ECONOMIES IN TRANSITION

ECON 380Lecture 2

September 3

Overview and Intro to Institutional Economics

INTRODUCTIONS

Dr. Ekaterina Brancato My background Your background

Econ majors?

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OBJECTIVES/COURSE OVERVIEW

• Topics in economies in transition• +Topics in growth• Emphasis will be placed on understanding the

basic material presented in class and supplemented by reading assignments, on improving economic problem-solving skills and on refining writing

• The course will emphasize the role of market institutions in the coordination of international economic activity

• Class meetings will consist of lecture and discussion of assigned readings and related topics

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TEXT AND READING ASSIGNMENTSRequired: Institutional Economics: Social Order and Public Policy by Wolfgang Kasper

and Manfred E. Streit How Capitalism Was Built: The Transformation of Central and Eastern

Europe, Russia, and Central Asia by Anders Aslund +two texts provided via blackboard

Recommended: The Mystery of Capital by Hernando De Soto

In Defense of Global Capitalism by Johan Norberg (2003) The Elusive Quest for Growth by William Easterly (2002) Economic Development (Fifth edition) by E. Nafgizer (2012) The Other Path: The Invisible Revolution in the Third World by Hernando De

Soto; Harper Collins Paperback (1989, 1990 or any later addition) Why Perestroika Failed? by Peter Boettke Markets vs Hierarchies: A Political Economy of Russia from the 10th Century

to 2008 by E. Brancato (2009) From Subsistence to Exchange and Other Essays by Peter Bauer

• THERE WILL BE EXTRA REQUIRED READINGS!!!

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MISCELLANEOUS

Grades Exam format Exam make-up procedures Paper

Presentations Attendance Honour code

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OUTLINE OF THIS LECTURE

Basic definitions What is economics? Short overview

Machlup (extra reading) Institutions

Knowledge I, Pencil (extra reading) Hayek (extra reading)

Fundamental human values

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SHORT OVERVIEW/DEFINITIONS Economics is the social science that studies the

production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek οἰκονομία (oikonomia, "management of a household, administration") from οἶκος (oikos, "house") + νόμος (nomos, "custom" or "law"), hence "rules of the house(hold)". Current economic models developed out of the broader

field of political economy in the late 19th century, owing to a desire to use an empirical approach more akin to the physical sciences.

A definition that captures much of modern economics is that of Lionel Robbins in a 1932 essay: “…the science which studies human behaviour as a

relationship between ends and scarce means which have alternative uses."

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SHORT OVERVIEW/DEFINITIONS Scarcity means that available resources are

insufficient to satisfy all wants and needs. Absent scarcity and alternative uses of available resources, there is no economic problem. The subject thus defined involves the study of choices as they are affected by incentives and resources. Scarcity, as we will see later, becomes an important factor in centrally planned economies.

Opportunity cost

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SHORT OVERVIEW/DEFINITIONS Economics aims to explain how economies

work and how economic agents interact. Economic analysis is applied throughout society, in

business, finance and government, but also in crime, education, the family, health, law, politics, religion, social institutions, war, and science.

The expanding domain of economics in the social sciences has been described as economic imperialism. But really?

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SHORT OVERVIEW/DEFINITIONS Common distinctions are drawn between various

dimensions of economics: between positive economics (describing "what is") and

normative economics (advocating "what ought to be") or between economic theory and applied economics or between mainstream economics (more "orthodox"

dealing with the "rationality-individualism-equilibrium nexus") and heterodox economics (more "radical" dealing with the "institutions-history-social structure nexus").

However the primary textbook distinction is between microeconomics, which examines the economic behavior of agents (including individuals and firms) and macroeconomics, addressing issues of unemployment, inflation, monetary and fiscal policy for an entire economy.

***

The term ‘liberalism’ is used in this course to mean classical liberalism

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SHORT OVERVIEW CONT. WHAT IS ECONOMICS?

First and foremost, a social science At some point in the development of

economic theory there came up a question of how to deal with economics

Mainstream economists Since this discipline involves quantities, deal with

it as with mathematical sciences

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WHAT IS ECONOMICS?

Other economists (notably a group called the Austrian economists) asked What is the nature of the subject? (Menger) Then ask, what tools should be applied? Economics is about the essence and meaning of

value, exchange, profit, entrepreneurship Meaning and purpose, this aspect is not present

in the natural sciences

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WHAT IS ECONOMICS?

From Mises’ Theory and History (1957): “[H]istorical experience is always the experience

of complex phenomena, of the joint effects brought about by the operation of a multiplicity of elements. Such historical experience does not give the observer facts in the sense in which the natural sciences apply this term to the results obtained in laboratory experiments.”

