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The New Institutionalist Economics of the State

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a draft summary of the issue [Mar. 10th, 2004|07:44 pm]
The New Institutionalist Economics of the State
The state is problematic for economics in that it has the power to intervene in markets, much to the consternation of those economists who prefer to only contemplate free markets. Though economists and polemicists enamored of the free market find the state an irritant, all but a few eccentrics will admit that some form of state, even in its minimalist night watchman form is a necessity.

Neoclassical economics frames the state as either the result of an archaic contract engaged in by society, or as having a necessary, though frequently “predatory” relationship to the market. The first form of explanation is related to the study of exchange, portraying its role as a wealth-maximizer for society. The second frames the state as being an agent of the interests of a particular faction in society. Public choice writers see the state as being used by “rent-seekers” in the form of bureaucrats and interest groups. This is in a way similar to the Marxist view of the state as an agent of class interest, though instead of the bourgeois, a New Class of bureaucrats is the agent of redistribution, steering resources to particular interest groups that are its clients.

Principal-agent contracting is considered the core of the New Institutionalist Economics conception of the state. This can take a number of forms. In a democracy, the citizens are conceived as principals and their representatives as agents. The use of force and the adjudication of property rights to increase the general good is negotiated among these parties. This contracting is of course incomplete due to asymmetric information.

Douglass North, for instance, addresses both concepts of the state, as both abetting commerce and stability and also as potentially confiscatory. In his view, the ruler of the state, which is often assumed in his writing to be an individual but also conceivably a government, has a monopoly on the use of violence and on public services. The state also mediates property rights because, “the essence of property rights is the right to exclude.” The ruler exchanges its services with the ruled with taxes serving as a fee. Rival states limit the ability of rulers to act with impunity. Labor supply can be siphoned off, as disgruntled citizens or subjects seek refuge in a neighboring area. This, for instance, checked the confiscatory powers of medieval lords. A more just lord could always attract labor supply away from an unjust neighbor. In essence, subjects could use substitution, when the “price” of their protection rose too high. The savvy ruler could challenge this by applying tax price discrimination, in the form of lighter or non-existent taxes on more organized or powerful constituents (the military for instance).

Other constraints on the ruler’s monopoly power included the high costs of monitoring his agents, tax collectors, soldiers, and public service providers, and the measurement costs of assessing the tax base.

North argues that transaction costs are key to understanding the formation of the institutions that oversee property rights and hence government. “Transaction costs are the costs of specifying and enforcing the contracts that underlie exchange”

Under the neoclassical model the state can be destabilized by various means. The state’s stability is kept by the free-rider problem, or as TK describe’s it in his book of that title, “the rebel’s dilemma.” In North’s formulation the typical actor believes that his efforts at attempting to change the system will make little impact and thus chooses to uphold the status quo. TK applies the reverse of that: the potential rebel weighs the choice of participating in reform activities: protests, activism, voting, letter-writing campaigns, or chooses instead to free-ride on the efforts of more committed rebels. Thus, any change in the state will come from those governing. The ruler has no free-rider problem.

But under the NIE, the influence of transaction costs is put into the model. Exchange has costs and institutions helps minimize those costs. North took transaction costs out of the firm and pondered their impact on the performance of the entire economy. He cites a telling example.

“….as early as the Roman Empire of the first two centuries AD, trade was possible over a vast area, even with the transport costs of the time; and that after the end of the Roman Empire trade declined and probably the well-being of societies and individual groups declined as well. It was not that transport costs had risen, but that the costs of transacting had risen with the disappearance of a unified political system and effectively enforced rules and laws over a large area.”

North argues that the amelioration of transaction costs is a necessary element in economic development. He constructs an example of personal exchange in a tightly knit gemeinschaft society:

“In personal exchange individuals either engage in repeated dealings with others or otherwise have a great deal of personal knowledge about the attributes, characteristics, and features of each other. As a result, the measured transaction costs in such a society are low…..cheating, shirking, opportunism, all features that underlie modern industrial organization theory, are limited or indeed absent, becase they simply do not pay."

Informality and honor mark these forms of society. But they are limited spatially. Such societies must remain insular. Once trade starts to occur with outsiders, transaction costs increase greatly.

The solution was institutions. In modern, geselleschaft societies it was necessary for actors in the economy to be prevented from taking advantage of high transaction costs. These transaction costs are raised by the difficulties associated with: a) measurement of goods, or the performance of agents; b) the size of the market, where repeated dealings or knowledge of the other actor’s characteristics are unknown; c) enforcement, and d) ideology, or conceptions of fairness, which in a world of interpersonal relations will make interpretations of just results to diverge. “As a result in modern Western societies we have devised formal contracts, bonding of participants, guarantees, brand names….In short, we have well-specified and well enforced property rights. The result of all this is that resources devoted to transacting are large (although small per transaction) but the productivity associated with the gains from trade are even greater.”

A special case of adverse selection, as described by Akerlof, can drive good products out of markets, replacing them solely with bad ones. Institutions can be used to hopefully correct such distortions: guarantees, reputation, diplomas, licenses, or certification.

But North cautions that all is not well with modern impersonal exchange. Institutions insure economic predictability, but can be hijacked by groups and used to produce inefficient property rights that favor their interests. In North’s Structure and Change in Economic History, he elaborates on how Madison in The Federalist No 10, hoped that by separation of powers, the system of checks and balances could help prevent such capture of the state’s institutions.

[User Picture]From: highfemme
2004-03-29 03:51 pm (UTC)
Nice intro - would give you a proper comment but not sure what you'd like to discuss. My own work (as a historian) intersects with NIE in that it argues that instiutions compromise information flow where it doesn't fit the form anticipated by existing institutions (imposing an opportunity cost) even as they minimise explicit transaction costs. Institutions reflect the economic and social expectations of the dominant force in society, and can be a spur or a hindrance to increasing economic efficiency accordingly.

What do you work on?
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[User Picture]From: rakehell
2004-03-29 06:07 pm (UTC)
Thanks for the input. Put up whatever you want in terms of comments. I am working on an MA in economics. Right now I am just doing some general reading on NIE to get a grasp of it, and have gravitated towards it's political science applications. Are you in school?
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