ECON 101 Makes a Lot of Assumptions About Institutions
Markets & price theory: how consumers and producers specialize, produce, and exchange within given, well-functioning markets (and politics)
Assumes the existence of "good" economic and political institutions that facilitate market exchange
- clear and enforced property rights (to goods, land, investment, ideas, etc)
- rule of law
- contract enforcement
- dispute resolution
- complete contracts
- low or no transaction costs
- high level of social trust
- capable, high-capacity, non-corrupt government
Perhaps the Opposite Extreme is More Realistic
Raguram Rajan
1963-
"And there is hope, supported by a growing body of research, that more students of development are realizing that a better starting point for analysis than a world with only minor blemishes may be a world where nothing is enforceable, property and individual rights are totally insecure, and the enforcement apparatus for every contract must be derived from first principles - as in the world that Hobbes so vividly depicted. Not only will this kind of work more closely approximate reality in the poorest, conflict-ridden countries, but it could also lead to more sensible policy", (p.56).
Rajan, Raghuram, 2004, "Assume Anarchy?," Finance and Development September: 56-57
"New Institutional Economics"
"New Institutional Economics" (1970s-): focus on the importance of institutions, economic history, transactions costs, and economic organization in understanding economics
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| Ronald Coase | Douglass North | Elinor Ostrom | Oliver Williamson |
| 1910-2013 | 1920-2015 | 1933-2012 | 1932- |
| Economics Nobel 1991 | Economics Nobel 1993 | Economics Nobel 2009 | Economics Nobel 2009 |
Recall: Making Fair Comparisons: Robust Political Economy I
- No system is perfect
We need to find arrangements that are robust to knowledge & incentive problems
Easy case: perfect information benevolence
Hard case: uncertainty and selfish behavior
Treat people as they are: sometimes good, bad, smart, stupid, opportunistic, altruistic depending on the institutions
Recall: Making Fair Comparisons: Robust Political Economy III
Recall: Making Fair Comparisons: Robust Political Economy IV
Economists often recommend optimal policies that could be installed by a benevolent despot
- A dispassionate ruler with total control, perfect information, and right incentives to implement optimal policy
- A "1st-best solution"
In reality, 1st-best policies are distorted by the knowledge problem, the incentives problem, and politics
- Real world: 2nd-to-nth-best outcomes
Recall: Comparative Analysis
Compare imperfections of feasible and relevant alternative systems
- Don't compare problems of an imperfect system with some ideal system!
Economics: think on the margin!
- One system's "failure" does not imply another's "success"!
- the real world requires tradeoffs
- "economics puts parameters on people's utopias"
- "compared to what?"
Institutions: Operationalizing Adam Smith
Adam Smith
1723-1790
"[Though] he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention…By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it," (Book IV, Chapter 2.9).
Smith, Adam, 1776, An Enquiry into the Nature and Causes of the Wealth of Nations
Institutions: Operationalizing Adam Smith
"[Though] he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention…By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it," (Book IV, Chapter 2.9).
Smith, Adam, 1776, An Enquiry into the Nature and Causes of the Wealth of Nations
Institutions: Operationalizing Adam Smith
"[Though] he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention…By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it," (Book IV, Chapter 2.9).
Smith, Adam, 1776, An Enquiry into the Nature and Causes of the Wealth of Nations
A Logical Framework for Political Economy
- Outcomes:
- relative level of wealth or poverty
- relative level of equality or inequality
- stability of politics, finance, macroeconomy
A Logical Framework for Political Economy
- Outcomes:
- relative level of wealth or poverty
- relative level of equality or inequality
- stability of politics, finance, macroeconomy
- ...are determined by Incentives:
- relative prices or costs of various choices
- profits and losses
- information
A Logical Framework for Political Economy
- Outcomes:
- relative level of wealth or poverty
- relative level of equality or inequality
- stability of politics, finance, macroeconomy
- ...are determined by Incentives:
- relative prices or costs of various choices
- profits and losses
- information
- ...are determined by Institutions:
- allocation of property rights, wealth, and power
- (in)equality before the law or corruption
- constraints on politics and economics
A Logical Framework for Political Economy
- Outcomes:
- relative level of wealth or poverty
- relative level of equality or inequality
- stability of politics, finance, macroeconomy
- ...are determined by Incentives:
- relative prices or costs of various choices
- profits and losses
- information
- ...are determined by Institutions:
- allocation of property rights, wealth, and power
- (in)equality before the law or corruption
- constraints on politics and economics
- ...are determined by Ideas:
- political and social worldview -"isms"
- which groups (should) have status
- moral and social norms
What are Institutions?