Why?

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WHAT IS ECONOMICS?

The methods of the social sciences must accept the existence of features to their subject-matter that are not present in the natural sciences

What are they? Again, such things as intentionality,

purposefulness, subjective (personal) meanings attached to actions, objects, and interactions

The distinction between intended and unintended F. von Wieser (1914): “Where the natural sciences

can only offer proof, the theory of economics can persuade, it can enlist the unqualified inner consent of the reader.” 15

WHAT IS ECONOMICS?

– F. Machlup, “If Matter Could Talk”– Take molecules. We can only observe, the

matter (molecules) cannot speak for themselves. We develop tools for measurement and apply the tools and test if our hypothesis is right in a laboratory

– But economics has a capacity to look inside the subject matter• You can not get into someone’s mind, but you

can try to guess, since you have a mind of your own similar to others. If not for this, we would not be able to understand each other

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WHAT IS ECONOMICS?

Economics, like social sciences, has a different source of knowledgeThis knowledge is imperfect. Sometimes

people lie or are simply not sure themselves why they have taken one course of action over another

Unintended consequences are inseparable from the intended result

Intentionality has no meaning in natural science

Will and meaning cannot be captured by equations 17

INSTITUTIONSCH 2=>>

What is an institution? It could be an organization founded for a specific

purpose But we are interested in the other meaning: A custom, practice, relationship, or behavioral

pattern of importance in the life of a community or society

Or, simpler, man-made rules that constrain unpredictable and opportunistic behaviour

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INSTITUTIONS

Why does all human interaction require predictability?

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INSTITUTIONS

First, this is linked to lower transaction costs Second, and more broadly, less uncertainty

and opportunism opens opportunities for more efficient uses of scarce resources In other words, people are freer to invent ways of

helping one another and earning income from this, instead of putting up fences

This means improving standards of living for everyone (in other words, economic growth)

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INSTITUTIONS

We have just answered why institutions matter

In our everyday lives we interact with a number of people and organizations that we barely know. Yet, we place a great deal of faith in them fulfilling their expected functions

Modern economic life depends on a number of written and unwritten rules. When those break down, as in an aftermath of a war, or a political crisis, the very foundations of our living standards, our sense of community and security fall apart

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INSTITUTIONS

So, institutions reduce the costs of coordinating human actions and, therefore, are of central importance to understanding human interaction

A large part of the service sector (accounting for almost 70% in OECD countries) is devoted to coordinating human activity – a rising need in complex modern world. Neglecting this fact would be neglecting a very important part of modern economic activity

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INSTITUTIONS

The book correctly points out (p. 6) the disconnect between mainstream economics and business applications. Businessmen rightfully regard mainstream theories as too abstract, barren, and basically, useless to their endeavors

The institutions are critical social capital, ‘software’, so to speak. (I like this analogy!)

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INSTITUTIONS

Institutions are man-made rules, which constrain possibly arbitrary and opportunistic behaviour in human interaction Institutions are shared in a community and are

always enforced by some sort of sanction Without sanctions institutions are useless

Generally, institutions are expected to affect how well people attain their economic and other objectives

Normally we expect people to prefer institutions that enhance their economic well-being and freedom 24

INSTITUTIONS Institutions are supposed to facilitate order. And they

do, if they are effective, however, the outcome may not always be enhancing for the average standards of living.

*division of labor is the main source of economic well-being, does it necessarily happen in all social orders?

Scarcity=>subjective evaluation of alternatives =>economic decisions should be left as far as possible to individuals who know their circumstances best rather than to central planners who are less informed (more on knowledge later in the course)

In this environment, order and trust are appreciated and a sophisticated division of labor is possible. Order-building institutions are then crucial for diverse people in a changing environment.

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INSTITUTIONS

Institutional economics as a discipline Origins of institutions and types of institutions

Internal institutions evolved through human interaction Ex customs, conventions, Anglo-Saxon natural law, custom to

greet,… Sanctioned informally

External institutions are imposed and enforced from above having been designed and established by agents who are authorized by a political process Ex legislation Enforced formally

Effectiveness of informal institutions depends greatly on whether they are complimentary to the internally evolved institutions, e.g., if the law supports morality or cultural conventions

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INSTITUTIONS: PRECURSORS OF CONTEMPORARY INSTITUTIONAL ECONOMICS

Scottish Enlightenment – moral philosophers and economists of the 18th century David Hume, Adam Ferguson, Adam Smith Understood importance of institutions Rule of law, private property, freedom of contract

