Dr Zhen YeThe University of HertfordshireBusiness School

Evolutionary and Institutional EconomicsEvolutionary and Institutional EconomicsLecture 1 Emerging Paradigm and Applications

Xiamen University The School of Economics April 2007

Postgraduate Lecture Series

Source: http://www.mbari.org/expeditions/EasterMicroplate/images/EasterCruise.jpg

The Easter island puzzleThe Easter island puzzle• Jared Diamond “Collapse:

how societies choose to fail or succeed” (2005)

• Giant statutes in a remote island on the south Pacific, about 2000 miles west to the Chilean coast

• Site of human society and early civilization which has collapsed

• What has caused the collapse of the Easter island society?

• What lessens can we learn?

Source: http://www.ianandwendy.com/OtherTrips/SouthPacific/Easter-Island/Rano-Raraku-9.jpg

Structure and learning outcomesStructure and learning outcomes

• Structure– Lecture 1: Emerging Paradigm and Applications– Lecture 2: Evolutionary Theorising of Economic Change– Lecture 3: Applying Evolutionary and Institutional Theories

• Learning outcomes for lecture 1– Provide an overview of evolutionary and institutional

economics – Understand the key concepts of new institutional economics

(NIE) / transaction cost economics (TCE)– Be able to apply transaction cost economics concepts in the

analysis of business venture

What are institutions?What are institutions?• The rules of the game of a society (North, 1997)• Systems of established and embedded social rules that structure

social interactions (Hodgson, 2006)• Giambattista Vico Sienza Nuova 1725 (ibid.) Latin roots:

instituere ， in + statuere : to make stand; similar French usage • Institutions ＝ or ≠ or ≡ 制度 ?• 中文“制度”一词早期用法：“凡将立国，制度不可不察也，治法

不可不慎也，国务不可不谨也，事本不可不抟也。制度时，则国俗可化，而民从制。”《商君书》；另见《说文解字》。

• 现代定义：复旦大学李韦森教授《社会制序的经济分析导论》：“中文的‘制序’概念对应于标准欧洲通语中宽泛含义的‘ institutions’ ”，祥见《从语言的经济学到经济学的语言》。

Questions?Questions?• Why are institutions important?• To what extent economic actions are underpinned by the rules

of the game of a society?• Can an individual learn without a habit of learning? • Can an organisation function without established routines?• Why is the computer keyboard layout follows the sequence

QWERTY? • Why are some production systems more successful than

others? e.g. Fordism versus Just in Time (JIT)• What do we learn from contrasting paths of economic reforms

in China and the Central and Eastern Europe (CEE) ? Experiment versus ‘big bang’

The old and new IEThe old and new IE

• Old institutional economics (OIE)– Thorstein Veblen (1898)– John Commons (1936)

• New institutional economics (NIE)– Oliver Williamson (1975)– Douglass North (1990)

• Evolutionary theorising based on both OIE and NIE – Richard Nelson and Sydney Winter (1982)– Geoffrey Hodgson (1998, 2003, 2004, 2006)

• Common linkage – importance of habit and routines – Organisational routines (Nelson and Winter, 1982) – Individual habit (Hodgson, 2006)

‘‘Routines as genes’Routines as genes’• Would learning and the attainment of skills be possible without

the acquisition of a habit?• Can an organisation function without established routines?• Routines play the role that genes play in biological theory. They

are persistent feature of the organism and determine its possible behavior (though actual behavior is determined also by the environment); they are heritable in the sense that tomorrow’s organisms generated from today’s (for example, by building a new plant) have many of the same characteristics, and they are selectable in the sense that organisms with certain routines may do better than others, and, if so, their relative importance in the population (industry) is augmented over time. (Nelson and Winter, 1982)

Routines as genes?Routines as genes?• Routines operate through the triggering of individual habit.

