Tuesday, October 7, 2008

On Economic Theory and Institutions

There is no pure economic theory of institutions. One has to draw the theme from other streams. Marxian theory gives emphasis on institutions. Most of the earlier theories emphasized on institutions. Myrdal’s Asian Drama is a milestone in development theory. The American school is known as the old institutionalists. New-institutionalist theory depends on transaction cost approaches. Old institutionalists depend on behaviorial approaches in understanding economic problems. Non-economists are much more concerned about behavior of institutions. If one looks at cross-country differences, then s/he can find the evolution of institutions. The nature of institutions does not affect the cross-country differences, according to Olson.

Production and exchanges are two basic spheres in an economy. Production depends on availability of factors of production. In the exchange sphere, consumption takes place. How does efficient allocation of resources occur? Basic problem of the economic theory was provided by Arrow. Under certain conditions, one would have optimum exchange and efficient production. These conditions are: existence of perfect market; large numbers of buyers and sellers; all the economic agents are capable of making rational decisions; firms maximize their profits and consumers maximize their utilities; firms and consumers come together to determine the terms of exchange. An exchange emerges under certain conditions. In this exchange process, there is free entry and free exit. There is perfect information, which is available at free of cost. The buyers have all information about the commodities. The exchange occurs at free of cost. There is no enforcement of cost on transaction. There is some implicit bidding process to determine price of exchange. (There is some imaginary auctioneer to initiate the bidding process). Then, there is attainment of equilibrium, when demand becomes equal to supply at the equilibrium price. Nothing is left unsold at the equilibrium price. The market gets cleared at the equilibrium price. There is no exchange which take place anywhere except the competitive market price. Exchange occurs at the market clearing price, and it happens at free of cost. Coase says that enforcement cost do take place. There is an implicit contract between the buyers and the sellers during the process of exchange. But exchange does not occur at free of cost. The moment costs are brought into the picture, the Arrow-Debreu theorem fails. Coase asks for the introduction of transaction costs. Similarly, transaction costs occur if the firm deals with other entities. Theories of economic development have arisen due to market failures. The postulates of perfect competition may not hold due to: (i) uncertainty; (ii) presence of capital markets, where moral hazards take place; (iii) presence of externalities.

Externalities happen due to interdependence. They can be positive or negative and are deemed to be time-bound. Under conditions of uncertainty, externality can give rise to market failures. Markets cease to follow a particular way. So the problem has to be tackled in some other way. All the earlier development theories assume that market failures are pretty pervasive in underdeveloped economies. A public good is the best example of externality and this can lead to the problem of free-riding. If free-ridership occur, then production would be stopped since nobody is paying for the good which is produced. Non-exclusion gives rise to the problem. Earlier development theories declined in the 1960s. Markets fail due to the introduction of transaction costs. Transaction costs are of various types: enforcement, monitoring, co-ordination, information etc. Share-cropper has an incentive in undersupplying his labour. So, the landlord makes certain rules. That is why the sharecropper has to bear half of the cost. So the transaction cost goes up since one has to see whether the share-cropper is using his 50% of fertilizers or the landlords’ fertilizer. Transaction cost creates a situation for market failures. So, to deal with it, property right legislation is introduced. The thing to do is to ‘internalize the externality’, and thus reduce the transaction cost. According to Douglass North, institutions are responses to reduction in transaction costs. Institutions are developed to reduce transaction costs. So, if market failures take place due to high transaction costs, then economies respond by reducing such costs.

The contemporary history of economic development and underdevelopment take into account the breaking-up of institutions. Some economists like Joseph Stiglitz, Pranab Bardhan et al argue for looking at economic theory through the framework of information cost since it is a better approach than the competing ones. Although both transaction and information cost are quite similar, still the latter is quite amenable. Stiglitz has focused on rural institutions like tenancy, share-cropping etc. Transaction cost approach is not impeccable as it does not reveal why institutions come into being into the first place.

Information involves cost. Perfect information is accessible and available at some cost. But this assumption can be challenged. So, there is a need to move to imperfect information. Information may be asymmetrically distributed. If A has certain information which s/he is not ready to pass to B, then the information becomes asymmetric.

