Evolution of Markets and Institutions
eBook - ePub

Evolution of Markets and Institutions

Murali Patibandla

Share book
  1. 352 pages
  2. English
  3. ePUB (mobile friendly)
  4. Available on iOS & Android
eBook - ePub

Evolution of Markets and Institutions

Murali Patibandla

Book details
Book preview
Table of contents
Citations

About This Book

The new institutional economics has been one of the most influential schools of thought to emerge in the past quarter century. Taking its roots in the transaction cost theory of the firm as an economic organization rather than purely a production function, it has been developed further by scholars such as Oliver Williamson, Douglas North and their followers, leading to the rich and growing field of the new institutional economics.

This branch of economics stresses the importance of institutions in the functioning of free markets, which include elaborately defined and effectively enforced property rights in the presence of transaction costs, large corporate organizations with agency and hierarchical controls, formal contracts, bankruptcy laws, and regulatory institutions. In this timely volume, Murali Patibandla applies some of the precepts of the new institutional economics to India - one of the world's most promising economies.

Frequently asked questions

How do I cancel my subscription?
Simply head over to the account section in settings and click on “Cancel Subscription” - it’s as simple as that. After you cancel, your membership will stay active for the remainder of the time you’ve paid for. Learn more here.
Can/how do I download books?
At the moment all of our mobile-responsive ePub books are available to download via the app. Most of our PDFs are also available to download and we're working on making the final remaining ones downloadable now. Learn more here.
What is the difference between the pricing plans?
Both plans give you full access to the library and all of Perlego’s features. The only differences are the price and subscription period: With the annual plan you’ll save around 30% compared to 12 months on the monthly plan.
What is Perlego?
We are an online textbook subscription service, where you can get access to an entire online library for less than the price of a single book per month. With over 1 million books across 1000+ topics, we’ve got you covered! Learn more here.
Do you support text-to-speech?
Look out for the read-aloud symbol on your next book to see if you can listen to it. The read-aloud tool reads text aloud for you, highlighting the text as it is being read. You can pause it, speed it up and slow it down. Learn more here.
Is Evolution of Markets and Institutions an online PDF/ePUB?
Yes, you can access Evolution of Markets and Institutions by Murali Patibandla in PDF and/or ePUB format, as well as other popular books in Negocios y empresa & Negocios en general. We have over one million books available in our catalogue for you to explore.