(Hodgson, 2006)• Habits are the necessary means of avoiding full reflection over

every detail, so that the more deliberative levels of the mind are freed up for more strategic issues. (ibid)

• Reasons and beliefs are often the rationalisations of deep-seated feelings and emotions that spring from habits that are laid down by repeated behaviours. (ibid)

• Habits replicate from individual to individual ； routines replicate from group to group and from organisation to organisation. (ibid)

• Habits are socially acquired, not genetically transmitted. • We should revisit these concepts in lecture 2 with regards to

evolutionary theorising of economic change

New institutional economics (NIE)New institutional economics (NIE)

• Governance structure– Market versus hierarchy (Williamson, 1985)

• Transaction cost – ‘The cost of using price systems’ (Coase, 1937) – The most obvious cost of ‘organising’ production through the

price mechanism is that of discovering what the relevant prices are. (ibid.)

• Dimensions of transaction• Asymmetrical information• Bounded rationality• Opportunism

Bounded rationality & opportunismBounded rationality & opportunism

• Bounded rationality– Human behaviour is ‘intendedly rational, but only limitedly

so’ (Simon, 1961)– Degree of environmental uncertainty/complexity– Recall the importance of habit and routines

• Opportunism– ‘Self interest seeking with guile’ (Williamson, 1975)– Adverse selection as ex ante opportunistic behaviour– Moral hazard as ex post opportunistic behaviour

Critical dimensions of transactionCritical dimensions of transaction

• Uncertainty/complexity & frequency• Asset specificity - the most critical dimension

– degree to which the transaction needs to be supported by transaction-specific asset

– one party may have the incentive to ‘hold up’ the other, e.g. moral hazard

• Incentives change once contract is signed• Importance of credible commitment

– the story of Ulysses and the Sirens– tactics work if the commitment is irreversible or can only be

undone at great cost (Schelling, 1960)

The hostage modelThe hostage model

Party A

Party B

Use non-specialized technology

Hold up

Don’t hold up

(½π, ½π)

(0, -C)

The hold-up threat in extensive form.

Party A

Don’t give in

Give in (0.9π, 0.1π)

Party A’s optimal strategy is to use the less-efficient technology. (Why?)

Party A incurs a sunk cost C once the contract is signed.

Use specialized technology

(¼π, ¼π)

Source: Langlois

The hostage modelThe hostage model

Party A

Party B

Use non-specialized technology

Hold up

Don’t hold up

(½π, ½π)

(-h, αh-C)

Party A

Don’t give in

Give in (0.9π , 0.1π)

The hostage — a credible commitment — is forfeit in the event of contract breach.

Use specialized technology

(¼π, ¼π)

Now suppose that Party B supplies a hostage of value αh before the game begins.

Source: Langlois

The hostage modelThe hostage model

Party A

Party B

Use non-specialized technology

Hold up

Don’t hold up

(½π, ½π)

(-h, αh-C)

h is the value of the hostage to B; α is the fraction of h that has value to A.

Party A

Don’t give in

Give in (0.9π, 0.1π)

A money deposit would have α = 1. But is an in-kind hostage a more credible commitment?

Use specialized technology

(¼π, ¼π)

Source: Langlois

The hostage modelThe hostage model

Party A

Party B

Use non-specialized technology

Hold up

Don’t hold up

(½π, ½π)

(-h, αh-C)

If αh-C > 0.1π, A will choose the more efficient specialized technology.

Party A

Don’t give in

Give in (0.9π , 0.1π)

Notice that if α = 0, hostage h doesn’t seem to affect outcome.

Use specialized technology

(¼π, ¼π)

Source: Langlois

The hostage modelThe hostage model

Party A

Party B

Use non-specialized technology

Hold up

Don’t hold up

(½π, ½π)

(-h, αh-C)

Alternative model: B gives up h as soon as chooses to hold up (but A doesn’t get αh unless he doesn’t give in).

Party A

Don’t give in

Give in (0.9π - h, 0.1π)

Even if α = 0, B has no incentive to hold up A if 0.9π – h < ½π (i.e., h > 0.4π).

Use specialized technology

(¼π, ¼π)

Source: Langlois

Some business applicationsSome business applications

• Drafting of contract and contracting problems– Short term and long term contracting implications– Payoff structure to different parties

• Design of joint venture (JV)– Investment – asset specificity

• Negotiation and bargaining– Military strategies (Schelling, 1960) and negotiation

• Supply chain management– Agency agreement and distributor commitment

• International business – Foreign market entry and mode of entry

CritiquesCritiques• Transaction cost economics relies too much on the

assumption of opportunistic behaviour – What about the role of trust? (Nooteboom et al, 1997)– Too much emphasis on opportunistic behaviour?