Exchange may occur in the presence of multiple imperfections. Imperfections mean there is a market. In the case of rural organizations, there may be absence of market. Institutions may be a response to ‘missing markets’. Stiglitz assumes rational individuals who are utility maximisers. Individuals act consistently and they respond to changes in external environment. If information is costly, then the decisions of individuals will differ from the decisions when information would have been costless. Institutions then adapt to reflect these costs. Institutions are endogenous. Outcomes would be Pareto-inefficient when exchange takes place that involves costs. There could be a potential role of the government to effect some kind of Pareto improvement, which may depend on many conditions—(a) Government should know about the working and the structure of the economy; (b) Within government there should be at least as much information as is being held by private agents; (c) Those making policies should have the incentive to make policies, which are Pareto-efficient rather than mere re-distribution (transfer gain from one group to another). There is also the need for providing incentive to efficient government workers. So, government should have the ability to make better choices.

Stiglitz then compares his approach with 3 alternative approaches i.e. theory of rational utility maximizing individual (in the Arrow-Debreu case), General Theory of Transaction Cost, and the Exploitation Hypothesis. There are three internal and external criteria from evaluation. The set that come under the internal criteria are: (i) Internal consistency (assumptions are internally-consistent); (ii) Simplicity (Fewest possible number of assumptions); (iii) Completeness (Primitive assumption).

The set for external criteria are: (i) Verifiablity (Relation of theory to reality); (ii) External consistency (Assumption of theory should be consistent with the reality); (iii) External completeness (With one’s theory, how much one can explain? How much externally complete is one’s theory?); (iv) Specificity (Theory should be able to make specific kind of outcomes. It should have predictive power).

Having set-up these tests, Stiglitz evaluates the information cost approach as against other approaches and shows that his approach met the criteria, whereas the other approaches partially met the criteria.

He finds ‘exploitation hypothesis’ very vague, which is quite opposite to what Utsa Pattnaik and Kaushik Basu talk about. Stiglitz has used his approach to see a large variety of rural organizations like share-cropping, rural credit market, interlocking of factor markets and labour market.

When one moves away from personalized exchange, then there is gradual emergence of a regulatory regime. In the case of a personalized exchange, bazaars, haats, mandis and other markets of villages, parties know each other. There is no need for guarantee. There is no division of labour, as opposed to what Adam Smith talks about. There is no specialization. There are no risks of defaults. There are no former rules as such. But there are certain customary norms.

In case of an impersonalized exchange, there is specialization which brings into existence interdependence. There is also exchange of goods between parties located at two different places and payments may be at two different time-periods. In such conditions, chances of opportunism are very high. To provide liability and stability, institutions in the form of rules or regulations emerge.

The entire concept of property rights has emerged over time. An entire gamut of institutions emerged during 7th-14th century A.D. in the Western Europe according to North. Not only rules and regulations emerge from the government but also from the private parties as well, such as in the form of corporate social resposibilities (which is controversial in nature). A third party is required for the private parties i.e. the State is required to influence and stabilize property rights. Emergence of State is the result of the breakdown of common life. There was no central authority but there were oral customs and laws in the earlier times. Rise of the State emerged with written rules and regulations (remember oral history in the subject Anthropology). State created the judiciary, legislative and the executive.

Pranab Bardhan has also examined the institution of caste-system. North has studied the emergence of State. He has observed two things: (a) Population growth leads to economies of scale in the exchange market; (b) Minimisation of the transaction cost.

This however unfolds before us the politics behind population control, which is based upon the neo-Malthusian ideology, that has been discarded by not only neo-Ricardians but also by the very scholars like Laxmi Murthy, who was associated with Saheli, once upon a time. It has also been found in the literature that the olden times are not gone when the civilized West came to tame the South with a gun in one hand and a Bible in another hand, simply to civilize the 'Man Friday'.

