toolkit of Institutional Economists I
Institutional economists employ a variety of tools to
analyze how institutions affect economic outcomes and
how institutions themselves evolve.
Game Theory is a crucial tool for analyzing strategic
interactions, where the outcome of an action depends on
the behavior of others.
It reduces complex interactions to essential components,
helping to predict behavior and understand how
institutions can reduce strategic uncertainty.
◦ Players
◦ Rules
◦ Strategies
◦ Information Set
◦ Payoff Functions
◦ Results: A Nash equilibria, outcomes of the game in
which given the other players’ action, none of the
players can benefit by unilaterally deviating from
that action.
The Toolkit of Institutional Economists II
Comparative Institutional Analysis involves
comparing actually realized institutions to
understand how different institutional
arrangements affect economic outcomes
and the associated transaction costs.

Case Studies Including Economic History

involve the detailed analysis of specific
cases, often focusing on the emergence
and impact of particular institutions in a
specific country or time period.
• ‘Most Different Systems Design’
• ‘Most Similar Systems Design’
The Toolkit of Institutional Economists III
Experiments in the Laboratory
or the Field test behavioral
predictions, often revealing
deviations from the standard
behavioral model, and help to
assess the relevance of internal
institutions like social norms
and values.

Trapped by misperceptions
The Toolkit of Institutional Economists III
Econometric Tests uses quantitative data to test the determinants and effects of institutions,
allowing for the comparison of institutions and their impact on economic outcomes such as
growth rates and investment

The best illustration you'll see that correlation doesn't equal causation
Data in Social Sciences
The dimensions of data: The number of cases:
▪Spatial (cross-sectional) ▪Small N: case studies, and process tracing
▪Functional (cross-organizational or cross-process) ▪Large N: statistical techniques, parsimonious
explanatory designs
▪Longitudinal (cross-temporal)

The type of data:

▪Official statistics: aggregate data at some
territorial level
▪Individual level data
▪Text as data
Review
Institutions and Cooperation
Neoclassical behavioral assumptions
Limitation and modification to classical
assumptions
Transaction costs
Measurement and enforcement costs
Informal and formal institutions
Internal and external validity
The challenge of causal inference
Confounder variable