• Markets and hierarchies should not be viewed as two mutually exclusive governance structure – Many examples of hybrid organisational forms

• Path dependency and lock in– Why QWERTY? (David, 1985)

• Importance of understanding change and change analysis

Research assignmentResearch assignment

• Evolutionary and institutional theories as “a general theory” on “how to develop specific and varied analyses of specific phenomena” (Hodgson, 1998)

• Research, discuss and develop a case study on the evolution of Yuandang lake ( 筼筜湖 ) and its surrounding economic environment

Source: http://www.xmfangzi.com/htm/xmhnews/20047183339.htm

The evolution of Yuandang lake in XiamenThe evolution of Yuandang lake in Xiamen• 制序演化的当地案例• 筼筜湖曾经是与大海相连的筼筜港。 “筼筜渔火”更是厦门八

大景之一。 70 年代政府围海造田，建成了从浮屿到东渡的西缇，割断了与大海的连接，筼筜港始成湖。 80 ， 90 年代作为刚开发出的新区，筼筜湖畔的几个生活小区曾是市内最不适合生活的小区之一。当时沿湖工厂排放出的大量工业废水和居民排放的生活污水使得原本自然循环的海水发黑、变臭，筼筜湖成为一潭死水。今日的筼筜湖经过多次综合整治后面目焕然一新。是什么原因使得今日的筼筜湖畔成为备受人们欢迎的生活和商务区？ 沿湖的经济环境经历过何种变化？

• 通过调查研究、分析筼筜湖的历史地理及沿湖经济环境的变迁，讨论‘诱致性变迁’和‘强制性变迁’ （林毅夫， 1994 ）过程中政府所起的作用，以及政府、企业行为对资源配置的长期影响。结合相关演化及制序理论探讨筼筜湖畔经济环境未来演变的几种可能。

References and further readingReferences and further reading• Coase (1937) “The nature of the firm” Economica, Vol. 4, November• Diamond, J. (2005) Collapse: how societies choose to fail or succeed

(London: Viking Books)• Langlois, R. “Economics of organisation”

http://vm.uconn.edu/~langlois/e386syl.html• Nelson, R. and Winter, S. (1982) An evolutionary theory of economic change

(Cambridge, MA: Harvard University Press) • Hodgson, G. (1998) “The approach of institutional economics” Journal of

Economic Literature, Vol. 36(1)• Hodgson, G. (2003) “The mystery of the routine: the Darwinian destiny of an

evolutionary theory of economic change” Revenue économique, Vol. 54((2) • Hodgson, G. (2004) The evolution of institutional economics: agency,

structure and Darwinism in American Institutionalism (London: Routledge) • Hodgson, G. (2006) Economics in the shadow of Darwin and Marx,

(Cheltenham: Edward Elgar) • Nooteboom, B. Berger, H. Noorderhaven, N. G. (1997) “Effects of trust and

governance on relational risk” Academy of Management Review, Vol. 40(2)

Key References (continue)Key References (continue)• North (1990) Institutions, institutional change and economic performance,

Cambridge: Cambridge University Press • Schelling (1960) The strategy of conflict, Cambridge: Harvard University

PressSimon (1961) Administrative behaviour (2nd Edn) New York: Macmillan

• Williamson, O.E. (1975) Markets and hierarchies: analysis and antitrust implications, New York: Free Press

• Williamson, O.E. (1985) The economics institutions of Capitalism: firms, markets, relational contracting, New York: Free Press

• Williamson, O.E. （ 2000 ） “ The New Institutional Economics: Taking Stock, Looking Ahead” Journal of economic literature, Vol. 38(3)

• 林毅夫《关于制度变迁的经济学理论：诱致性制度变迁与强制性制度变迁》上海 : 上海三联书店： 1994

• 李韦森 《社会制序的经济分析导论》上海：上海三联出版社： 2001• 李韦森 “从语言的经济学到经济学的语言— 评《鲁宾斯坦经济学与语言 ”》

上海 : 上海财经大学出版社： 2004