Santiago S

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The Emergence of Institutions

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

The Emergence of Institutions
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Introduction

• Coordination failures (opportunism, distrust,
  misunderstandings) plague even the most basic
  economic interactions.
• In this paper we investigate the emergence of
  institutions that act as Coordination devices.
• We define an institution as a body with the power
  to enhance the efficiency of economic
  interactions.

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Examples

• Developing economies at early stages.
• Witnesses in commercial exchange (Attali, 2003),
  Informal contract
  enforcement (Fafchamps, 2004).
• Economies in transition to industrial stage.
• Japan after WWII, East Asian countries (Aoki et
  al., 1997), Transition countries (Johnson et
  al., 2002).
• Specific markets
• US Cotton market (Bernstein, 2001)
  Diamond market (Bernstein, 1992).

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Institutions and coordination failures

• Two lines of enquiry
• Analysis of specific institutions.
• Coalitions of Genoese traders (Greif, 1997).
• Merchant courts in 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 they may
  arise.
• The emergence of the institution is the
  equilibrium of a game that agents play in the
  state of nature.
• That is, its emergence is self-enforcing.

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Our contribution

• We characterize
• The factors that make possible or hinder the
  formation of institutions.
• The level of efficiency at which they arise.
• We do not to model explicitly its internal
  functioning.
• Still, it is easy to think of enforcement
  mechanisms, for instance when applying our model
  to the emergence of the State.
• (more on this later)

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The Model

• N1 identical 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
Player C j NC
C x,x -z, z
Player i NC z, -z 0,0

• - We assume z gt x gt 0.
• Two strategies C cooperative, NC not
  cooperative.
• (NC, NC) is the unique Nash eq. 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)
  profile is played.
• But someone has to run it

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The Model

• One of the agents becomes the centre.
• She must relinquish the ability to trade.
• But is compensated in exchange.
• Agents must pay a fee a ? to interact under the
  centres umbrella.
• Trade certification, dispute prevention /
  resolution, reputation management

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Timing
t1 Participation decision. If none participates,
the status-quo remains.
t2 The formality fee a 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 2 formal agents

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Formality decisions

• Proposition 1 For a given level of the fee a
• (i) Informality can be supported in equilibrium
  for all a 0
• (ii) Full formality can be supported in
  equilibrium only if a a(N)

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The procedure of institution formation

• Our procedure of institution formation starts
  with a lottery over the set of agents who freely
  participate in it.
• It determines who will become the central agent.
• Reasonable with identical agents.

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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 a(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.
• High trust undermines the position of the
  institution.

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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.
• Otherwise, the institution arises at a
  sub-optimal level. The rent associated with being
  the centre is quite high.

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Other procedures

• One can consider alternative procedures by
  relaxing these requirements.
• Imposing individual commitment alone has no
  effect.
• Collective commitment alleviates the second type
  of inefficiency.
• First best is achieved only when commitment is
  imposed in both dimensions.

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The emergence of the State

• These procedures can be applied to the classic
  concept of the State as an entity aimed at
  solving coordination problems.
• Our model predicts when such state will emerge
  and its level of efficiency of its operations.
• And endogenizes the rise of a ruler from a
  population of identical individuals.

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The emergence of the State

• In this context, the ruler/state could enforce
  cooperation in two ways

• A là Hobbes via a Leviathan, a canonical State
  with the monopoly of violence who ensures
  coordination through coercion.

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The emergence of the State

• A là Hume via a political entrepreneur, able to
  persuade others to take a particular action or
  change their beliefs about its consequences.

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Endogenous commitment

• Ideally, commitment should not rely on some
  exogenous enforcement mechanism.
• We consider two ways to endogenize commitment
• Threshold strategies.
• Threat of secession.

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Secession

• The threat of secession can alleviate the second
  type of inefficiency.
• We assume that when withdrawing, groups employ
  the same procedure of institution formation as
  the whole society.
• Secession can be avoided if N is low enough.
• And if in addition the level of status-quo trust
  is low enough, the threat of secession enhances
  welfare.

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The alternative to institutions

• Implicit mechanisms in repeated games Folk
  Theorem applies.
• Can this type of results be obtained in games
  with random matching and when players have
  limited information about others (past)
  behaviour?
• Yes, under certain assumptions.
• Information is crucial.

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Relation-based vs. rule-based enforcement

• Relation-based Exchange between pairs of members
  of one homogeneous group enforcement is
  multilateral (norms, communication).
• Rule-based Groups exist, but trade may be
  between strangers enforcement is bilateral.
• We have focused on the rule-based case (relevant
  in larger groups) and tried to explain why/how
  some agents specialize in being institution
  /judge, etc.

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Conclusions

• We have presented a model where an institution
  emerges as the equilibrium of a game played in
  the state of nature.
• The institution may not emerge despite being
  welfare enhancing
• This happens for intermediate population sizes
  and high levels of status quo trust.
• But even if it emerges it can do it at a
  suboptimal level.

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Conclusions

• Only full commitment at the individual and social
  level can avoid this.
• Secession has two effects
• To efficiently tame the central agent.
• Inefficient proliferation of institutions.
• In future research we intend to explore the
  effect of endowment heterogeneity.