*note below on neoclassical

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INSTITUTIONS: PRECURSORS

Austrians – started in the 19th cent Vienna, carried to the US post-WWII Carl Menger, Ludwig von Mises, Hayek, Rothbard,

Kirzner + George Stigler and Milton Friedman Analyze rules in terms of limited knowledge methodological individualism (economic

phenomena are explained by actions of individuals, not collectives, like nations, classes, or races)

subjectivism (people differ in ability to understand world and will have different value judgments

This means interpersonal differences prevent aggregating into collective goals

Economy is complex, evolving system, non-E28

Au

stri

an

s

Time

Evolution

Imperfect knowledge

Methodological Individualism

Subjectivism

Complexity, open-ended process of trial

and error

Uncertainty 29

INSTITUTIONAL ECONOMICS: BRANCHES

Ordo Liberalism (Freiburg School, 1920-30s) Walter Eucken, Franz Bohm, adapted Scottish

moralists’ concepts to modern industrial society Public Choice – applies economic principles to

the analysis of political decision making Buchanan, Tullock, Mancur Olson (rent-seeking) +Doug North (institutional historian)

Showed how competition among communities and jurisdictions led to the evolution of more citizen- and enterprise-friendly rules, such as limited government, property rights, due process, and the rule of law

Evolutionary economics Open-ended systems Disequilibrium is normal and people thrive in it

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INSTITUTIONAL ECONOMICS: BRANCHES

Two camps Incorporate transactions cost and other

institutional concepts into mainstream (neoclassical)

Accept that institutional economics concepts are incompatible with assumptions of perfect knowledge and objective rationality

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PROSPERITY MAP OR NOT…

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?Institutions

-

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LECTURE 2/3HUMAN BEHAVIOUR

Sept 3/10

Let’s talk about human nature and overcoming scarcity

What is the central problem to overcoming scarcity?

Is there perfect knowledge? Where is knowledge stored? Is it costly to obtain knowledge?

For that matter, is anything we do costless? And, in the end, what motivates humans to

benefit others in the context of large society rather than a small social group? 34

BASIC TRAITS OF HUMAN BEHAVIOUR

Knowledge problem Limited knowledge is central problem to

satisfying wants could we hunt wooly mammoth more efficiently?

Hayek (also see bio, http://www.econlib.org/library/Enc/bios/Hayek.html) Much of economic profession pretended to know what

was really unknowable and pretended to give sound advice when it was not

Uncertainty about future Uncertainty about actions and intent of others

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Knowledge problem Note on economic man (max (U))

Which is totally inapplicable in business How much knowledge do we carry in our heads?

Has this changed since the Stone Age? Could you make a pencil all by yourself? I, Pencil

Highly specialized local knowledge

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I, PENCILNotes to I, Pencil by Leonard Read

http://www.econlib.org/library/Essays/rdPncl1.html Edition online at the Library of Economics and Liberty:

Summary: No one person knows how to make a pencil. Even something as simple as a pencil has a very large number of parts, each of which has its own complex history and supply c hain. Nobody knows everything about how to make even one component of one of those parts. Nobody knows how to source the raw materials: log the cedar, mine for graphite, smelt the brass. Nobody knows how to build, maintain, or use all the tools and equipment needed to assemble a part, or knows how to procure all the goods and services needed to sustain the workers. Few people involved know or care what the end product is; their individual “creative human energies” are brought together by combination of miracles. Freedom lets people respond naturally and spontaneously to each o ther’s needs and desires in a way that a ”mastermind” directing them cannot. Evidence of the success of voluntary coordination of creative energies is everywhere, but people need to believe in freedom in order to r emove the obstacles that their governments set in their way. Comments: Leonard Read described the incredible complexity of a single product, with a set production process, fifty-eight years ago. He did not describe the incredible story of how that production process evolved to that point (check out Wikipedia for an interesting history). Of the roughly 14 billion pencils produced annually worldwide a few years ago, roughly 2.8 billion pencils were produced “in the U.S.”. But the whole concept of “in the U.S.” makes little sense; it greatly oversimplifies the complexity of the supply chains of goods made anywhere. The bottom of the essay states “My many ingredients are assembled, fabricated, and finished by Eberhard Faber Pencil Company.” But as you have read in that very article, it seems that many ingredients are not made in the US, and not by Eberhard Faber. We now have a worldwide markets for services as well as goods: for design, engineering, advertising and marketing, in addition to th e worldwide market for raw materials, intermediate goods, and fabrication services we have had for a long time. Usually, a pencil which is made in the USA just means final assembly is made in the USA – nothing more. (An “American car” doesn’t even have to be made in the USA; it can just be made by a firm that has its headquarters and incorporation in the USA.) Material or Service Source Then Source Now Cedar Northern California and Oregon CA Sierra Nevada Mountains Transportation Railroad Cars Cargo Ship, Flatbed Truck Mill San Leandro, CA Worldwide Graphite Ceylon (Sri Lanka) Sri Lanka, Mexico Clay Mississippi Mississippi Candelilla Wax Mexico May not be used. seed oil Dutch East Indies EU, Canada, US, China, etc. Pumice Italy Italy, Greece, Australia, etc. While I, Pencil focuses on the value of the knowledge of the production process itself; the knowledge, and its value, is “distributed” throughout the supply chain, down the suppliers, and suppliers of suppliers. I, Pencil does not cover how competitive advantage accrues to the firm that learns how to provide either an equal or better part or service at as good or lower price. When machining or fabrication can be simpl ified by an ingenious device, or a new floor layout, or a genetically modified tree, or a quicker -drying wax, or a single pass metal stamp, this sends ripples up the supply chain – on to the consumer. Eberhard Faber is no longer an independent firm; taken over in 1978, its U.S. pencil manufacturing business was sold to Fab er-Castell in 1994. Glossary Vocation: Job Avocation: Calling Supercilious: Arrogant Grievous: Severe