Information

Publisher
Routledge
Year
2006
ISBN
9781134299911

1 Introduction

The 1980s and 1990s witnessed extraordinary changes in the world economy. Several socialist and developing economies made a dramatic move towards free markets and outward orientation after pursuing decades of the socialistic economic system as activist states. At the same time, a general reduction in barriers to international trade and investment and rapid technological progress in information and communication technology contributed to increasing globalization of the economic activity of nations. At the beginning of the millennium, China and India are the two fastest-growing developing economies, with important implications in the world economy as they are also the two most populous countries.1 One of the dominant reasons for their growth is the unleashing of the free market forces of capitalism. While China remains politically a communist state, it started to open its economy to free market forces and the outside world in the late 1970s. On the other hand, economic reforms in India relate to the reduction in excessive intervention in the economy by the state, which took up a developmental role under a democratic polity. Internal reforms were initiated in the middle of the 1980s and major internal and external reforms began in 1991, necessitated by the balance of payments crisis, with the help of the World Bank and International Monetary Fund (IMF) structural adjustment and stabilization program. India achieved an average annual growth rate of 6 percent throughout the 1990s, and about 7 percent in the early 2000s, which is a success story compared to a 3 percent Hindu growth rate in the 1970s and the early 1980s.
The structural adjustment and stabilization program is basically a package deal based on a textbook case of a free market mechanism in which markets are the central institutions and others do not matter. As the outcome of the reforms in India is fundamentally a success story, why should we talk of institutions? If one examines India’s growth pattern, a major part of growth benefits have accrued mostly to the urban middle class and there are significant regional differences in growth levels. While the states in the western and southern part of India have been growing at a rapid pace, the large states in the north and some in the east remain stagnant. Even after fifteen years since the initiation of the reforms, close to 300 million people remain below the poverty line and illiterate, outside the market mechanism.
The international and intranational differences in the growth outcomes of the reforms towards the free market economy can be traced from differences in the initial endowments of capitalist institutions, apart from technological and capital endowments at the onset of the reforms.2 The new institutional economics emphasizes the importance of the institutions of capitalism, such as the rule of law, social and economic norms, property and contractual rights and transaction costs of enforcement in determining the economic prosperity of societies.
Ronald Coase (1992) in his Nobel lecture commented:
The value of including
 institutional factors in the corpus of mainstream economics is made clear by recent events in Eastern Europe. These ex-communist countries are advised to move to a market economy, and their leaders wish to do so, but without the appropriate institutions no market economy of any significance is possible. If we knew more about our own economy, we would be in better position to advise them.
The free market mechanism of the Western advanced capitalist nations functions on the basis of underlying economic and political institutions that have evolved through painstaking process over time. The following illustration shows the importance of institutions in the efficient functioning of capitalism. One of the indicators of economic development of nations is the productivity of the workforce. In the mainstream neoclassical economics, productivity is determined by capital and technology. A worker who has access to capital and better technology is more productive than the one who works with inferior technology and less capital. However, this is only a partial explanation. A worker with similar skills and access to similar technology in India may still turn out to be less productive than one in the US because of the inefficient market institutions he or she operates in. Let us take three basic elements of economic institutions to discuss this issue – property rights, incentives and transaction costs. A person refrains from investing his/her efforts in a particular activity (durable asset) if he or she is not sure of receiving the returns on the investment, particularly if there is fear of appropriation by the state and other private agents. A productive worker is not motivated if rewards within an organization are not based on performance relative to peers, that is, organizations (and societies) fail to adopt incentive-compatible practices. A worker will be less productive in a given activity if he or she has to divert her time and resources in dealing with transaction costs (searching, information processing, paper work, long queues, etc.).
In analyzing the evolution of markets and institutions in response to policy reforms, this book takes the following approach. From the neoclassical economics, the evolution of markets can be viewed in terms of the emergence of non-existing markets and of prices approaching long-run marginal (opportunity) costs. The new institutional economics shows that the presence of transaction costs due to information search and contracts makes the costs of operating competitive markets non-zero. The efficiency of markets is determined by minimizing transaction costs, but it is impossible to eliminate them, which leads to the issue of comparative economic organization, elaborated on later. The new institutional economics makes a distinction between the institutional environment (North, 1990) and the institutions of governance (Williamson, 1985, 1998). The institutional environment is defined jointly by the rules of the game (the formal constraints: constitutions, laws, and property rights) and the conditions of embeddedness (the informal constraints: sanctions, taboos, customs, traditions, and codes of conduct). The institutions of governance are market, quasi-market, and hierarchical modes of contracting, more generally of managing transactions and seeing economic activity through to completion (Williamson, 1998). The interaction between the institutional environment and governance mechanisms determines the economic efficiency of exchange and incentives for investments in durable assets, both physical and human (skills). Policy reforms refer to changes in certain elements of institutional environment, which, in turn, influence micro-level governance mechanisms with feedback effects on the institutional environment.
Policy reforms in the east European (transition) economies relate to shifting from a socialist to a capitalist system. Shifts within the paradigm imply that there exists a broad framework of capitalism, but with inefficient institutions, and that policy changes are necessary to improve these institutional elements. This distinction is important because the fundamental paradigm shifts from communism to capitalism involve complex issues and this book’s focus is on the development of institutions. I approach the evolution of institutions under the condition that there is a critical minimum level of capitalist institutions at the onset of economic reforms, on the basis of which further evolution takes place.3 The initial institutional endowments are existence of a certain level of property rights, and commercial laws (the rules of the game) so that there are privately owned firms with functioning product and input markets.4
Economic reforms are taken as exogenous shifts in certain elements of the institutional environment which trigger an endogenous process of evolution of markets and institutions. I make a distiction between parameter and qualitative shifts. The former refer to quantitative changes in taxes, exchange rates, tariffs, and licensing fees, etc., while the latter refer to changes in the rules of the game between different players. To illustrate the qualitative shifts, removal of licensing policies changes the rules of the game between producers, consumers and government agents, for example by increasing competition. The shifts change absolute and relative prices in an economy (between different sectors and economic actors), as well as the transaction costs of doing business in different spheres. This, in turn, determines structural changes in terms of growth and the relative importance of different sectors, and micro-level governance of technology and organization through increased competitive dynamics. The direction of the endogenous process is determined by initial institutional and market endowments.
The changing economic interests of different agents and groups determine whether the reforms progress, and there will be cohesive bargaining for effciency-enhancing institutional change. The importance of the initial conditions is that they determine how soon the positive gains of the reforms are realized, so that political interests become entrenched for further efficiency-enhancing institutional change.5
To illustrate the above point, in applying transaction-costs logic to political aspects of the reform process, Dixit (1999) characterizes three phases in the formation of interest groups under information asymmetry: ex ante, interim, and ex post. At the ex ante stage, each individual is uncertain about his own type (preferences) as well as the types of others because there is no private information. At the interim stage, each individual knows his own type, but not the types of others. The ex post stage is when all players’ types are publicly revealed. In the case of countries such as India, unlike Eastern Europe and China, one might start from the interim stage because of the existence of powerful incumbents, both private firms and the policy-makers, with their interests known at least for the short term. Policy reforms would mean a fall in monopoly rents to dominant incumbent firms and a decline in the control and rent-seeking powers of government agents. To illustrate this with an example of industrialists in India, when reforms initiated the process of liberalizing the entry of transnational corporations (TNCs) in the mid-1980s, a few dominant incumbent industrialists organized themselves into what was then called ‘the Bombay Club’. They put forward the argument of a level playing field to lobby against the entry of TNCs. However, the reforms continued in a slow process. By the early 2000s, two main benefits of the increasing presence of TNCs in the Indian economy became apparent. The competitive dynamics between TNCs and local firms resulted in several incumbent local firms becoming efficient. Local firms started to derive gains through the expansion of markets, a part of it caused by increased competition (fall in prices). Second, the case of software and service industries has shown the employment and export benefits of TNCs’ operations in India, which altered both the public and policy perceptions about TNCs. Consequently, both the policy-makers and the main industry body, the Confederation of Indian Industry, now want to attract more foreign direct investment (FDI). Several companies who lobbied against the entry of TNCs, have become multinational firms themselves by investing in green-field ventures and acquiring firms abroad by the early 2000s. The argument is that the reforms may make everybody better off in the long run, but in the interim period the myopic interests of incumbents can block or distort the process. If the initial conditions are such that the benefits of the reforms are realized quickly, then institutional evolution may not be blocked

India: a brief background

A major part of the reason for the positive outcome of economic reforms is that India possessed a critical level of markets and capitalist institutions on the basis of which policy reforms were undertaken. Several of the initial endowment conditions were acquired both from the free market mechanism of British rule and the import substitution policies of the postindependence period since 1947.
India’s economy in the early part of the twentieth century under the British rule was basically a free market economy, which declined economically (Clark and Wolcott, 2001). However, British rule established a critical level of infrastructure conditions for free markets in terms of railroads and telegraphs, which reduced the transaction costs of trade both internally and internationally, and certain elements of capitalist institutions of contract and property laws through the adoption of Common Law, which continued after independence. At the time of independence in 1947, the Indian leadership bestowed on the government the responsibility of overcoming India’s poverty and achieving economic prosperity. In order to achieve this objective, the government adopted a highly interventionist planning system for rapid industrialization, with relative success, accelerating the aggregate growth rate to about 6 percent in the 1950s and early 1960s. In the following decades, the growth rate declined to a ‘Hindu growth rate’ of 3 percent as the state started to impose several controls and transaction costs on economic actors in the name of socialism and eradicating poverty.
The dominant philosophy in development economics in the 1950s was that developing economies, most of which were victims of colonial rule, required a ‘big push’ by the state taking up the developmental role. The basic concern was that the private sector would be unable to save enough, and government was seen to be in a position to lift the saving rate through budgetary manipulations (Nurske, 1953). Apart from this, there was the concept of ‘development externalities’ drawn from Hirschman’s (1958) theory of sectoral linkages, namely that private investments in individual products were unprofitable unless there were a concerted program of investment in a number of complementary sectors, each providing demand and reducing costs for the other. This required massive investments simultaneously in different sectors such as railroads, power, roads, banking, mining, and heavy industry. At that time, government alone was in a position to undertake the investment because, singly, private investors would have found it unprofitable. These investments by the government reduced several types of transaction costs by generating developmental externalities, contributing to increased growth rates in the 1950s and early 1960s. Similarly, the active policy intervention in the agriculture sector in the late 1960s contributed to the Green Revolution, which made India self-sufficient in food grain production within a short period. However, as the policy intervention increased over time, creating vested interest groups with rent-seeking interests (bureaucracy, politicians, and the monopoly businesses), the government started to impose new types of transaction costs on private activity, thereby stunting growth.
In several areas, the stock of the previous government investments made it easy for private sector and markets to take over and reduce transaction costs significantly in the post-reform era. One example is the communication sector. Another is the government’s massive investment in higher education for facilitating import substitution, which became the basis for high-tech industries such as the software and pharmaceutical industries to expand significantly in the post-reform period (Patibandla et al., 2000). The other side of the story is that the government intervention took on a life of its own as it became a major source of rents to government agents and powerful incumbents, imposing efficiency-curtailing transaction costs at every level of economic activity. This trapped the economy into distributional politics at the cost of wealth-generation (Sanyal, 1984; Bardhan, 1984). As mentioned before, India’s growth in the post-reform period remains fragmented, with close to 300 million people below the poverty line and outside the market economy. One possible explanation is that, in the pursuit of heavy industrialization, the previous government ignored the generation of universal primary and secondary education and the generation of social security systems (or land reforms), and thereby failed to create conditions of ‘equality of opportunity’ for its people.
As is well known in the literature on India, the major economic reforms of 1991 were made possible by the balance of payments crisis, a crisis driven reform in a complex democratic polity. Although the reforms of 1991 can be considered a major policy shock, they were only a partial reduction in government intervention, and the subsequent reform process continues in a slow process owing to the complex web of interactions of the different interest groups. To exemplify this observation, the Indian economy averaged about 7 percent growth rate, its foreign exchange reserves crossed $100 billion and the country came to be known globally as a software superpower in the early 2000s. The then ruling NDA (National Democratic Alliance) government went to the elections in 2004 with the slogan of ‘India Shining’, but lost. The Congress party in coalition with the communist parties formed the government at the center. One of the explanations given for the fall of the NDA government by several writers in the popular press (including Salman Rushdie) was that the economic reforms and growth benefited only the rich and the middle class, while a large section of the rural poor were left behind. The reforms process continues slowly with a complex interaction between the coalition members, the Communist Party, which wants to block market-friendly reforms, and the Prime Minister, Dr Manmohan Singh, an eminent economist, who favours reforms and was the major architect of the 1991 reforms as the then finance minister.
India is probably the most interesting case among the emerging economies with which to study the evolution of markets and institutions in response to economic reforms, owing to its democratic polity, which is characterized as ‘one polity and many countries’ (Clark and Wolcott, 2001). India as a nation-state is like putting all of Europe into one country. When the East Asian economies and China were growing at a rapid pace in the 1980s, they were called ‘Tigers’ in the popular press. In view of her slow growth rate and the presence of a large section of poor and illiterate people, India is generally referred to as a ‘lumbering elephant’. A few attribute this to the way in which democracy functions in India, while the East Asian countries and China have been able to implement policy changes quickly because of their totalitarian systems. As mentioned before, India, unlike the Eastern European countries and China, has a critical level of markets and capitalist institutions acquired both from British rule and under the Fabian socialist policies of the prereforms period. The institutional evolution in response to the policy reforms operates from the basis of the initial conditions under a complex democratic process. These factors make India an interesting case and at the same time render the task at hand a very difficult one. Just to give an example, the striking duality of India is that in the early 2000s, India has come to be known as a great destination for outsourcing of high-tech jobs in the areas of software and services, pharmaceutical, and biotechnology industries. One of the results of the reforms is by the early 2000s India had started to produce a few indigenous, world-class companies both in the service and manufacturing industries. There has been a rapid increase in the incomes of especially the urban middle class. At the same time, she houses the largest number of poor and illiterate people in the world.

