Institutional Analysis and Decision Making

Dimitar Terziev

Introduction

It is not easy to place New Institutional Economics (NIE) among other social sciences, based on traditional understandings. It includes elements from economics, management, public administration, law and psychology. The Nobel Prize winner Oliver Williamson calls it "Microeconomics of macroeconomics". He, for example, is a professor of Law and Economics. On the other hand, NIE is in a process of dynamic development. We decided to follow the modern point of view, clearly expressed by one of the world famous scientist in this area - Joseph Stiglitz, Senior Vice President and Chief Economist of The World Bank: "To the classical three questions of economics - what should be produced, how it should be produced, and for whom should it be produced - we now add a fourth - how should these decisions be made, and who should make them".

In any case our course is interdisciplinary oriented. It was created by incorporation of the achievements of Decision Theory (DT) and NIE. The formal structure of the process of decision making, the anatomy and classification of the decisions, some mathematical models we took from DT. The new view on market, government and organizational failures, transaction cost approach, problems with externalities, contract enforcement, understanding that institutions are the rules of economy come from NIE. The knowledge common for both DT and NIE are in the field of behavioral characteristics of economic agents (bounded rationality, moral hazard, adverse selection), the problem with information (perfect, imperfect and asymmetric), risk and uncertainty.

As a result we created a course oriented to future entrepreneurs and middle level managers, that will help them to make a profitable decisions on various markets (capital, labor, other) and in various organizations (by type and size) in the dynamic time of transition and economic globalization.

The MBA program of Department of Business, New Bulgarian University (NBU) was built and is developing based on requirements of Bulgarian educational legislation. It's main aims are; a) to improve the students ability for analysis and decision making, b) to apply interdisciplinary approach, and c) to be concentrated on practical managerial skills. It includes of two modules - for students with bachelor degree in economics or management, and for students with bachelor degree in other sciences (non-economists). Both modules are designed according to the state requirements and consist of compulsory (economics, statistics, accounting, marketing, law, management and other studies) and eligible courses. The approximate proportion is 60% of credits from compulsory courses and 40% - from eligible. The course "Institutional Analysis and Decision Making" is included in both modules of the program as eligible course.

There are no any special formal requirements for student participation in the course, out of standard for the program. The module for non-economists is two years long and this course is in it second year, after main basic courses. That is why, the students from both modules come in the course with equal knowledge. The experience of our work in this first semester shows that they need of very strong (not formal) knowledge on traditional (Neoclassical) economics, to be able to understand and estimate the institutional point of view.

Objectives of the course

The academic objectives of the course are:

  1. to show the limit of Neoclassical economics and traditional management science for explanation of the real economic word;
  2. to construct a new understanding for economic reality not only in transitional period, but for modern global economy;
  3. to build a practical skills for making a proper decisions in real managerial situations.

After finishing the course, the students are able to:

  1. consider modern economy as a transaction cost economy;
  2. examine institutional modernization and development as not less important than traditionally used policies, based only on macroeconomics indicators;
  3. apply formal process of decision making;
  4. define critical points of the decision process - problems with information, costs of transaction, behavioral assumptions, asset specificity, risk, uncertainty;
  5. develop and use specific tools for such kind of problems solving;
  6. look at business organizational forms not only from technological point of view, but as an alternatives for economic exchange.

Course Details

I . Economic problems and characteristics of the countries in transition. Traditional models for analysis of transitional development. Failure of the neoclassical economic framework.

Lecture Synopsis

The goal of this lecture is to explain the traditional competitive paradigm (Walrasian paradigm and neoclassical economics), and why it is a poor guide in the process of transition. The neoclassical theory will be present as a big constrained maximization problem, due to the scarcity of resources, and born of it competition. The first point of view is Pareto optimum, as a modern equivalent of Adam Smith's theorem of invisible hand, and it's main result that every competitive equilibrium outcome is efficient. The second point of view is based on the understanding that any specified Pareto optimal resource allocation that is technically feasible can be achieved by establishing of free markets and appropriate pattern of ownership. The last ten years of Central and Eastern Europe Countries Development will be analyzed in the second part of the lecture. The main problems and impossibility to solve them by neoclassical economic theories will be thought.

Seminar Synopsis

The aim of the seminar is to demonstrate in practical way the neoclassical economic framework fails. The main assumptions of the welfare theory will be clarified. Imperfect information, existence of transaction costs, nonexistence of markets for some goods, imperfectly competitive markets, externalities and public goods will be underline as a cases when free market mechanism fails.

Questions and Problems for Further Thought

  1. How is efficiency defined by neoclassical economics?
  2. Give some reasons why issues of efficiency and fairness cannot be easily separated.
  3. What would be the main advice of traditional economists for countries in transition?
  4. What is asymmetric information and how it affects the efficiency? Give several examples on asymmetric information observed in your country.
  5. What would be the best way to privatize state owned enterprises to avoid the problems of asymmetric information in the future?
  6. How are institutions defined? Give examples on informal and formal institutions observed in your country. Give examples of institutions that reduce transaction costs and the ones that increase transaction costs.