The key thing of emergence of institution is factor price ratio of land and labour. When there is increase in population, it impacts upon the wage-rent ratio and also on the size of the market. Thus the scale of exchange increases. When there is an expansion of the exchange, it gives rise to economies of scale. When population increases, pressure on land rises, wage rates goes down and rent rises. Hence, demand for land goes up and labour supply goes up. (This is based on a very simplified logic). At a later stage, because of fall in population growth, due to migration of labour to non-agricultural sector, pressure on land goes down but since labour becomes scarce, wages goes up. This is the case in the US and in Europe. Regulations emerge to make land a commodity. People start asserting their rights when scarcity increases. In case of tenancy, there is a transition from share cropping to fixed tenancy. In the case of labour market, various kinds of rules and regulations emerge. There is collapse of bonded and slave labour system. Casual labour emerges. Scarcity of labour governs the land-labour relations. Factor price ratio has led to some kind of emergence of institutions. When population increases, demand increases and so supply increases (Say’s law). So, economies of scale appear. For producing per unit output, it takes lesser money (cost). Douglass observed the change from individual enterprise to corporation (MNCs or national MNCs or share-holding companies shift from unlimited liability to limited liability). It happens when production happens on a larger scale. Proprietorship changes from one individual to many individuals (joint stock companies or share holding companies).

Population growth-->Higher demand-->Higher Exchange-->Large scale production

Douglass explains three cases that lead to minimization of the transaction cost:
(i) Externalities
(ii) Imperfect Information
(iii) Risk and Uncertainty

There are three market situations which are outside the normal situation. These things can lead to market failure. So, institutions are needed to avoid market failures.

Market works on purchasing power. Sellers sell to those who pay the price. Externality is a situation when consumers can use a good without paying for it. For e.g. market failures happen in the case of public goods like constructing road. Enforcement cost/ task is very high/ difficult. There is problem of estimation. The producer thus will not have the incentive to produce. In this kind of situation, institutions develop. For e.g. consider the case of patent rights. Therefore, according to Douglass North several regulatory mechanisms were developed to continue the production of certain commodities, which may not be accessible to free-riders. Water charges, surcharge, road-tax, irrigation tax were introduced. Concept of surcharging emerged. Concept of fees emerged. (Nowadays economists talk about public private partnership). Concept of intellectual property rights and royalties emerged.

Most of the mainstream theories assume perfect information in the market. But in reality, we do not have perfect information. Several institutions were developed to bridge information gap. From the side of manufacturer, there are certain things to consider—information about the market, size of the market, creation of market bureaus, trading centres, stock exchanges etc. Concept of stock-exchange is an institutional set-up to inform the share-holders. Concept of brokers emerged. They tell about the price and profitability of the company’s share. Concept of magazines, journals emerged. All these and more to bridge the information-gap. Concept of all sellers located at one place, give the idea of competitive information. The motto is to provide as much information to producers and buyers.

Risk is involved and this leads to market failures. In the financial market, risk is very high. Even in the case of durable goods, risk is involved. So guarantee is needed to provide incentive to the consumers to purchase goods. To avoid losses, partnerships, joint stock companies were made. Insurance is a major innovation. It was developed over a period of time. During trade, transport insurance is introduced. Car insurance is nowadays available. Medical insurance too is available. Hence, one finds a number of institutional changes. Technology has played an important role in economic development. But at the same time, institutions have played a positive role in the development.

Growth of institutional economics was because of the contributions by economists, sociologists, lawyers etc. The economic aspect/ dimension of law was contributed by lawyers. There is an element of rule/ law in economics. One of the approaches, which thus emerged was property rights approach. There are four issues which property rights approach deals with. What are property rights? How do they emerge? Whether property rights are equivalent to institutions? System of property rights assigns an individual the authority to use factors of production in a specific manner. Whenever property rights are assigned, one has the right to use the factors of production/ consumer durables. But there are constraints in the usage. Use of property should be in a particular manner. There is an element of restriction. Property rights can be of different types/ forms. It can be in the form of private ownership, state ownership or communal ownership. In private ownership, there is an element of exclusivity. There is a principle of exclusion of others. So, enforcement issue arises. In a state property ownership, the right to use is given to the citizens but in a particular way. In case of communal ownership, there are rules for utilisation. There are restrictions on usage. One must remember the case of tragedy of commons here. Property rights are a legal step. If property (say land) is an income earning asset, there can be exchange and so there is a market. Several laws have emerged, which are laid down by the government for ensuring private property rights. Society also makes rules to use resources—in the case of communal property. Property rights developed/ emerged to internalize the externalities. There has been a transition from communal property rights to State ownership and then private property rights.