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Knowledge problem To satisfy our wants we depend on many people

who we will never meet and have no clue of their existence

How then millions of people coordinate their efforts to produce a pencil?

Two types of ignorance: A person knows roughly what they are looking

for (informational search) A person is surprised by the discovery; he has no

prior knowledge of this and could not have sought it in rational (economizing) ways

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Knowledge and coordination Knowledge we have in our heads is result of

evolutionary knowledge Old, useless knowledge gets forgotten, we adapt to

change through accumulation and analysis of experiences

Most relevant knowledge is the “learning-by-doing” knowledge gathered by individuals in a decentralized process by trial and error

Knowledge through human interaction and exchange Internet learning?

P. 47 bottom – a bit of uncomplicated psychology Sensation=>reflection

We think of major discoveries as break-throughs However, much adaptive change usually precedes

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Types of knowledge Explicit vs implicit (tacit, inarticulate, knowhow) Polanyi 1966 Hayek “The Use of Knowledge in Society”

P. 51 conservative vs experimental instinct! Are you more conservative or inquisitive?

Knowledge of time and place is most important for human interaction, in large part refers to commercial knowledge

Does an economic man exist? Human existence is constant attempt to test old

and find new knowledge; limited knowledge is part of who we are

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DECIPHERING REALITY: COGNITION, BOUNDED RATIONALITY

Lost in translation Mind makes certain images of reality based on

specific experiences Difficulty in communicating between different

cultures because many images of the mind are not shared and must be explicated before they are understood

Language is very important! Sun and banker

Human mind can attach abstract, non-intrinsic meanings to signals and turn these into symbols that mean something that has nothing to do with the original signal (red light)=> cultural context matters!

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DECIPHERING REALITY: COGNITION, BOUNDED RATIONALITY

This speaks to the human ability of internalizing concepts and learn (practice them) to gain conditioned reflexesWe acquire honesty not through analysis

but through observation and mimicking behaviour

Conditioned reflexes speed up decision processes

The information paradox Will all the knowledge be acquired? Do you search until benefit equals cost or until

experience tell you enough? Rational ignorance

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DECIPHERING REALITY: COGNITION, BOUNDED RATIONALITY

If people are not omniscient they cannot make rational choices about how much to search

Three types of rationality: End-means rationality – ends means are known,

e.g. from earlier experience Bounded, adaptive rationality – adjust

aspirations in light of past experience Entrepreneurial-creative rationality =>

discoveries

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MOTIVATION: LOVE, COMMAND, SELF-INTEREST

Individual and the collective Social bond/‘tribal mentality’<= better survival

through cooperation Motives to benefit others:

By love, solidarity Altruism has been conditioned for mlns of years and is

automatically praiseworthy in our minds Does not work to the full extent in a large society

By command or coercion Principal-agent problem

By free-will but out of self-interest in expectation of reward Would you do things for other people if you are not

allowed to keep your reward?44

PRINCIPAL AGENT PROBLEM

What is the culprit here? Why do we have the problem?