II New Institutional Economics (NIE) - history, theoretical foundations and basic definitions. Concept for institutional analysis. New vs. traditional Institutional Economics.

Lecture Synopsis

The goal of the lecture is to present the idea for institutions and the differences between them and organizations. Institutional Economics is constructed from the theory of human behavior and the theory of transaction costs. Following Douglas North institutions are "humanly devised constraints that shape human interaction or as the rule of the game". Institutions are both formal and informal. Formal institutions include the constitution, the written laws, etc. Informal - include unwritten codes of behavior, social norms or conventions. Institutions are created to reduce the uncertainty involved in human interaction, by providing of stability in every day life. They are devised to give structure in human interaction. Yet institutions need to enhance efficiency. There are efficiency reducing institutions too. Institutional frame work provides incentive structure. They determine whether effort will be directed to productive activity or to redistribution. In former case institutional framework will be conductive to economic growth while in the later case it the cause of economic stagnation.

Institutions cannot be equaled with organizations. Organizations are created to take advantage of institutional framework. Institutions give rise to organizations and organizations alter institutions. at margin. Self-motivated behavior combined with barging power of organizations leads to alteration of institutions. this is the base for institutional change.

Institutional economics asserts the traditional assumptions of human behavior are not applicable in each instance. Traditional behavior assumptions are summarized in expected utility theory. NIE states that the motivation of the individuals are not simply to maximizing wealth. some other motives play role too. Moreover, the individuals does not have the capacity to describe the environment. This situation leads to subjective perceptions of reality.

NIE explicitly deals with transaction costs, that are somehow neglected by neoclassical economics. Transaction costs reflect the cost of measuring the attributes of products and services and the cost of enforcing contracts. Transaction costs are the key to creation of social, political and economic institutions.

Seminar Synopsis

The aim of the seminar is to show the way of development of NIE. Briefly will be presented Austrian School (K. Menger), Neoclassical Economics (L. Walras, A. Marshall, A. Pigou, V. Pareto), Traditional Institutionalism (T. Weblen, J. Commons, W. Mitchell), Behavior Theory (H. Simon), Transaction Cost Economics (R. Coase), New Institutional Economics (O. Williamson, D. North).

Questions and Problems for Further Thought

  1. Define institutions and give several examples on formal and informal institutions.
  2. Give examples on productivity enhancing and redistribution promoting institutions.
  3. Formal socialist countries have already created all institutions needed for democracy and market economy. Agree or disagree? explain.
  4. What is the role of institutions in economic development?
  5. Why can one observe such divergent paths of economic development between Developed countries and Third World?

III Decision Theory (DT) - economic, management and psychological point of view. The anatomy of decision. Bounded rationality. Heuristics.

Lecture Synopsis

The goal of this lecture is to present modern point of view on the process of decision making. Neoclassical economics does not interest in this process. It considered the firm as a black box, that just follows the market prices. Decision makers and the structure of decision play no role. The modern economic understanding is different. "To the classical three questions of economics - what should be produced, how it should be produced, and from whom should it be produced - we now add a fourth - how should these decisions be made, and who should make them" (Stiglitz).

The students are well familiar with the managerial theory of decision making. That is why briefly will be explained traditional structure (anatomy) of the process: define the problem; identify the criteria; generate alternatives; rate alternatives; compute the decision.

Special attention will be paid on the psychological point of view and the process of judgment in managerial decision making. Decision making with two and more parties will be explained and elements of Game theory avoided. Traditional (H. Simon) and more modern theories on bounded rationality will be discussed.

Seminar Synopsis

The aim of the seminar is to extend students understanding on the human constrains and biases in the process of decision making. Few popular test from Kahnemann and Tversky will be used to show the human side of the process of decision making.

Questions and Problems for Further Thought

As a "homework" one test for defining of preferred way of thinking and working will be given to the students. There duty will be to test a few colleagues or friends, to summarize and analyze the results in short essay.

IV Transaction cost approach and measurement costs of organizations and market in transition. Transactions - a basic units of economic analysis. Main behavioral assumptions and critical dimensions of transactions. Matrix of alternative governance forms.

