INTRODUCTION TO INSTITUTIONAL ECONOMICS

1. The Big Picture

Framework for analysis of connection between choice-coordinating institutions
and the performance of the economy. Alternatives range from the market with
alternative property and contract rules to government enterprise and commands.
Role of formal and informal institutions.
Property as Power and as EconomizingInstitutions as constraints and as
enabling. How paradigms affect what you see, what you question.
Eggertsson, Thrainn, Economic Behavior and Institutions. (1990), Ch. 1. Also see
Foreword and Preface.
2. Institutions & Organizations "Organizations (firms), Institutions and
Boundaries"
b. Simon, H. "Organizations and Markets," J. Econ. Perspectives, 5:25-44 (1991).
(Available from JSTOR)
c. Hodgson, G. "Evolutionary & Competence-Based Theories of the
Firm," Evolution and Institutions, (1999), 247-275.
3. Institutional Change
a. North, D. Institutions, Institutional Change and Economic Performance, (1990)
b. Bowles, Chs. 11-13 (optional, see study notes)
4. CAN WE PREDICT THE CONSEQUENCES (PERFORMANCE) OF
ALTERNATIVE INSTITUTIONS?
Experimental Economics
Vernon Smith won the Nobel Prize for his work on experimental economics. In
his article, "Theory, Experiment and Economics, J. Of Economic Perspectives,
3(1): 151-69 (1989) (JSTOR) he contrasts what can be learned in field and
experimental tests? On p. 154, he argues the advantage of experiments over
field data. Are you convinced?
"Institutions matter." 156 This is the main message of these experiments. This
may explain why Smith has attached the Economic Science Association meetings
to those of the Public Choice Society.
Smith suggests three parts to a theory so that it might be tested: environment,
institution and behavior (153). His conception of environment includes all agents'
characteristics, and for him this is primarily preferences whose essence is
expressed in willingness to pay or accept. Preferences are fixed and not learned
in the context of the game. Does this fit what we know about how the brain
works?

His conception of institutions include the language of communications--examples

of language include bids, offers and acceptances. Institutional rules specify when
a communication is converted to a contract. (I don't think he is referring to the
amount of the bid itself which he categorizes as behavior.) Also included in his
category of institutions are the characteristics of the commodity, which he seems
to include implicitly (see below on HEC and HIC). This seems a strange mixture-are not institutions something that is a variable open to human choice while the
characteristics of a commodity are fixed by physics and biology? He also includes
"rules under which messages become contracts and thus allocations." If the legal
foundations of an economy were so simple we wouldn't have much to do. "The
order in which economic agents move" sounds so innocent.
"Behavior is concerned with agent choices of messages or actions given the
agent's characteristics (environment) and the practices (institutional rules)
relating such choices to allocations." He wants to test the assumptions of
maximization of utility, risk aversion, and Bayesian learning (as opposed to
bounded rationality, gamblers, and selective perception in the face of cognitive
dissonance?).
Smith categorizes "behavior" as the agents's choices of messages or action. The
examples of utility maximization and risk aversion make sense. But I do not
understand him when he illustrates behavior as including the "transaction costs"
of thinking, deciding, acting. Makes sense if it refers to the acts of cognition.
"Theories of behavior make predictions about messages (bids, offers)..." Maybe
he uses the term transaction costs quite differently than Williamson or Schmid.
He includes zero transaction costs as part of behavior though this seems a part
of the environment-characteristics of the good rather than an attribute of people.
His classification seems appropriate in the context of observing that double
auctions come to equilibrium faster than ascending price auctions. He see that
bidders and sellers learn more about the others' demand or supply schedules
faster with the double auction and in that sense transaction costs are less with
one institution rather than another. For Smith, transaction cost and the institution
seem to be the same thing rather than one separable thing interacting with
another. Why is the conceptualization of separability important? If an institution
creates the cost, then change the institution and the cost is gone. But if the cost
is independent of the institution, then the institution may not abolish the cost,
but only change who bears it or who bears the consequences of the cost.
Consider the cost of traders discovering the demand and supply schedules of the
other person. If these schedules were written on their foreheads the cost would
be cheap, but they are not. (It reminds me of the difference between blood and
shirts--information on blood quality is harder to determine than for shirts.) So the
information cost seems inherent in nature. When this HIC situation is then
combined with different institutions such as Dutch or English auctions we can
observe how quickly both parties learn these schedules and reach a trading
agreement. Smith observes that the type of auction makes a difference.

Since time is money, a better institution is one that saves money by reducing a
cost. Both parties may gain though one may gain more than another. A reduction
in transaction costs may be Pareto-better, but one must be careful to assume
than all transaction cost is like friction and that all gain by its reduction.
He seems to assume here that all messages are bids (exits) rather than voice.
Footnote 3 is worth studying carefully for how 'value is induced." The subject is
made to have a well ordered preference map (demand schedule), whether that is
the way the person usually thinks or not. Smith controls for commodity
characteristics by making the good featureless and abstract. Smith's 'induced
value' approach means the game is for money only--there can be no attachment
to the commodity or any divergence between reservation and bid price.
Experimental subjects are assigned to be buyers or sellers. Each demander is
given a schedule indicating the redemption value of each unit acquired in a
market period. For example, if the demander acquired one unit, the experimenter
would give the buyer .60, .50 for the second unit, .40 for the third, etc. Each
seller is charged for any units sold according to a schedule. e.g. the cost
schedule might be .20 for the first unit, .40 for the second, and .60 for the third,
etc. So for instance, if at the end of the trading period, the buyer of one unit
could redeem it for .60 and be credited with the difference between the
redemption value and what she paid, assume .45. Thus .60 - .45 = .15 net credit.
The net credit possibility provides the incentive to trade advantageously. This is
the way that characteristics of the commodity are controlled. For this to work of
course, it is implied via the payoff schedules that this is not a HEC good--you
can't get a payoff without trading. Like all auctions, it is assumed the goods
already exist. The problem is not one of investment and decisions involving
immobile assets.
"Much of the experimental literature is guided by nothing more sophisticated
than the static theory that markets will clear." (155) What does this mean when
we observe that a lot of markets do not clear (labor markets being an obvious
case at the moment)?
Smith says most people don't have to calculate to act in a way consistent with
calculation. Market competition means that either (1) those who randomly fall
into the right behavior survive and others do not. (2) a few who do calculate
force the others to approximate their behavior. How square this with Frank who
observes that people who are non-opportunistic (non-calculation of advantage)
are sought by business partners insuring their survival. How relate to Heiner who
suggests because of the C-D gap, the firm with the maximization calculation may
actually make more mistakes? How relate to fact that the people making
mistakes are part of the environment of the smart calculating firm and cause the
calculation to go wrong? Smith attacks Khaneman and Knetsch and their
observations of people regarding market clearing behavior as unfair.
Even if Smith is right on the producing firm side, there is nothing equivalent on
the part of consumers. Consumers who choose fair producers, who try to justify
sunk costs, and regard opportunity cost as different from out of pocket costs do

not perish; they just don't consume as many goods (even if they might have
more utility and wind up less often in mental hospitals).
Vernon Smith's Nobel Prize acceptance speech is "Constructivist & Ecological
Rationality in Economics, AER, 93(3):465,508 (2003).