Douglass C. North
1920-2015
Economics Nobel 1993
"Institutions are the humanly devised constraints that structure political economic and social interaction. They consist of both informal constraints (sanctions, taboos, customs, traditions, and codes of conduct), and formal rules (constitutions, laws, property rights)", (p.10)
"Institutions are the rules of the game in a society", (p.1).
North, Douglass C, (1991), "Institutions," Journal of Economic Perspectives 5(1): 97-112.
North, Douglass C, (1990), Institutions, Institutional Change, and Economic Performance
Incentives are Structured by Institutions
"Who needs this nail?"
"Don't worry about it! The main thing is that we immediately fulfilled the plan for nails!
Markets as an Evolutionary Process
Joseph Schumpeter
1883-1950
"Capitalism...is by nature a form of economic change and not only never is but never can be stationary...The essential point to grasp is that in dealing with capitalism we are dealing with an evolutionary process.," (pp.82).
"[I]n capitalist reality as distinguished from its textbook picture, it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization...competition which commands a decisive cost or quality advantage which strikes not at the margins of the profits and the outputs of the existing firms but at their foundations and their very lives." (p.132).
Schumpeter, Joseph A, (1947), Capitalism, Socialism, and Democracy
Creative Destruction I
Joseph Schumpeter
1883-1950
"Industrial mutation--if I may use that biological term—that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in" (p.83).
Schumpeter, Joseph A, (1947), Capitalism, Socialism, and Democracy
Creative Destruction: Examples
Creative Destruction: Example II
Creative Destruction: Example III
59 years of progress
No Corporate Monolith Lasts Forever
Creative Destruction: The Problem
Creative Destruction: The Problem
Creative Destruction: The Problem
Creative Destruction: The Problem
Successful Economies Create a Political Problem I
Markets serve consumers (consumer sovereignty), not workers or producers!
Successful market economies produce wealth and destroy jobs
Economic growth ≡ more output with fewer inputs!
A political problem: how do producers permit the destructive side of creative destruction?
Successful Economies Create a Political Problem I
- Moral dilemmas:
- Do we have a moral obligation to insulate workers from the pain of competition that is no fault of their own?
- How do we secure the gains from trade and innovation without punishing the workers who lose their jobs?
Recall: Profit-Seeking
π=pq⏟revenues−(wl+rk)⏟costs
The firm's costs are all of the factor-owner's incomes!
- Landowners, laborers, creditors are all paid rent, wages, and interest, respectively
Profits are the residual value leftover after paying all factors
Profits are income for the residual claimant(s) of the production process (i.e. owner(s) of a firm):
- Entrepreneurs
- Shareholders
Recall: Who Gets the Profits?
π=pq⏟revenues−(wl+rk)⏟costs
Residual claimants have incentives to maximize firm's profits, as this maximizes their own income
Entrepreneurs and shareholders are the only participants in production that are not guaranteed an income!
- Starting and owning a firm is inherently risky!
Profits and Entrepreneurship
In markets, production must face the profit test:
- Is consumer's willingness to pay > opportunity cost of inputs?
Profits are an indication that value is being created for society
Losses are an indication that value is being destroyed for society
Survival for sellers in markets requires firms continually create value and earn profits or die
Profit Seeking: the Microeconomics I
Production generates economic surplus
In a competitive market in long run equilibrium, economic profit is driven to $0.
- p=AC(q)min, otherwise firms would enter/exit
- p=MC(q), allocatively efficient (goods produced until MB=MC)
- Consumer surplus and producer surplus is maximized
Some assumptions to make the graph simple: C(q)=aq∀a∈R+, i.e. the firm has no fixed costs, and constant marginal costs. See more information here.
From Profits to Rents
Adam Smith
1723-1790
"People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices," (Book I, Chapter 22).