Lecture Synopsis

The goal of this lecture is to present how the Transaction Cost Economizing approach could be applied to understanding of transitional markets and economic organizations. Transactions between individual agents and costs associate it with them will be made the basic unit of economic analysis. Types of transactions, and structure of costs for market mediation and internal organizations of transacting will be classified. Behavioral characteristics of economic agents such as bounded rationality, opportunism, reputation considerations etc. will be studied and their transitional dimensions determined. Problems with measurement of absolute and relative levels of costs of transacting will be thought. Differential transaction costs will depend on critical dimensions of each transaction and they will be specified as degree of investment in specific to particular transaction capital, and uncertainty surrounding transactions, and frequency in which a transaction occur between the same partners. Various formal and informal market, and private, and third party involvement forms of transactions will be studied as continuum of alternative cost minimizing governance modes for organization of individual transacting. General matrix of effective governance forms will be determined through alignment of attributes of transactions with governance structures in a discriminating transaction cost minimizing way.

Seminar Synopsis

The aim of the seminar is to deepen the transaction cost economizing understanding of existence, evolution, and failure of various market, and private, and public, and hybrid organizations in transition. It will be practiced how to approach and define precisely economic transactions and transaction costs in transitional conditions. Forms of human bounded rationality and opportunism, and other behavioral assumptions for economic agents in transitional conditions will be clarified. Types and degree of transacting uncertainty, nature and character of assets specificity and dependency of transactions, and frequency of recurrence of a transaction will be elaborated. It will be exercised how the matrix of available and cost minimizing governance structures to which transactions might be feasibly assigned in transitional economies will be identified.

Questions and Problems for Further Thought

  1. Why are there various markets and different kind of organizations in a market based economy?
  2. What is a transaction and which costs associate it with transactions could be observed in transitional conditions?
  3. Which types of transactions costs can be distinguished and how they can be measured?
  4. Why the human agents are not fully rational and why do they tend to behave opportunistically?
  5. What are the main critical dimensions of transactions according to which their costs for individuals differ?
  6. What is the potential of available for economics agents governance modes to save on bounded rationality, and to protect against opportunism, and to economize on costs of transacting?
  7. How can we design the most effective forms for organization of transacting, and to fill the matrix of alternative governance modes of transactions?
  8. Why does the Transaction Cost Economizing framework allow to understand better transitional market development, and to improve business and public policy design?

V Contractual economics in the process of transition. Private ordering. Contract enforcement. Law and Economies

Lecture Synopsis

The goal of this lecture is to show how any problem that arises as or can be reformulated as a contracting problem could be examined in a transaction cost economizing terms. Concept of "contractual man" and uncompleted contracting will be introduced. Various governance modes of organization of transactions will be presented as different types of formal and informal contracts. Nature and specificity of different types of contracts determined by the Common and Private Contractual Laws will be elaborated. Control and transaction cost economizing feature of classical, and neoclassical, and rational contracts will be described. Preferable forms of governing of private commercial relationships will depend on critical dimensions of transactions, and on dominant legal system, and on efficiency of contract enforcement system. General structure of modern contracts will be systematized. Ownership will be presented as a special form of contract on residual rights. Firm will be studied as a nexus of internal and external contracts. Private ordering will be pictured as a typical self-enforceable contract. Specific features of employment contract will be distinguished. Factors for domination of strong personal links and interlinked transacting as well as for developing of complex contract agreements such as franchises, strategic alliances, equity linkages etc. in transitional conditions will be clarified. Relationships between optimal contract structure, and development of legal system and social customs will be described. Necessity for an interdisciplinary approach to contract, and for integration of Law and Economics will be justified.

Seminar Synopsis

The aim of the seminar is to extend contractual imaginary of students and to apply it practically to any organizational problem. It will be discussed how in the real life situations economic agents act as contractual men, and different governance modes of transacting take forms of various types of private contracting. Incentive and cost minimizing features of various classical, trilateral, obligation, and ownership contracts will be clarified. Matrix of effective contractual modes for governing of various transactions will be developed according to critical dimensions of trade relations. Specific character of labor contracts will be distinguished, and notion of firm as a web of internal and external contracts will be justified. Factors for failure of comprehensive contracting, and for development of specific transitional structure of optimal contracts will be elaborated.

Questions and Problems for Further Thought

  1. What is nature of contract and which types of real life contractual problems we can distinguish?
  2. Why is it not possible to write a complete contracts?
  3. What are differences between contracting of specific and residual rights?
  4. What types of contracting costs can be distinguished, and what consequences are for the organizational design?
  5. Which are similarity and differences between employment and external contracts?
  6. Which are the cost minimizing features of classical contracts?
  7. When is most efficient to apply arbitration and trilateral contracting?
  8. Why do rational contracting develop?
  9. Which are factors for development of transitional contractual structures, and what are remunifications for designing of optimal private contracts?

VI Institutions, development and economic reform. Collective and Public choice, and political institutions. Economic role of government and international assistance. Economic performance through time.

Lecture Synopsis

The goal of this lecture is to avoid elements of political analysis in studying economics. The role of government in the economy, determination of government policy and explanation of the government behavior has been engaging the attention of economists since the beginning of economics as a science. The roles of government are often divided into four categories: