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RESEARCH FRONTIERS OF NEW INSTITUTIONAL ECONOMICS

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Professor Claude Ménard


Third National Economic Foundation Forum

Shanghai, May 29 2017



INTRODUCTION

Mr. President of the National Economic Foundation, honorable guests, dear colleagues,


It is a great honor and a pleasure for me to contribute to this third National Economic Foundation Forum and I sincerely thank you for this invitation. From the suggested title for my speech and the title of this Third Forum (The post-crisis economic reflection), it is my understanding that I have to accomplish two complementary tasks: one is to introduce research at the frontiers of the New Institutional Economics (NIE) agenda, the other is to suggest how NIE could help understanding the ongoing economic situation. This is quite a challenge that I will do my best to meet.

 

In doing so, I intend to deliver two central messages. First, I shall argue that understanding the conditions of implementation and enforcement of rules and norms and the institutional devices through which this is done is central for understanding how economies actually work and for solving crisis. Indeed I shall argue that it is in the implementation and enforcement that most actions happen. Second, I would like to show in a very simplified way that New Institutional Economics provide tools to do this.

 

My talk will be organized in three sections. In section I, I will shortly remind you where New Institutional Economics is coming from and its conceptual hard core. Section II will rapidly

 


review recent developments in the branch of NIE focusing on the economics of organization to point out possible micro-economic foundations to malfunctions and crises. Section III will turn to the institutional dimension, in which organizations are embedded, to show sources of institutional misalignment that can contribute to keeping an economy out of equilibrium. Section IV will draw some lessons for economic policies.

 


I: NEW INSTITUTIONAL ECONOMICS: FOUNDATIONS

 

The leading figures (Ronald Coase, Douglass North, Elinor Ostrom, Oliver Williamson) at the origin of the development of the New Institutional Economics program are now extremely well-known, since they all got the Nobel Awards in Economics.

 

Let me just emphasize the variety of their contributions and the numerous field they pollinated, from organization theory to public choices, law and economics, economic history and so on.

 

Leading concepts

 

However, I would like to use the scarce time I have to focus on the conceptual framework that progressively emerged through the research they did or initiated.

 

Figure 1: Concepts: the ‘golden triangle’


 

This conceptual apparatus has been tagged as the ‘golden triangle’ of NIE. The components of this triangle define the (economic) institutional environment framing economies. Let me introduce them very briefly since I will develop them later on. The first corner of the triangle is about rights: more precisely about two types of rights, property rights and decision rights which rarely fully coincide, an important source of potential mismatch and flaws. The second corner is about transactions and transaction cost. Recent developments in NIE suggest a distinction between economic transaction costs and political transaction cost. And the third corner is about contracts. This emphasis on contracts has been criticized. True, they don’t explain everything, by far. However, they provide a good point of entry to the analysis of the role played by rights and transactions; and, by revealing the incompleteness of most contracts they also provide a good point of entry to the analysis of organizations (firms, markets, and interfirm agreements) embedded in institutions.


 

Structuration of the domain

 

These concepts have structured two main branches in the New Institutional Economics program: one focusing on the micro-analytical level at which transactions are actually organized (the organizational level, very much identified to the williamsonian filiation); the other focusing on the macro-level of the political, judicial, and administrative institutions that delineate the domain within which transactions are developed and implemented (a domain much associated to the name of Douglass North and, to a lesser degree, Elinor Ostrom). So let me now turn to a short exploration of these two domains, pointing out aspects that might be particularly relevant for the topic of this Third Forum.

 

II: NEW FRONTIER IN THE ECONOMICS OF ORGANIZATION

 

Let me first pay attention to the “New Frontier in the economics of organization”, that is, the micro-institutional level, the level at which decisions regarding the actual organization of economic activities are made.

 

Understanding the variety of organizational arrangements

 

A major contribution of NIE in that respect has been to pay attention, and to attract attention to the variety of organizational arrangements that structure a market economy (and, in that respect, any economic system). We have learned and we need to acknowledge that there are many different ways to organize transactions. This is not trivial. Even today, if you look at most leading economic textbooks, they characterize economies through a dyad: markets, and the firm, to which consumers provide the background. Identifying other, alternative organizational arrangements has been a long process that is still going on. Acknowledging this diversity has a very important consequence for theoretical developments but also for policy makers: most of the time there is no one single optimal solution for organizing transactions. We live in a world of second, even third best, in which there is NO “ONE SIZE FITS ALL.” A short reminder might be useful here: since I am referring all the time to transactions, let me remind to those of you not familiar with this approach that ECONOMIC TRANSACTIONS are about the transfer of rights to use resources.

 

As it is now well-known, the initial insight on this variety of organizational arrangements was provided by Williamson (1985; 1996). Building on the intuition of Ronald Coase, Williamson made the concept of transaction operational by identifying three leading characteristics (or ‘attributes’ in his parlance) of transactions: the frequency (F) with which a transaction is repeated, the uncertainty (U) surrounding its organization, and the specificity of investments (AS) the transaction may require. But the main point that Williamson made is that we face a major problem here: if you have to choose a modality to organize a transaction (say, outsourcing the supply of a strategic input), you face the problem of finding the right alignment between this organizational choice and the attributes of the transaction at stake. Hence the possibility of a misalignment that can generate discrepancies, even a ‘crisis’, at the microeconomic level. Let me briefly mention two examples: (1) a classical reference is about the potential mismatch between coal suppliers and producers of electricity in the energy sector (Joskow, 1985; 1987); (2) a much more recent example is about the organizational maladaptation following the emergence of the new technologies of information and communication, as vividly illustrated by the so-called ‘uberization’ of our economies.

 

Since the task I have been assigned is to look at ‘new frontiers’ of NIE, let me point out what I consider the major development of the last two decades when it comes to the economics of organization. It might be summarized as the revisiting of the attributes (characteristics) of transactions, mainly Uncertainty (U) and Specificity of Investments (AS) in association to the allocation of rights. In sum, we are looking simultaneously at two corners of the ‘golden triangle’, with a special attention to the distinction between property rights and decision rights.

 

Property rights (PR) are hereafter identified as the capacity of the holder of these rights to be residual claimant and to control the transfer of rights needed to organize transactions. In other terms, the residual claimant is the one WHO in last resort control what to do with available resources and who determines the conditions under which rights over these resources can be transferred. An example is the decision to develop a joint venture between two otherwise independent and even competing firms.

 

By contrast, decision rights are about HOW rights to use are going to be actually exercised, and/or about the procedures through which decision-makers can operate. The central example (and a key issue in developed economies) is of course the rights allocated to managers to reorganize tasks within the rules defined by holders of property rights (or some of them!). A great virtue of NIE in that respect is to have introduced the key role of managers in our theoretical economic landscape.

 

Capturing the variety of organizational arrangements: a framework

 

We can now put these ingredients together and provide a general framework to capture the resulting variety of organizational arrangements.


 

 Figure 2: The Variety of arrangements conceptualized


 

On the horizontal axis, we have the intensity at which property rights are put together (centralized) depending on the strategic intensity of investments (from low to high). On the vertical axis, we have the intensity of decentralization (or ‘delegation’) of decision rights, again from low to high. Combining these two dimensions delineates the domain of possible organizational arrangements. The upper curve delineates the ‘possibility frontier”, above which the organization of transactions would be unsustainable if we take into account the characteristics of these transactions (e.g., the uncertainty surrounding their organization is just too high). The lower curve delineates the domain under which transactions tend to become hardly tractable or push towards the adoption of pure forms (pure ‘spot’ markets, pure ‘hierarchies’), which tend to be rather exceptional, contrarily to the prediction of standard theory.

 

Most transactions are actually organized within the lens delineated by these two curves. This lens (the ‘acceptance zone’) is the domain of relational contracts (the third corner of our ‘golden triangle’), that is: the domain within which contracts are incomplete, providing only a framework, a blueprint within which parties to the transactions adjust mutually (through the role of managers; or through arbitration; or through court decisions, etc.). This is also the domain within which hybrid arrangements tend to prevail. The existence and significance of these hybrid arrangements, that is: organizational solutions that are defined neither by pure market relations in the usual sense (with the price mechanism at the center of coordination) nor by pure ‘firms’ in the usual sense (with hierarchy at the center of coordination) is in my view a major breakthrough in modern economics of organization. Hybrids can be defined as the organization of transactions among legally autonomous entities that keep their property rights separated and share some decision rights because it is the best way to create added value: only joint usage can deliver an extra benefit.

 

The case of cooperatives

 

Let me illustrate with the example of cooperatives. Cooperatives play a very important role as a modality to organize transactions in developed market economies. In some countries (e.g. Finland) it is even the dominant form that entirely structures the economy. For example, the number of cooperatives in the German-energy sector has grown dramatically over the last 10 years.

 

 Figure 3: The example of energy-cooperatives


 

The case of these energy-coops is illustrative because their development is connected to two crucial components of the NIE framework. Indeed, it is the result of: (1) changes in the nature and specificity of investments (in this case related to technological changes, as is often the case: the emergence of new technologies –from solar panels to smart grids-) allowing more decentralized organizations to deliver energy; (2) changes in institutional rules of the game (in this case changes in the German fiscal regime to facilitate ‘renewable energies’). Moreover, the characteristics of cooperatives make them homothetic to the concept of HYBRID.

 

There are many other examples of HYBRID arrangements that could be developed: (1) franchising, which now represents a ‘heavy weight’ in distribution (but not only!); (2) strategic alliances (that now dominate the airline industry); (3) Plural forms (when a firm diversify the type of arrangements on which it relies for getting supplies, as in the automobile industry –the so-called ‘Toyota’ model-, in agri-business, etc.)

 

Some consequences for economic policies

 

This variety of organizational arrangements has important consequences for economic theory (the need to revisit the dualism of ‘markets’ and ‘firms’ (hierarchies)); but also for economic policies, e.g., revisiting competition rules (ex.: are strategic alliances falling under ‘collusion practices’?), fiscal regimes (see the case of cooperatives already mentioned), labor laws and ‘liability’ (in a franchising system, who is responsible: the franchisor? Or the franchisee?)

 

III: NEW FRONTIERS IN INSTITUTIONAL ANALYSIS

 

These issues bring into the picture the other dimension of the New Institutional Economics research program: the institutional embeddedness of organizational arrangements, e.g., the judiciary, the polity, the administrative setting.


 

 Figure 4: Political institutions illustrated


 

Institutional embeddedness: guiding principles

 

In that respect we have gone much further than simply stating that ‘institutions matter’ (do remember that the idea that institutions matter was long ignored in economic theory or considered not belonging to its domain). First, it is now accepted that organizational arrangements, including markets, are deeply framed by and embedded in their institutional environment. Second, it is increasingly acknowledged that this institutional environment is not a homogenous gelatin in which all transactions would be soaked, but that it is composed of intricate layersThird, recent developments suggest that the interactions among these institutional layers (and between these layers and the technologies) involve the existence of ‘critical functions’. Critical functions are those requirements that some transactions must meet in order for economic activities to be sustainable.

 

Some consequences to our understanding of economic systems

 

These achievements have important consequences if we want to better understand gaps, flaws, even crises in the running of economic systems. For example, properly identifying the critical functions might be decisive to adapt … or fail to adapt to changing circumstances.

 

Let me illustrate very briefly with two examples. At the micro-level, consider the running of a railway system. In that sector, inter-operability is central to meet passengers’ expectations … and to avoid crashes. On the technical side, there is the need to coordinate and properly maintain the signaling systems (there are several signaling systems involved in the running of THALYS between Paris and Amsterdam); on the institutional side, there is the need to implement appropriate institutions to coordinate (e.g., who is going to allocate the slots between Paris and Amsterdam if competition is going to be introduced, and according to what criteria).

 

At the macro-level, there is also the risk of a mismatch between the general rules of the game and the actual organization of transactions by operators. For example the rules of the game in the energy sector, largely built in the context of centralized systems that prevailed until now are less and less well adapted to the complex requirements of interdependent and technologically heterogeneous sources of energy (e.g., the coordination of wind farms, solar energy, hydro, etc.), which impose a different technological architecture.

 

There are two major consequences here. First, mismatches among institutional layers and/or between institutional rules and technologies (and the potential gaps in their mutual adjustment) can be the source of major crises. Second, if we refer to the distinction between property rights and decision rights, the mismatch between these two vectors of rights might generate major political transaction costs. Political transaction costs, a concept introduced by Douglass North, Barry Weingast and others, are the costs of reaching and stabilizing a coalition among constituencies with different, diverging, even conflicting interests. Illustrative are the difficulties faced by the implementation of the so-called ‘public-private partnerships’.

 

The initial insights on these issues were largely provided by Douglass North (1981, 1990, 2005, 2009) and to a lesser degree of influence, Elinor Ostrom (2005). Although defending a different approach, the influential contribution of Acemoglu and Robinson (2012) also goes in this direction, in which the focus has been on a dyadic approach, looking at the interaction between what North called the ‘institutional environment’ (defining the ‘rules of the game’) and the organizations and individual actors (identified as ‘the players of the game’).

 

A general model of institutional interactions

 

Ongoing researches provide a much more complex representation of these interactions. This figure summarizes the set of interactions that have been identified in recent literature. It is out of question to comment this framework extensively in the short time allocated. Let me just emphasize two aspects.

 

 Figure 5: A general institutional framework



 

First, there is the increasing awareness of the necessity to take on board technologies in their interaction with institutions: if we have entered into a new ‘industrial revolution’ (and I think we have), there is the imperious necessity to look at how this can transform existing institutions. Second, in that perspective it is essential to disentangle the concept of institutions. In particular there is a layer that has long been ignored by institutionalists (whatever their approach and school of thought), which is the institutional intermediate between the level at which general rules and rights (and the modalities of their allocation) are defined, and the level of organizational arrangements (markets, firms, hybrids) through which transactions are actually implemented. I suggest identifying this intermediate layer as meso-institutions. Meso-institutions are the set of devices and mechanisms through which specific rules (embedded in the general ones) are delineating the domain of transactions that are possible and allowed and the modalities of their enforcement.

 

The missing ling: meso-institutions illustration and functions

 

Illustrative of these meso-institutions are the following: (1) public bureaus, for example CALTRANS, the department of transportation in charge of organizing and monitoring the road system in California; (2) regulatory agencies, for example authorities in charge of regulating telecoms; (3) specialized courts, for example courts monitoring labor relations, thus impacting the allocation of decision rights in employment relationships; (4) arbitraging organizations, such as the Stockholm Chamber of Commerce arbitrating litigation in international contracts among private partners.

 

What these diverse forms share is their central role in linking the general rules of the game and the actors operating within these rules through three major sets of functions.

 

 Figure 6: Meso-institutions functions with respect to rules and rights


 

First: meso-institutions translate, adapt, and allocate rights. For example, once the European Union has decided to introduce competition in the railway system, there is the need to install an entity (it can be a bureau, an independent agency, etc.) to allocate rights to use (which company is authorized to compete!) and to allocate slots. Second, meso-institutions are the central node for the implementation of theses specific rules and rights: hence the importance of their properties (e.g., do they have the potential to investigate, the right to penalize, etc.). Third, meso-institutions play also a crucial role in monitoring the actual running of the system (e.g., checking that safety standards in the delivery of drinkable water are met) and providing adequate incentives (e.g., adopting the right tariff system).

 

Why meso-institutions matter: the case of public utilities

 

I would have like to illustrate the key role of these meso-institutions through the analysis of their status in the running of public utilities, using the theoretical framework introduced above.

 

 

Unfortunately, I don’t have time to do so. Let me just mention that there is a growing literature on these issues, and that important research projects are also developed in that perspective (e.g., at the OECD, at the National University of Singapore, etc.)

 

 

IV: IMPORTANT LESSONS AND ORIENTATIONS

 

Let me conclude by what I consider to be the main lessons learned from the rich development of the New Institutional Economics research program.

 

Bridging the gap

 

First and above all, there is the increasing awareness of the need to fill the gaps:

 

(1) between ‘markets’ and ‘hierarchies’ (firms): indeed, there is a whole set of organizational arrangements – hybrids- that differ from these two categories, sharing some of their properties and diverging on others. As rightly emphasized by Ronald Coase, these arrangements might well be the prevalent form for doing business;


 

(2) between the general rules defined at the macro level of institutions such as the political system or the judiciary and the actual operation of transactions implemented by entrepreneurs and actors –the central domain of meso-institutions.

 

Revising economic theory

 

The point I wanted to emphasize in this rather conceptual presentation is that this is where most action is happening. If it is so, we need a deep revision of some fundamental components of economic theory. Acknowledging the existence and importance of hybrids requires revising organization theory, industrial organization, and, more substantially, our micro-economic theory. Acknowledging the existence and importance of meso-institutions requires much more attention to a revised version of political economy (taking on board political transaction costs), the law and economics approach etc.

 

Impact for economic policies

 

Again, I want to emphasize that hybrids and meso-institutions is where most actions happen. If it is so, there are important consequences for economic policies. Illustrative is the need to an in-depth revision of competition laws and guidelines to make room for hybrid arrangements; or the need to better take into account the role of meso-institutions in adapting general rules to specific organizational arrangements and specific technologies, for example allocating property rights and decision rights in public-private partnerships.

 

V: CONCLUSION

 

New Institutional Economics does not pretend to provide answers to all these complex issues. But it provides substantial support for going further in our exploration of these questions. It does so by:

 

- Providing conceptual tools, as I have illustrated with the ‘golden triangle’.

 

- Providing a rich and integrated framework of analysis, as I have illustrated with the figures summarizing what we have learned about the diversity of organizational arrangements and the need to disentangle institutional layers.

 

- Delivering results through substantial empirical contributions.

 

- Opening a research program that hopefully can attract an increasing number of researchers, particularly young ones.

 

Indeed, beside the necessity to continue enriching this theoretical framework, there is the need to face a major challenge in NIE: how to make progress from already very substantial conceptual developments towards measurement, an issue lacking behind.

 

 

published version:

2018--Research Frontier of NIE--RAUSP & REV MAN--V2.pdf





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