Institutions as Instruments of Social Welfare

Abstract

Since the emergence of New Institutional Economics movement, the study of institutions have regained prominence in the field of economic studies. There are three main tenets of institutional economics. First, institutions matter when it comes determining outcomes by guiding interaction among the members of the society. Second, there is a definite link between the welfare of a society and the institutional arrangements that are prevalent there. Basically, institutions act as instruments of welfare. Third, it has been observed that not all institutional arrangements work. Some institutions have performed better than others. The question that this paper tries to address are what is the exact procedure through which institutions improve welfare and why certain institutions work and others do not. With the help of a hypothetical example of an uncertain situation the process of institutions is described. A formal model of the process is then developed which is used to derive efficiency conditions for any institution.

Notes

1 For more on this see introductory chapter of the book New Institutional Economics A Guidebook by Joskow (2008)

2 X could also refer to a bundle of various commodities. For example, X could be comprised of food, clothing, shelter, etc. The interpretation of X either as a single commodity or as a bundle of commodities will not affect the analysis.

3 It is not necessary to make this assumption but doing so would make further analysis much simpler.

4 Note that this assumption is not too unrealistic. While it is true that configuration 4 is the Nash equilibrium, it however does not mean that other configurations were not played out in this strategic situation. It is possible that other configurations were played out which would have allowed individuals to gather information on the other individual individual’s full production capacity.

5 This is because producing output level of 93 necessarily implies that individual 1 has forgone investment in appropriation. Remember, the maximum output that individual 1 can produce after investing time in appropriation is 60. A fact, that will also be known to individual 2 since we have already assumed that each individual has the capacity to learn about the other individual’s production and appropriation capabilities.

6 As was mentioned before this belief could be generated through an external agency imposing restrictions on appropriation which will be akin to a formal institution. The important point here is that as long as the belief that other individual will not engage in appropriation there exists a possibility of moving towards a socially desirable outcome.

7 This example is taken from Chapter 3 of the book A Cooperative Species: Human Reciprocity And Its Evolution by Bowles and Gintis (2013)

8 In this case $\sum L$ will take 4 values. It will be zero when no individual follows the institution. The second possible value of $\sum L$ will be when only individual 1 follows the institution and individual 2 does not, which is $L_1.$ Third possible value of $\sum L$ will be when only individual 2 follows the institution but individual 1 does not, which is $L_2.$ And finally, the fourth possible value of $\sum L$ will be when both individuals follow institution, which is $L_{1+2}.$ Of course, for n = 3 $\sum L$ will take 8 values, for n = 4, $\sum L$ will take 16 values and so on. Note that $\sum L$ ∈ [0, -∞).

9 One can even take $\underset{¯}{\gamma }$ as zero implying no utility before emergence of institution.

10 The assumption of linearity is taken only for the sake of simplicity. The conditions for the other two cases – increasing at increasing rate and increasing at decreasing rate can also be derived.

11 It is recognized that the question of whether or not the risk of death due to cirrhosis is low or whether or not the proportion of population suffering from alcoholism is small is very subjective and could differ across society.

12 One can interpret social engineering schemes as nothing but changes in institutional setting

13 Interested readers may refer to Sheila Fitzpatrick’s book Stalin's Peasants: Resistance and Survival in the Russian Village after Collectivization.For more information on resistance strategies that the peasants adopted to counter the State policy of collectivization (Fitzpatrick 1996).