Smith, Adam, 1776, An Enquiry into the Nature and Causes of the Wealth of Nations
Profit Seeking: the Microeconomics II
Firms with market power will want to set q∗:MC(q)=MR(q) and raise price p∗
Still creates economic surplus
- Generates less consumer surplus than before
- Some surplus is captured as profit
- Some surplus is wasted as deadweight loss
Some assumptions to make the graph simple: (C(q)=aq \quad \forall a \in \mathbf{R}^+), i.e. the firm has no fixed costs, and constant marginal costs. See more information here.
Rent: Microeconomics I
- Firms may have different cost structures due to differences in:
- Managerial talent
- Worker talent
- Location
- First-mover advantage
- Technological secrets/IP
- License/permit access
- Political connections
- Lobbying
Rent: Microeconomics II
With differences between firms, long-run equilibrium p=AC(q)min of the marginal (highest-cost) firm
- If p>AC(q) for that firm, more entry into industry!
Inframarginal (lower-cost) firms earn economic rents: returns higher than their opportunity cost (what is needed to bring them online, p>AC(q)
Economic rents arise from relative differences between firms
Rent: Microeconomics III
Relatively scarce factors in the economy (talent, location, secrets, IP, licenses, being first, political favoritism, lobbying)
Inframarginal firms using the scarce factors gain a cost-advantage
It would seem these firms earn profits as other firms have higher costs
But what will happen to the prices for the scarce factors?
Rent: Microeconomics IV
Rents ≠ profits!
Rival firms willing to pay for rent-generating factor to gain advantage
Rents are included in the opportunity cost (price) for inputs
Firm does not earn the rents, they raise firm's costs and squeeze out profits!
Factor owners (workers, landowners, inventors, etc) earn the rents as higher payments for their services (wages, rents, interest, royalties, etc).
Recall: Ricardo on Rent in the Long Run
David Ricardo
1772-1823
- In Ricardo's view, land was the fixed factor
Marginal product of land would fall to 0, requiring more and more labor and capital to scrape off marginal land
- Profits to capital fall to 0
- Wages to laborers fall to subsistence level
- Rents to land skyrocket due to land being the fixed factor
Ricardian rents describe these excess returns due to scarcity
Institutions Channel Entrepreneurship
William Baumol
1922-2017
"If entrepreneurs are defined, simply, to be persons who are ingenious and creative in finding ways that add to their own wealth, power, and prestige, then it is to be expected that not all of them will be overly concerned with whether an activity that achieves these goals adds...to the social product," (pp897-898).
"The rules of the game that determine the relative payoffs to different entrepreneurial activities do change dramatically from one time and place to another. Entrepreneurial behavior changes direction from one economy to another in a manner that corresponds to the variations in the rules of the game," (p.898).
Baumol, William J, (1990), "Entrepreneurship: Productive, Unproductive, and Destructive," Journal of Political Economy 98(5): 893-921
Profit Seeking and Rent Seeking
Productive entrepreneurship
Profits from serving customers
Unproductive entrepreneurship
Rents from political privileges
Destructive entrepreneurship
Loot from theft and violence
A Story of Rent-Seeking vs. Profit-Seeking in the Early U.S. I
Robert Fulton
Fulson, Burton, (2010), The Myth of the Robber Barons: A New Look at the Rise of Big Business in America, 6th ed.
A Story of Rent-Seeking vs. Profit-Seeking in the Early U.S. II
Edward Gibbons
Cornelius Vanderbilt
Fulson, Burton, (2010), The Myth of the Robber Barons: A New Look at the Rise of Big Business in America, 6th ed.
A Story of Rent-Seeking vs. Profit-Seeking in the Early U.S. III
Gibbons v. Ogden (1824)
John Marshall
1755-1835
"A right over [licenses and patents] has never been pretended to in any instance except as incidental to the exercise of some other unquestionable power. The present is an instance of the assertion of that kind, as incidental to a municipal power; that of superintending the internal concerns of a State, and particularly of extending protection and patronage, in the shape of a monopoly, to genius and enterprise. The grant to Livingston and Fulton interferes with the freedom of intercourse, and on this principle, its constitutionality is contested.(p. 22 US 229)
"If there was any one object riding over every other in the adoption of the Constitution, it was to keep the commercial intercourse among the States free from all invidious and partial restraints," (p. 22 US 231)
Gibbons v. Ogden, 22 U.S. 1 (1824) Justia Case Law
The Allocation of Talent Matters II
Murphy, Kevin M, Andrei Shleifer, and Robert M. Vishny, (1991). "The Allocation of Talent: Implications for Growth," Quarterly Journal of Economics 106(2): 503-530
Economic Rents Induce Rent-Seeking
Think of an economic rent as a "prize," the payment a person receives for a good above its opportunity cost
Creating rents creates competition for the rents, causing people to invest resources in rent-seeking
The cost of the rent is not just the rent itself, but the resources invested in rent-seeking!
Government Intervention Creates Rents I
Political authorities intervene in markets in various ways that benefit some groups at the expense of everyone else
- subsidies to groups (often producers)
- regulation of industries
- tariffs, quotas, and special exemptions from these
- tax breaks and loopholes
- conferring monopoly and other privileges
These interventions create economic rents for their beneficiaries by reducing competition
This is a transfer of wealth from consumers/taxpayers to politically-favored groups
Government Intervention Creates Rent-Seeking
The transfer is not the worst of it
The real problem is you cannot give away money for free even if you tried!
The promise of earning a rent breeds competition over the rents (rent-seeking)
Rent-Seeking I
Anne Kreuger
1934-
"In many market-oriented economies, government restrictions upon economic activity are pervasive facts of life. These restrictions give rise to rents of a variety of forms, and people often compete for the rents. Sometimes, such competition is perfectly legal. In other instances, rent seeking takes other forms, such as bribery, corruption, smuggling, and black markets."
"When quantitative restrictions are imposed upon and effectively constrain imports, an import license is a valuable commodity...It has always been recognized that there are some costs associated with licensing: paperwork, the time spent by entrepreneurs in obtaining their licenses, the cost of the administrative apparatus necessary to issue licenses, and so on. Here, the argument is carried one step further: in many circumstances resources are devoted to competing for those licenses," (p.848).
Kreuger, Anne, (1974), "The Political Economy of the Rent-Seeking Society," American Economic Review 84(4): 833-850
Rent-Seeking II
Kreuger, Anne, (1974), "The Political Economy of the Rent-Seeking Society," American Economic Review 84(4): 833-850
Rent-Seeking: The Ugly of Monopoly
The monopoly profits earned with market power are an economic rent
- This is the "prize" of market power
What if the market power is earned through political lobbying for an anti-competitive regulation?
Rent-Seeking: The Ugly of Monopoly
The monopoly profits earned with market power are an economic rent
- This is the "prize" of market power
What if the market power is earned through political lobbying for an anti-competitive regulation?
Firm(s) willing to invest resources into the "competitive market" of creating and maintaining economic rents
Total loss to society =DWL+Rent-seeking (of all competitors!)
Rent-Seeking III
Gordon Tullock
1922-2014
"The rectangle to the left of the [Deadweight loss] triangle is the income transfer that a successful monopolist can extort from the customers. Surely we should expect that with a prize of this size dangling before our eyes, potential monopolists would be willing to invest large resources in the activity of monopolizing. In fact the investment that could be profitably made in forming a monopoly would be larger than this rectangle, since it represents merely the income transfer," (p.231).
Tullock, Gordon, (1967), "The Welfare Cost of Tariffs, Monopolies, and Theft," Western Economic Journal 5(3): 224-232.
Rent-Seeking IV
Gordon Tullock
1922-2014
"Entrepreneurs should be willing to invest resources in attempts to form a monopoly until the marginal cost equals the properly discounted return. The potential customers would also be interested in preventing the transfer and should be willing to make large investments to that end. Once the monopoly is formed, continual efforts to either break the monopoly or muscle into it would be predictable. Here again considerable resources might be invested. The holders of the monopoly, on the other hand, would be willing to put quite sizable sums into the defense of their power to receive these transfers," (p.231).
Tullock, Gordon, (1967), "The Welfare Cost of Tariffs, Monopolies, and Theft," Western Economic Journal 5(3): 224-232.
Rent-Seeking V
A Microcosm of the Political Economy of Creative Destruction I
A Microcosm of the Political Economy of Creative Destruction II
Another Mundane(?) Example
Source: New York Times (Feb 13, 2017)
If You Look at the World Long Enough...
