edinburgh, 17th may 2008the emergence of institutions1 1 santiago sánchez-pagés (university of...

Edinburgh, 17th May 2008 The Emergence of Institutions 1The Emergence of Institutions 1

The Emergence of Institutions

Santiago Sánchez-Pagés (University of Edinburgh)

Stéphane Straub (University of Edinburgh)

Edinburgh, 17th May 2008 The Emergence of Institutions 2

Introduction

Coordination failures (opportunism, distrust, misunderstandings) plague even the most basic economic interactions.

In this paper we investigate the emergence of institutions that act as Coordination devices.

We define an institution as a body with the power to enhance the efficiency of economic interactions.


Examples

- Developing economies at early stages.Witnesses in commercial exchange (Attali, 2003),

Informal contract enforcement (Fafchamps, 2004).

- Economies in transition to industrial stage.Japan after WWII, East Asian countries (Aoki et al., 1997),

Transition countries (Johnson et al., 2002).

- Specific marketsUS Cotton market (Bernstein, 2001)

Diamond market (Bernstein, 1992).

The Emergence of Institutions 4

Institutions and coordination failures

Two lines of enquiry:1. Analysis of specific institutions.- Coalitions of Genoese traders (Greif, 1997).- Merchant courts in fairs (Milgrom et al, 1990).

2. Coexistence of formal and informal institutions.

- Reciprocity vs. Markets (Kranton, 1996; Dixit, 2004).- Tribes vs. National states (Ensminger, 1992).

Edinburgh, 17th May 2008


Our contribution

Little has been said on the emergence of institutions.

We model the process through which they may arise.

The emergence of the institution is the equilibrium of a game that agents play in the state of nature.

That is, its emergence is self-enforcing.


Our contributionWe characterize:

The factors that make possible or hinder the formation of institutions.

The level of efficiency at which they arise.We do not to model explicitly its internal

functioning.Still, it is easy to think of enforcement

mechanisms, for instance when applying our model to the emergence of the State.

(more on this later)


The Model

N+1 identical agents with initial endowment ω.

Agents are randomly matched and play a prisoner’s dilemma game.

Payoff are returns per unit of endowment invested.


The Model

- We assume z > x > 0.

- Two strategies: C cooperative, NC not cooperative.

- (NC, NC) is the unique Nash eq. and is Pareto-inferior .

PlayerC

jNC

C x,x -z, z

Player iNC z, -z 0,0


The Model

In the state of nature, agents play the previous game without interference.

Expected payoff is then αx.The parameter α denotes the status-quo

level of coordination or trust.The institution is able to ensure that the

(C,C) profile is played.But someone has to run it…


The Model

One of the agents becomes the centre.She must relinquish the ability to trade.But is compensated in exchange.Agents must pay a fee a ≤ ω to interact

under the centre’s umbrella.Trade certification, dispute prevention / resolution,

reputation management…


Timing

t=1

Participation decision. If none participates, the

status-quo remains.

t=2

The formality fee a is chosen.

t=4

Agents are randomly

matched and play game.

t=3

Formality decisions


Formality decisions

Having observed a, agents must decide whether to become formal or not.

If they become formal, interacting with another formal agents yields per unit return

where xa> 0, xaa< 0 and x(0) > 1/α.The efficiency of interactions depends on the

fee paid to the institution.

)(axvF


Formality decisions

Interacting with an informal agent yields

regardless of your status.Expected payoffs when K ≥ 2 formal agents:

)(axv I

)()(1

)()(11)( axa

NKNaxa

NKKV F

)()( axKV I


Formality decisions

Proposition 1: For a given level of the fee a(i) Informality can be supported in equilibrium for all

a ≥ 0(ii) Full formality can be supported in equilibrium only if

a ≤ a(N)


The procedure of institution formation

Our procedure of institution formation starts with a lottery over the set of agents who freely participate in it.

It determines who will become the central agent.

Reasonable with identical agents.


The fully decentralized procedure

In this procedure, the institution must emerge in the most decentralized way possible.

First, the fee is freely chosen by the central agent: The institution is a revenue-maximizer.

So it will “tend” to set the maximum fee compatible with formality, a(N).



Second, the agent that runs the institution can renege ex-post.

For the institution to arise then

)0()( xcaN



Ex-ante participation constraint given the fee a

because either all agents or none participate in the lottery.

With a(N), the institution arises iff the (stronger) ex-ante constraint is met. It rewrites:

)()()(1

))((1

1 axaxaN

NcaNN

))(())(( NaxcNaN



Proposition 2: If the ex-ante constraint holds, there exists a SPE of the fully decentralized procedure that implements formality under a(N).


Two sources of inefficiency

Corollary 1: There exists a range of parameters for which a potentially welfare enhancing institution does not arise.

This is more likely for economies of intermediate size and relatively high levels of status-quo trust.

High trust undermines the position of the institution.


Two sources of inefficiency

Corollary 2: The utilitarian first best fee can be implemented in a SPE of the fully decentralized procedure only for high enough or low enough levels of status-quo trust α.

When status-quo trust is high, revenue and welfare maximisation are aligned.

Otherwise, the institution arises at a sub-optimal level. The rent associated with being the centre is quite high.


Other procedures

One can consider alternative procedures by relaxing these requirements.

Imposing individual commitment alone has no effect.

Collective commitment alleviates the second type of inefficiency.

First best is achieved only when commitment is imposed in both dimensions.


The emergence of the State

These procedures can be applied to the classic concept of the State as an entity aimed at solving coordination problems.

Our model predicts when such state will emerge and its level of efficiency of its operations.

And endogenizes the rise of a ruler from a population of identical individuals.



A là Hobbes: via a Leviathan, a canonical State with the monopoly of violence who ensures coordination through coercion.

In this context, the ruler/state could enforce cooperation in two ways:



A là Hume: via a political entrepreneur, able to persuade others to take a particular action or change their beliefs about its consequences.


Ideally, commitment should not rely on some exogenous enforcement mechanism.

We consider two ways to endogenize commitment:

1. Threshold strategies.2. Threat of secession.

Endogenous commitment


Secession

The threat of secession can alleviate the second type of inefficiency.

We assume that when withdrawing, groups employ the same procedure of institution formation as the whole society.

Secession can be avoided if N is low enough. And if in addition the level of status-quo trust is

low enough, the threat of secession enhances welfare.


The alternative to institutions

Implicit mechanisms in repeated games: Folk Theorem applies.

Can this type of results be obtained in games with random matching and when players have limited information about others’ (past) behaviour?

Yes, under certain assumptions.Information is crucial.


Relation-based vs. rule-based enforcement

Relation-based: Exchange between pairs of members of one homogeneous group ; enforcement is multilateral (norms, communication).

Rule-based: Groups exist, but trade may be between strangers; enforcement is bilateral.

We have focused on the rule-based case (relevant in larger groups) and tried to explain why/how some agents specialize in being institution /judge, etc.


Conclusions

We have presented a model where an institution emerges as the equilibrium of a game played in the state of nature.

The institution may not emerge despite being welfare enhancing

This happens for intermediate population sizes and high levels of status quo trust.

But even if it emerges it can do it at a suboptimal level.


Conclusions

Only full commitment at the individual and social level can avoid this.

Secession has two effects:1. To efficiently tame the central agent.2. Inefficient proliferation of institutions.

In future research we intend to explore the effect of endowment heterogeneity.

edinburgh, 17th may 2008the emergence of institutions1 1 santiago sánchez-pagés (university of...

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