Understanding the role of institutions in the economy: A mathematical approach

Over the past couple of decades it has become more and more recognised in economics that socio-economic institutions are essential for the functioning of the economy. This research has emanated from the seminal work of Douglas North in his study of various economic systems throughout economic history and of Ronald Coase in the understanding of hierarchical organisations and mechanisms in market economies.

This reasoning has recently been extended by Daron Acemoglu to a wide variety of environments, the main one being the influence of political institutions on economic performance in his work with James Robinson. (I refer here to the very accessible account of this work in their book Why Nations Fail: The Origins of Power, Prosperity and Poverty.)

Together with Emiliya Lazarova and Pieter Ruys, I have been working on a mathematical theory that gives expression to the essential nature of institutions. We interpret institutions mainly as guidelines or rules that people apply to build socio-economic relationships. These rules should provide economic stability in the sense that the economy tends to a stable state in which prosperity can be achieved regardless of how exactly the production technologies or preferences in the economy change. Thus, while production technologies and preferences evolve, the institutions are in some sense timeless and provide the possibility to achieve stability regardless of these changes.

Our mathematical analysis shows that the institutional structure of the economies that humans devised throughout history are indeed the ones that provide stability. There are three major institutional structures that provide such stability:

  • The creation and assumption of socio-economic roles through specialisation of human capital. By assuming professional roles in the economy and following certain well-established rules of how one should act in these professional roles, all of us together provide a stable foundation for economic development. This started out as hunters and gatherers in the most primitive, tribal economies and it evolved into our highly complex 21st century global economy in which we assume a multitude of diverse socio-economic roles through professional specialisation.
  • The second major institution is that of social hierarchy. By assigning individuals to positions of authority over other individuals, the economy is stabilised and is able to prosper. Social hierarchies have been around from the dawn of mankind. Political leadership usually coincides with economic power and control. Kings, knights, bishops and monastic priors used to exercise control over large groups of productive individuals, resulting in wealth creation in the medieval, feudal economy. This evolved into capitalist systems of democratic governmental authority and hierarchical social production systems in which leaders control subordinates. Our conclusion is that social hierarchies are very effective institutional structures that provide stability irrespective of the productive abilities of these individuals.
  • Finally, the role of market makers and platform entrepreneurs is crucial in the functioning of the economy. By binding the economy across differentiated local markets and creating a global economy, the economy again provides a foundation of stability and the accommodation of wealth creation through a wide variety of socio-economic processes. It is recognised here that “markets” do not emerge naturally, but are explicitly created by market makers and platform providers. (These platforms include markets as centralised trading places, operating systems, chain stores and systems of laws and rules that conduct how we interact with each other.)

Our mathematical theory shows that these three fundamental forms of socio-economic institutions are effective stabilisers of the processes that occur in any economy. This points away from the point of view promoted in traditional neoclassical economics that wealth creation is driven only by markets and the incentives emanating from market institutional arrangements. It is also an indication that we still are far away from a deep understanding of how the economy functions and that lessons for our ongoing economic crisis should be drawn from an institutional perspective.

A preliminary draft of the paper can be found on my economic theory page.

The paper has now been published in the Journal of Economic Behavior & Organization.

New paper on partial cooperation

I just added a new working paper on partial cooperation in non-cooperative games on the economic theory page. It addresses how to consider a group of decision makers to coordinate certain strategic actions, while all other actions remain purely non-cooperative. The paper generalises the existing contributions to this partial cooperation problem to include more complex decision situations.

We provide two applications of this framework. First, we look at cartel formation in a multi-market oligopoly. In this case the cartel operates only in one market, while all cartel members and other firms remain competitive in the other markets. Interestingly, we show that the merger paradox vanishes if the cartel takes a leadership position in determining its actions.

Second, we consider the writing of international treaties to curb environmental pollution. In particular, in our framework we can now study how a group of countries can agree on emissions control, while other countries do not participate. Furthermore, all countries remain competitive in the production of non-polluting goods. We show that even when few countries participate, emissions control efforts are Pareto improving.

New paper posted

I have posted a new paper, co-authored by Owen Sims, on critical nodes in directed networks. It addresses the appropriate definition of what exactly critical nodes or middlemen are in the general class of directed networks. We also discuss the link with contestability in networks.

Visit the network analysis page for more information and PDF files of the paper.

Thinking about networks and platforms

I just posted a new paper with Dimitrios Diamantaras on how middlemen compete in a network environment. We view a middleman here as an explicit provider of a two-sided interaction platform. FRom that a theory of competitive behaviour is developed as ambiguous decision making in a game theoretic framework. Here the middleman is ambiguous whether she is contested in her middleman position or not.

Interestingly we conclude that there emerges a mixed picture. In many cases the middleman will continue to extract maximal rents, but if competition is “normal” and effective, then middlemen can actually engage in a more competitive fashion, as expected through a standard Bertrand-like argument.

Visit the economic theory page for details.

Thinking about the consequences of economic networks

I just posted a new paper on multilateral matching in network economies on the game theory page. This paper is co-authored with Emiliya Lazarova (University of Birmingham) and Pieter Ruys (Tilburg University).

This paper investigates a network economy in which economic agents are connected within a structure of value-generating relationships. Agents are assumed to be able to participate in three types of economic activities: autarkic self-provision; binary matching interactions; and multi-person cooperative collaborations. We introduce two concepts of stability and provide sufficient and necessary conditions on the prevailing network structure for the existence of stable assignments, both in the absence of externalities from cooperation as well as in the presence of size-based externalities. We show that institutional elements such as the emergence of socioeconomic roles and hierarchical leadership structures are necessary for establishing stability and as such support and promote stable economic development.

Investigating network formation under mutual consent

It seems to me there is a lack of game-theoretic modelling of network formation under mutual consent in the relationship building process. To model such a process of mutual consent is rather difficult. The simplest model from the literature is Myerson’s network formation game in which all individuals announce which links they want to build. Subsequently only those links that are supported by both parties are actually formed.

The main problem with this static approach is that the class of networks supported through Nash equilibria in this game is very large. In particular, the empty network (without any links whatsoever) is very strongly supported in this model; it is a strict Nash equilibrium if building links is costly, which is usually the case. My paper with Chakrabarti and Sarangi (2011) reports an exact description of the properties of the equilibrium networks in Myerson’s model under arbitrary cost structures in the link formation process.

In my (now published) paper with Sarangi (2010) we introduce a concept that pulls us away from the conclusion that the empty network is always a strict equilibrium. This alternative concept is founded on modelling a form of trusting behaviour or “confidence” in the brain of the individuals in the link building process. The result is a much smaller class of stable networks, usually not including the empty network. This actually shows that we can support the idea that trust builds meaningful social networks.

The referred papers on network formation under consent are posted on the network formation page at this web site. In particular, this post addresses the material covered in the first two papers posted there.