Externalities emerge when goods are used without payment. This leads to market failures. Pricing mechanism fails and free riding take place. Externalities mean those who can’t pay are allowed to use. When there was open land (community owned), everybody used it as population was scarce and land was abundant. But communal property rights started moving out since population pressure increased and land became scarce. So, factors of production, which became scarce led to their valuation. We must know that Economics is the study of scarce resource. Failures of the norms in the community led to the creation of State in pari pasu with the rise in private property. Rise of the State means breakdown of the community. There are variations in the way private property is defined by different type of States i.e. autocracy, democracy etc.

In the property rights approach, theory of the State has not been developed properly. Rules of property emerge due to population pressure. After the rules emerge, are these rules economically efficient? Do these rules have fair income distribution? The impact of social rules (such as caste system) determines property rights. Customs too determine user rights/ property rights. Are the set of rules efficient and promote equity? What kinds of property rights promote economic efficiency? How do you define economic efficiency vis-à-vis property rights? The key cost is enforcement cost. What is enforcement cost? Enforcement of property rights also means coercion to exclude others from consumption of that property. Neo-classical economics say that there is no enforcement cost. But enforcement cost is positive Property rights are efficient if enforcement cost is minimum. If the enforcement cost is high, property will become expensive and its rate of exchange will go down. Government land is bought less since the enforcement rate is high. Exchange value is determined by the degree of enforcement. The easier is acquisition of property rights, the lesser will be the enforcement cost (such as registration fee). Property rights should be allowed to lease in and lease out assets/ property. So, tenancy should be allowed so that more land is available for cultivation. Tenancy rules should be changed to increase productivity. Property rights should be such that acquisition cost and enforcement cost be minimized.

There are two kinds of approaches for understanding institutional changes:
(i) Neo-classical explanation.
(ii) Marxian explanation.

In the standard neoclassical approach, there are those who look at institutional change in a historical way such North. Neoclassical approach is based upon ‘institutional determinism’ whereas Marxian approach is based upon ‘technological determinism’. Neoclassical economists look at two things: factor price ratio and size of the market. General theoretical understanding is that if one has some rules, which govern economic decisions/exchanges, the motivation to change customs will come provided change leads to economic gains (additional economic gain). But change of institution will lead to certain additional cost. The mainstream neoclassicists will say if gain is greater than cost, then institution will change. If there is net gain, then there will be motivation to change. Historically, institutions change if there is net economic gain, according to North. The rise of private property rights depends on scarcity and thus relative price ratio. If price of land changes due to excess/ less supply of land, then the rules governing the ownership of land also changes. People start enforcing their rights owing to scarcity of land. In the case of labour (excess labour), there can be bonded/ attached labour system. But when there is labour scarcity, there exists free labour, which is mobile. So, due to scarcity of labour, the rules governing use and exchange of labour changes. North has also brought into the picture population pressure concept i.e. if population pressure increases or decreases, scarcity increases or decreases accordingly. Population pressure not only affects the rules governing the usage of factors of production but also the demand for output. There are economies of scale associated with the size of the population. Ruttan says that there are forces on the demand side and forces on the supply side. If the price of the land becomes high, then the owners of land will ask for change in the rules governing ownership of land. Relative factor price ratio on the demand side will lead to changes in rules. The concept of cost sharing increases income owing to technological changes, which leads to institutional change. So, technology can bring in institutional change. Capacity to innovate depends on certain factors. It depends on existing knowledge base. The more advanced is the social science knowledge, more regulations will crop up, which is economically efficient. Investment in knowledge depends on rate of return. There is not much literature on the supply side of institutional change. Institutions change due to demand and supply side factors. It is the profit/ utility maximization motive that leads to change in institutions.

In the Marxian framework, Marx talks about mode of production. (For one's knowledge, one must read 'mode of production debate). In the mode of production, one has forces of production and production relations. There are 5 modes of production: primitive communism, slavery, feudalism, capitalism, socialism and communism. Forces of production are nothing but factors of production and technology. Technology is the operative knowledge of the factors of production. Production relations are determined by distribution of the means of production. Forces of production determine production relations. Production relations are nothing but institutions. The contradiction between the production relations and forces of production lead to transition from slavery to feudalism. So, this leads to a new mode of production. Institutions are created which are economically efficient.

Labour market efficiency is possible when there is a market situation which closely resembles perfect competition. There are certain characteristics of a labour market. There are large numbers of labourers and there are large numbers of employers. There is perfect information of wage. Productivity of labour is identical. There is no restriction on entry or exit. This situation leads to competition, which determines competitive wages. Competition between factors of production leads to competitive remunerations. Economic outcomes will then be optimum.

In an imperfect market situation, one can find monopolist or monopsonist. Any imperfect market is a sort of market failure. There are other situations of market failure. Informal institutional set-up can favourably or unfavourably make an impact on economic transactions. In the Indian situation, the role of caste system in the working of the market has been analysed by many economists.

Caste-system is an economic organization, which determines rules of production and distribution (factor distribution). They recognize features: (a) Caste-system rewards distribution of occupation across the social groups. The property-right is pre-determined by caste. (b) Caste-system notably determines division of property rights but it fixes those rights to the ownership by different social groups. (c) It not only divide the property rights and restricts its ownership but encourages unequal distribution. Caste division involves division of labour.

(a) Brahmin-Right to education
(b) Kshtriyas—Right to enter army but not education
(c) Vaishyas—Right to trade but not education
(d) Shudras—agriculture—right to land but not education
(e) Untouchables—No right to anything but only to serve the above four

Akerlof has not gone for economic foundation but only features of caste-system.

The features of perfect competition are:
(a) Large numbers of buyers and sellers
(b) Perfect information (zero transaction cost)
(c) Free entry and exit
(d) Homogeneity
(e) Perfect mobility

There is no perfect mobility of factors of production since under the caste system occupation and property rights are fixed. Investment across the occupation is not allowed under the caste-system. It brings segregation in the market particularly in the sellers’ side. There is not a single homogenous market. There are specialized, fragmented and segregated markets. Since capital mobility is not allowed, so it leads to no factor price equalization. Knowledge is not allowed to spread because there are social barriers. All these lead to imperfect market situation. Ultimate economic outcome is not Pareto-optimal i.e. production level is less and cost associated is high. Wage differences exist in the labour market. Rate of return if high in one sector would not lead to mobility of either labour or capital. So, caste system leads to inefficient outcome. Neither land nor capital is mobile. So Akerlof, Scoville, and Lal argue that economic outcome is economically inefficient under the caste-system. Caste-system never promotes optimum results.

There is an element of social ostracism/ punishment or penalty. The informal rules of property rights/ occupation if challenged will lead to punishment. So, there is an in-built enforcement mechanism. It is a very cost-effective mechanism. Social boycotts are tools to enforce social rules. All these features operate in all the markets i.e. labour, land, capital, entrepreneurial and consumers markets.

One must know that 97% of untouchables do not own land in Punjab because a caste law is converted to formal law by the Britishers in 1901 that jats can only own land for cultivation in Punjab.

There is restriction on the mobility of labour from one sector to another. Voluntary unemployment takes place due to social restrictions on the mobility of labour. People do not take others’ occupation because of the feeling of dignity.

George Akerlof and Deepak Lal argue how economic dimension function leads to imperfection in the labour market. Market imperfections come from immobility of factors of production. For a competitive market, mobility is the necessary condition. Caste-system involves economic discrimination in the market of certain groups, which brings imperfection in the factor market. In fact, restrictions on the mobility of factors of production is effected through discrimination. Economic discrimination is also found among gender and race (according to Baker). Economic analyses of neo-classical economists lead to the conclusion that caste-system lead to economic discrimination.

According to the Marxian approach, caste system is an economic institution. Economic structure determines the social structure. At a larger level, all institutions or social relations are determined by class relations. Caste-system which include norm, culture etc. is determined by economic structure. Social aspect of caste-system (superstructure) is basically determined by economic foundation (base). Differences between high and low caste is the difference between high and low class. Caste is determined by class-status. Role of the ownership of property is used to explain the caste-system. Marxists won’t talk about efficiency but would definitely talk about exploitative/ equity aspect of the caste-system. To change the social structure, ownership structure of the caste-system needs to be changed.

Like neo-classical economists, Ambedkarians say caste-system is a production organization and a distributive system. Caste-system specifies the property rights of individual group, which is unequal. Property rights distribution is pre-determined. Caste system put restrictions on the mobility of the factors of production. Neo-classical economists argue that social ostracism is used to control the caste-system. But Ambedkar makes two additional points—occupation is not only fixed but there is dignity attached to the occupation. There is a concept of dignity of labour which has its implications on efficiency. How the superstructure affects the base is not explained by Marxists. Ambedkar argue that there is inter-relation between Hindu ideology and the caste-system. The religious principle of Hinduism forms an ideological base for the economics of caste-system. Both Lal and Ambedkar have argued like this. Like Islam, in the caste-system the moral economic principle is strengthened by the religion. (However, one should not forget that in Islam, there is ban on interest rate on loans). Religious principles are not positive in nature: (i) It is not efficient; (ii) It does not promote equity.

Caste system does not promote growth and efficiency. Neoclassicists look at the caste-system from the aspect of labour market efficiency. Even Lal focuses on labour market. But Ambedkar went beyond labour market. Caste system put restrictions on whole lot of things. There is a restriction on the land market. Trading community and shudras are not allowed to own land in Punjab. There are restrictions on capital flows. Caste system involves specification of all property rights. Caste system is not confined to only labour market. Caste-system brings economic inefficiency in all markets. So the system is inefficient at the macro-level.

Lal says that caste system provide second best Pareto optimality (which is a sympathetic stand against caste-system). But Ambedkar says that not only labour but capital too is not allowed to flow. The system is totally inefficient. That is why monopolies are found. People from higher castes suffer from voluntary unemployment as they do not take low dignity occupations. Non-voluntary unemployment is faced by low caste. Unemployment rate is high among low castes. No Indian economist has theorized the caste-system. Economists have not applied their minds but political scientists and sociologists have. Notion of dignity of labour affect efficiency. Under the caste-system, social status is determined by economic occupation. Occupations are prioritized. Education is good but scavenging is bad, as per the Hindu ideology. So, people involved in scavenging are considered to be unclean. Concept of purity and impurity is attached to one’s occupation. In the Western society, this dignity aspect is missing. But in India, scavengers live differently. If by doing a particular job the status goes down, then this definitely affects economic efficiency. The incentive to work decreases. This is called work shrinking i.e. not working efficiently because of the stigma of social discrimination, which affects production. People from low caste are excluded from better off jobs. Dignity leads to inefficiency. By and large, neoclassical economists are involved only in efficiency and not in income distribution. Some Indian intellectuals talk about wage, unemployment and inefficiency. General argument is that the caste system as an economic organization is based on the principle of economic inequality.

Economic inequality is the basic ideology. Certain groups are more privileged than others. Untouchables as a matter of fact do not have the right to own property. Their job is to serve the upper castes. Economic inefficiency leads to economic inequality, according to neoclassical economists. The actual mechanism of economic inequality has not been examined by the Marxists and the neoclassical economists. Economic inequality has not crept into the caste-system accidentally from history. Caste-system itself is based upon inequality. That is why there is wage discrimination.

[Based upon the class lectures delivered by Prof. Ravi Srivastava and Prof. S.K. Thorat, Centre for the Study of Regional Development (CSRD), School of Social Sciences, Jawaharlal Nehru University].

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