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PRINCIPAL AGENT PROBLEM

Imperfect information Moral hazard – people feel they can get away

with opportunistic behavior Control by

Coercion Making part of group - solidarity – employee

loyalty to managers Indirect control - incentives

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FUNDAMENTAL HUMAN VALUESCH 3=>>

Freedom

Security

PeaceProsperity

Justice

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If people are forced to follow goals that are not related to fundamentally shared values, this will undermine free society

Conflicts of course arise in pursuit of fundamental values, but it can be attenuated through a system of general rules rather than ad hoc measures

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FreedomPursue self-

chosen purposes,

autonomously, bounded by rules not to harm others

SecurityEnjoy life and

freedom without

coercion/force+

environment

PeaceAbsence of internal and

external violence

ProsperityMaterial

betterment

JusticePeople in

equal circumstances are treated

equallyRule of law vs rule of men

Complementarity between fundamental values Prosperity=> security

But conflict also, pursuit of freedom without restraints=>less peace

Since 9/11 trade-off between security and freedom Short-term conflicts are more often

Divert private investment into defense spending *we are not “all dead in the long-run”

Institutional economics has long-term focus What kind of focus does politics have?

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What is a good society? Probably where fundamental values can be attained and where majority adheres to those spontaneously

Individual human values are also a yardstick for institutions and public policies

Fundamental values undergo the internalization process (like honesty we mentioned above)

They “grow on you” within family and become part of culture and broadly part of society 51

Totalitarian societies violate human values The community’s institutions are then not self-supportive

and cannot coordinate human behaviour well => other forms of coordination need to be applied – coercion being one of them

P. 77 Very important note on negative vs positive freedom resources, such as right to job, financial assistance and so on Freedom from coercion vs freedom to claim

Power and freedom When threatened with a firearm, coercion is

unquestionable In other cases, such government bodies, unions – not so

clear cut In economic life, restricted competition is coercion In general, coercion is limitation of alternatives

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Social justice Rule of law means no one is above the law, similar to

religious concept Procedural justice is the only justice the government can

guarantee – that everyone can pursue goals without unnecessary legal constraints

Government cannot guarantee social justice because it cannot guarantee equal outcomes – role of chance and lots of people influencing outcomes that are unknown to government agents

Government can take on a redistributive role but then it has to treat people unequally There is a private mechanism of redistribution – charity

In sum think about it this way, if we are unequal by default, just treatment of all will produce unequal outcome, if outcome is to be equalized, we have to treat some unjustly

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Security Security has time dimension Emphasize security too much, and society looses

its ability to cope with change constructively and progress deteriorates

Environment Is there constraint on natural resources? Is there a constraint on growth because of

natural resource limit? Prices can signal that it maybe time to shift to another

technology

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“INEQUALITY” IN THE U.S.WHAT’S REALLY GOING ON?

It’s true that the share of “income” going to the richest 1% has increased But that 1% are never the same people

And increasingly, the new 1% are just setting up their own philanthropy shops to give most of it away while they are alive or after death

But income is measured in households And divorce has increased substantially,

increasing the number of households, even as incomes stay the same

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IF INCOME INEQUALITY IS INCREASING IN THE US, SO WHAT?

Russ Roberts http://cafehayek.com/2005/05/inequality_i.html http://cafehayek.com/2005/05/inequality_ii.html http://cafehayek.com/2005/05/inequality_iii.html http://cafehayek.com/2005/05/inequality_iv.html http://cafehayek.com/2005/05/inequality_v.html http://cafehayek.com/2005/05/inequality_vi.html

Don Boudreaux http://cafehayek.com/2005/06/the_irrelevance.html

Cato Unbound http://www.cato-unbound.org/archives/october-2009-inequality-facts-and-

values/

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WHAT THE 10 RICHEST AMERICANS HAVE COMMITTED TO CHARITY

1. Bill & Melinda Gates $53B ($30B) 2. Warren Buffett $47B ($40B)3. Larry Ellison $28B ($1B)4. Christy Walton $22.5B ($2B)**5. Jim Walton $20.7B6. Alice Walton $20.6B7. S. Robston Walton $19.8B8. Michael Bloomberg $18B ($1B)9. Sergey Brin $17.5B (?)10. Charles Koch $17.5B ($0.5B) **Helen Walton, who died in 2007, left substantial portions of her $16B

estate to charity.

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FUNDAMENTAL VALUES CONT.

People generally have no problem interacting in the markets

It is when this interaction is limited and common goals are imposed from above that we see more conflict and animosity

Expansion of commercial society is good for promoting fundamental values

Security net (old age, illness) maybe agreed upon as a collective action by society, but should not be taken out of social sphere and imposed onto economic sphere

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