Santiago S

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The Emergence of Formal Institutions

• Santiago Sánchez-Pagés
• Stephane Straub
• (University of Edinburgh)

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Introduction

• Institutions are key in enhancing the efficiency
  of economic interactions.
• Huge variation. Both temporal and spatial.
• New Political Economy Institutions as protectors
  of property rights.
• A neglected role Coordination devices.

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Institutions and coordination failures

• Institutions can help to correct the coordination
  failure that plague basic economic interactions.
• Developing economies at early stages.
• Witnesses in commercial exchange (Attali, 2003).
• Economies in transition to industrial stage.
• Japan after WWII, East Asian countries (Aoki et
  al, 97).
• Specific markets
• US Cotton Market (Bernstein, 2001).

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Institutions and coordination failures

• Two lines of enquiry in the literature
• Analysis of specific institutions
• Coalitions of Maghribi traders (Greif, 1993).
• Merchant courts and fairs (Milgrom et al, 1990).
• Coexistence of formal and informal institutions
• Reciprocity vs. Markets (Kranton, 1996 Dixit,
  2004).
• Tribes vs. National states (Ensminger, 1992).

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Our contribution

• Little has been said on the emergence of
  institutions.
• We model the process through which these
  institutions may arise.
• We characterize
• the factors that make possible or hinder the
  formation of institutions.
• the level of efficiency at which they arise.

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Formal institutions as equilibria

• In our model an institution is a body enhancing
  the efficiency of economic interactions.
• Its emergence is the equilibrium of a game that
  agents play in the state of nature.
• That is, it is self-enforcing.
• If formal institutions do not arise, the economy
  remains in the status-quo.

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The Model

• N1 identical risk-neutral agents with initial
  endowment ?.
• Agents are randomly matched and play a prisoners
  dilemma game.
• Payoff are returns per unit of endowment
  invested.

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The Model

• - We assume z gt x gt 0 and ? lt 1.
• Two strategies C is cooperative, NC is not
  cooperative.
• (NC, NC) is the unique Nash-equil. and is
  Pareto-inferior .

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The Model

• In the state of nature, agents play the previous
  game without interference.
• Expected payoff is then ax.
• The parameter a denotes the status-quo level of
  coordination or trust.
• The institution is able to ensure that the (C,C)
  equilibrium is played.
• But someone has to run it

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The Model

• A lottery among those who chose to participate in
  it determines who will become the central agent.
• She must relinquish the ability to trade.
• But is compensated in exchange.
• Agents must pay a fee a ? to become formal.

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Timing
t1 Participation decision. If none participates,
the status-quo remains.
t2 Formality fee is chosen.
t4 Agents are randomly matched and play game.
t3 Formality decisions
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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 xagt 0, xaalt 0 and x(0) gt 1/a.
• The efficiency of interactions depends on the fee
  paid to the institution.

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Formality decisions

• Interacting with an informal agent yields
• regardless of your status.
• Expected payoffs when K formal agents

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Formality decisions

• Define
• K formal agents can be supported in equilibrium
  if and only if
• But a (K) is increasing.

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Formality decisions

• Proposition 1 For a given level of the fee a
• (i) Informality can be supported in equilibrium
  only if a a(1)
• (ii) Full formality can be supported in
  equilibrium only if a a (N)
• Moreover, a (1) a (N) if a is below a certain
  threshold

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The procedure of institution formation

• A procedure of institution formation is a lottery
  over the set of agents who freely participate in
  it.
• The procedure also describes the degree of
  commitment available at the individual and
  collective level.
• Freedom to chose the fee.
• Agents ability to renege ex-post of the central
  role.

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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).

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The fully decentralized procedure

• Second, the agent that runs the institution can
  renege ex-post.
• For the institution to arise then

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The fully decentralized procedure

• Ex-ante participation constraint given the fee a
• because either all agents or none participate in
  the lottery.
• With a1(N), the institution arises iff the
  (stronger) ex-ante constraint is met. It
  rewrites

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The fully decentralized procedure
Proposition 2 If the ex-ante constraint holds,
there exists a SPE of the fully decentralized
procedure that implements formality under a
(N).
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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.
• Small populations make informality dominant, big
  ones makes formality more likely.
• High trust undermines the position of the
  institution in societies with high ?, outside
  option of informality is more attractive, so
  formality is not individually IC despite being
  socially efficient.

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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 a.
• When status-quo trust is high, revenue and
  welfare maximisation are aligned.
• For low enough a, trigger-like strategies can
  endogenously limit the ability of the central
  agent to choose the fee.

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The role of commitment

• Inefficiencies are the result of the lack of
  commitment along two dimensions individual and
  collective. Introducing commitment would mean
• Individual Agents cannot renege ex-post whatever
  their role.
• Collective The fee is chosen collectively before
  the lottery takes place.

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The role of commitment

• Imposing individual commitment alone has no
  effect.
• Collective commitment alleviates the second type
  of inefficiency.
• Only when commitment is imposed in both
  dimensions, the institution arises whenever it is
  welfare enhancing.

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Endogenous commitment

• Problem how to enforce this?
• We consider two ways to endogenize commitment
• Trigger-like strategies.
• Threat of secession.

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Secession

• When there is no commitment, secession is an
  issue.
• No group in society should be able to improve its
  situation by withdrawing and forming its own
  mini-society.
• We study when the institution will be
  secession-proof and the impact of this threat on
  welfare.

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Secession

• Definition Denote by aN the fee set by the
  institution. A coalition of S interacting agents
  is said to be blocking if and only if
• Note that when a group secedes, it sets a
  self-enforcing fee.
• A fee is secession-proof (it is in the core of
  the procedure of institution formation) if it
  does not spawn any blocking coalition.

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Secession

• Proposition 4 The set of secession-proof fees
  is non-empty if and only if N is low enough.
• The reason for blocking is the prospect of
  becoming the central agent in the new mini
  society.
• When the level of status-quo trust is low enough,
  the threat of secession can tame the central
  agent.

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Secession
N
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Inequality (in progress)

• Inequality of endowments can generate
  intermediate levels of formality.
• A revenue-maximizer institution may leave an
  inefficient amount of agents informal.
• In fact, as the level of status quo trust
  increases, the equilibrium level of formality
  drops.

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Inequality (in progress)

• How does this change as the distribution of
  endowments changes?
• Preliminary results with uniform distributions
  show that more inequality tends to generate lower
  levels of formality.