A few conceptual issues

Does evolution of markets and institutions refer to movements towards an optimum? Arrow-Debreu’s general equilibrium theory of the neo-classical economics is basically a formalization of Adam Smith’s idea of the ‘invisible hand’ of free markets, which shows the efficiency of free markets through the lens of the Pareto optimality conditions. In the presence of a complete set of markets, prices in equilibrium reflect their true opportunity costs in space and time. With a large number of perfectly rational anonymous agents with perfect foresight under an assumed perfect set of markets, the model shows how free markets lead to Pareto optimal outcomes of welfare. If one goes by the optimality criteria, policy reforms should be aimed at letting these conditions prevail either by withdrawing government controls or by public policy intervention in specific spheres, depending on the nature of the market failure. Market failure refers to the presence of externalities and non-convexities. Any student of economics knows that it is literally impossible to meet all the conditions necessary for Arrow-Debreu general equilibrium in the real world, which, in turn, can be used to justify selective policy intervention in correcting for market failures. If government intervened as a result of market failure considerations in the first place, where is the need for reforms eliminating government intervention? The question leads to the notion of ‘government failure’. Ronald Coase envisaged the notion of government failure as early as 1964 through his conceptualization of comparative economic organization.6 Commenting on the obsession of the economics profession with the frictionless free markets, he observed,
It has led economists to derive conclusions for economic policy from a study of an abstract of a market situation. It is no accident that in the literature . . . we find a category of market failure but no category of government failure. Until we realize that we are choosing between social arrangements which are more or less failures, we are not likely to make much headway.
The Arrow-Debreu general equilibrium theory helps in identifying different conditions necessary for the efficient functioning of markets under the equilibrium criteria of collective economic welfare of societies (Arrow, 1964). Where does the notion of economic institutions of capitalism become germane? One of the fundamental assumptions of the neoclassical economics is that people participate in economic activity as anonymous and autonomous agents acting in a large group context. We all know that a major part of economic activity is organized with more than one agent as a group or an organization. For several reasons of indivisibility of economic tasks, collective action results in higher surplus than individual action, and economic activity by organizations instead of by single individuals reduces the transaction costs of markets – ‘Robinson Crusoe gets married’. The rules and norms at the micro level of firms, bureaus, and societies at large are a result of collective action of the public and private order institutions.
When economic exchange moves from small-group to large-group exchange, it results in a high degree of uncertainty for economic agents in figuring out the attributes, and ownership rights of what is exchanged (North, 1990). High uncertainty reduces gains through specialization and expansion of markets and number of transactions, thereby stunting economic progress. This is where government, which can be viewed as a public order institutional arrangemen...

Table of contents