The Emergence of Institutions
Santiago Sánchez-Pagés
(University of Edinburgh)
Stéphane Straub
(University of Edinburgh)
Edinburgh, 17th May 2008
The Emergence of Institutions
1
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.
Edinburgh, 17th May 2008
The Emergence of Institutions
2
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).
Edinburgh, 17th May 2008
The Emergence of Institutions
3
Institutions and coordination failures
 Two lines of enquiry:
1. Analysis of specific institutions.
-
Coalitions of Genoese traders (Greif, 1997).
Merchant courts in fairs (Milgrom et al, 1990).
2. Coexistence of formal and informal
institutions.
-
Reciprocity vs. Markets (Kranton, 1996; Dixit, 2004).
Tribes vs. National states (Ensminger, 1992).
Edinburgh, 17th May 2008
The Emergence of Institutions
4
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.
Edinburgh, 17th May 2008
The Emergence of Institutions
5
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)
Edinburgh, 17th May 2008
The Emergence of Institutions
6
The Model
 N+1 identical agents with initial
endowment ω.
 Agents are randomly matched and play a
prisoner’s dilemma game.
 Payoff are returns per unit of endowment
invested.
Edinburgh, 17th May 2008
The Emergence of Institutions
7
Player j
C
NC
The Model
C
x,x
-z, z
Player i
NC
z, -z
0,0
- We assume z > x > 0.
- Two strategies: C cooperative, NC not cooperative.
- (NC, NC) is the unique Nash eq. and is Paretoinferior .
Edinburgh, 17th May 2008
The Emergence of Institutions
8
The Model
In the state of nature, agents play the
previous game without interference.
Expected payoff is then αx.
The parameter α 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…
Edinburgh, 17th May 2008
The Emergence of Institutions
9
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 ≤ ω to interact
under the centre’s umbrella.
Trade certification, dispute prevention / resolution,
reputation management…
Edinburgh, 17th May 2008
The Emergence of Institutions
10
Timing
t=1
t=2
t=3
t=4
Participation
decision. If none
participates, the
status-quo
remains.
The formality fee a is
chosen.
Formality
decisions
Agents are
randomly
matched and
play game.
Edinburgh, 17th May 2008
The Emergence of Institutions
11
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
v  x(a)
F
where xa> 0, xaa< 0 and x(0) > 1/α.
 The efficiency of interactions depends on the
fee paid to the institution.
Edinburgh, 17th May 2008
The Emergence of Institutions
12
Formality decisions
 Interacting with an informal agent yields
v  x(a)
I
regardless of your status.
 Expected payoffs when K ≥ 2 formal agents:
K 1
N K
F
V (K ) 
(  a) x(a) 
(  a)x(a)
N 1
N 1
V I ( K )  x(a)
Edinburgh, 17th May 2008
The Emergence of Institutions
13
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)
Edinburgh, 17th May 2008
The Emergence of Institutions
14
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.
Edinburgh, 17th May 2008
The Emergence of Institutions
15
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 revenuemaximizer.
So it will “tend” to set the maximum fee
compatible with formality, a(N).
Edinburgh, 17th May 2008
The Emergence of Institutions
16
The fully decentralized procedure
Second, the agent that runs the
institution can renege ex-post.
For the institution to arise then
N (a  c)    x(0)
Edinburgh, 17th May 2008
The Emergence of Institutions
17
The fully decentralized procedure
 Ex-ante participation constraint given the fee a
1
N
( N (a  c)   ) 
(  a) x(a)  x(a)
N 1
N 1
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:
N (a( N )  c)    x(a( N ))
Edinburgh, 17th May 2008
The Emergence of Institutions
18
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).
Edinburgh, 17th May 2008
The Emergence of Institutions
19
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.
Edinburgh, 17th May 2008
The Emergence of Institutions
20
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 α.
When status-quo trust is high, revenue and
welfare maximisation are aligned.
Otherwise, the institution arises at a suboptimal level. The rent associated with
being the centre is quite high.
Edinburgh, 17th May 2008
The Emergence of Institutions
21
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.
Edinburgh, 17th May 2008
The Emergence of Institutions
22
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.
Edinburgh, 17th May 2008
The Emergence of Institutions
23
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.
Edinburgh, 17th May 2008
The Emergence of Institutions
24
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.
Edinburgh, 17th May 2008
The Emergence of Institutions
25
Endogenous commitment
 Ideally, commitment should not rely on
some exogenous enforcement
mechanism.
 We consider two ways to endogenize
commitment:
1. Threshold strategies.
2. Threat of secession.
Edinburgh, 17th May 2008
The Emergence of Institutions
26
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.
Edinburgh, 17th May 2008
The Emergence of Institutions
27
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.
Edinburgh, 17th May 2008
The Emergence of Institutions
28
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.
Edinburgh, 17th May 2008
The Emergence of Institutions
29
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.
Edinburgh, 17th May 2008
The Emergence of Institutions
30
Conclusions
 Only full commitment at the individual
and social level can avoid this.
 Secession has two effects:
1. To efficiently tame the central agent.
2. Inefficient proliferation of institutions.
 In future research we intend to explore
the effect of endowment heterogeneity.
Edinburgh, 17th May 2008
The Emergence of Institutions
31