The Emergence of Formal Institutions

1. The Emergence of Formal Institutions Santiago Sánchez-Pagés & Stephane Straub (University of Edinburgh) The Emergence of Formal Institutions

2. 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. The Emergence of Formal Institutions

3. 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). The Emergence of Formal Institutions

4. 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). The Emergence of Formal Institutions

5. 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. The Emergence of Formal Institutions

6. 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. The Emergence of Formal Institutions

7. The Model • N+1 identical risk-neutral agents with initial endowment ω. • Agents are randomly matched and play a prisoner’s dilemma game. • Payoff are returns per unit of endowment invested. The Emergence of Formal Institutions

8. The Model • - We assume z > x > 0 and  < 1. • Two strategies: C is cooperative, NC is not cooperative. • (NC, NC) is the unique Nash-equil. and is Pareto-inferior . The Emergence of Formal Institutions

9. The Model • In the state of nature, agents play the previous game without interference. • Expected payoff is then αx. • The parameterαdenotes 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… The Emergence of Formal Institutions

10. 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 ≤ ωto become formal. The Emergence of Formal Institutions

11. Timing t=3 Formality decisions t=1 Participation decision. If none participates, the status-quo remains. t=2 Formality fee is chosen. t=4 Agents are randomly matched and play game. The Emergence of Formal Institutions

12. 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 xa> 0, xaa< 0 and x(0) > 1/α. • The efficiency of interactions depends on the fee paid to the institution. The Emergence of Formal Institutions

13. Formality decisions • Interacting with an informal agent yields regardless of your status. • Expected payoffs when K formal agents: The Emergence of Formal Institutions

14. Formality decisions • Define • K formal agents can be supported in equilibrium if and only if • But a(K) is increasing. The Emergence of Formal Institutions

15. 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 α is below a certain threshold The Emergence of Formal Institutions

16. 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. The Emergence of Formal Institutions

17. 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). The Emergence of Formal Institutions

18. The fully decentralized procedure • Second, the agent that runs the institution can renege ex-post. • For the institution to arise then The Emergence of Formal Institutions

19. 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: The Emergence of Formal Institutions

20. 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). The Emergence of Formal Institutions

21. 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. The Emergence of Formal Institutions

22. 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. • For low enough α, trigger-like strategies can endogenously limit the ability of the central agent to choose the fee. The Emergence of Formal Institutions

23. 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. The Emergence of Formal Institutions

24. 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. The Emergence of Formal Institutions

25. Endogenous commitment • Problem: how to enforce this? • We consider two ways to endogenize commitment: • Trigger-like strategies. • Threat of secession. The Emergence of Formal Institutions

26. 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. The Emergence of Formal Institutions

27. 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. The Emergence of Formal Institutions

28. 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. The Emergence of Formal Institutions

29. Secession N The Emergence of Formal Institutions

30. 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. The Emergence of Formal Institutions

31. 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. The Emergence of Formal Institutions