Regulation has a Dark Side
George Stigler
1911-1991
Economics Nobel 1982
"[A]s a rule, regulation is acquired by the industry and is designed and operated primarily for its benefits," (p.3).
Stigler, George J, (1971), "The Theory of Economic Regulation," Bell Journal of Economics and Management Science 3:3-21
Private Rent-Seeking I
The Rievers (1969) based on William Faulkner’s (1962) book
Private Rent-Seeking II
Institutions Matter
Executive Constraints: A measure of the extent of institutionalized constraints on the decision making powers of chief executives. The variable takes seven different values: (1) Unlimited authority(there are no regular limitations on the executive's actions, as distinct from irregular limitations such as the threat or actuality of coups and assassinations); (2) Intermediate category; (3) Slight to moderate limitation on executive authority (there are some real but limited restraints on the executive); (4) Intermediate category; (5) Substantial limitations on executive authority (the executive has more effective authority than any accountability group but is subject to substantial constraints by them); (6) Intermediate category; (7) Executive parity or subordination (accountability groups have effective authority equal to or greater than the executive in most areas of activity). This variable ranges from one to seven where higher values equal a greater extent of institutionalized constraints on the power of chief executives. This variable is calculated as the average from 1960 through 2000, or for specific years as needed in the tables. Source:Jaggers and Marshall (2000).
Glaesar, Edward L, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, 2004, "Do Institutions Cause Growth?" Journal of Economic Growth 9: 271-303
Institutions Matter II
Expropriation Risk: Risk of "outright confiscation and forced nationalization" of property. This variable ranges from zero to ten where higher values are equals a lower probability of expropriation. This variable is calculated as the average from 1982 through 1997, or for specific years as needed in the tables. Source: International Country Risk Guide at http://www.countrydata.com/datasets/.
Glaesar, Edward L, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, 2004, "Do Institutions Cause Growth?" Journal of Economic Growth 9: 271-303
Institutions Matter III
Autocracy: A measure of the degree of autocracy in a given country based on: (1) the competitiveness of political participation; (2) the regulation of political participation; (3) the openness and competitiveness of executive recruitment; and (4) constraints on the chief executive. This variable ranges from zero to ten where higher values equal a higher degree of institutionalized autocracy. This variable is calculated as the average from 1960 through 2000, or for specific years as needed in the tables. Source:J aggers and Marshall (2000).
Glaesar, Edward L, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, 2004, "Do Institutions Cause Growth?" Journal of Economic Growth 9: 271-303
Institutions Matter IV
Government effectiveness: This variable measures the quality of public service provision, the quality of the bureaucracy, the competence of civil servants, the independence of the civil service from political pressures, and the credibility of the government's commitment to policies. The main focus of this index is on "inputs" required for the government to be able to produce and implement good policies and deliver public goods. This variable ranges from −2.5 to 2.5 where higher values equal higher government effectiveness. This variable is measured as the average from 1998 through 2000. Source: Kaufman et al. (2003).
Glaesar, Edward L, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, 2004, "Do Institutions Cause Growth?" Journal of Economic Growth 9: 271-303
Political Institutions
Politics: process by which society chooses rules that will govern it
AJR1:
Economic performance ← economic institutions ← politics ← political institutions ← distribution of political power
- Key role of state capacity or "political centralization" in development
1 The colloquial term for "Acemoglu, Johnson, and Robinson" who frequently collaborate together on these issues!
AJR: Inclusive vs. Extractive Institutions
Extractive Institutions/Colonies
Inclusive Institutions/Colonies
Political Institutions
Strong feedback loops:
under extractive institutions, political & economic elite can structure institutions to maintain their wealth and power to extract rents at the expense of the population
under inclusive institutions, more equitable distribution of wealth and power, competition prevents any one group from creating and maintaining enough rents to exert control
institutions are maintained by elites who control power, choose economic institutions with few constraints or opposing forces to them!
Why would elites ever permit reform?
AJR's Ultimate Framework
Acemoglu, Daron, Simon Johnson, and James A. Robinson, 2006, "Institutions as a Fundamental Cause of Long-Run Growth," Handbook of Economic Growth, Phillippe Aghion and Steven N. Durlauf, eds., pp.385-414
Luddites
The "Luddites" destroying power looms in early 19th century Britain