institutions are more successful at achieving objectives than others.
Institutions arise as solutions to a given set of problems. Should the
elements of the problem change (the actors, agents, technology, information,
other institutions), the institutions may need to adapt. However, any set of
institutions is correlated with the interests of particular individuals. Some of
these individuals benefit from the particular structure while others are not.
Those who benefit from a particular institutional structure have a vested
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4.2 Institutions and Costs
interest in preventing changes in the institutions. These vested interests may
use their positions and power to prevent institutional change and to work to
alter institutions (particularly explicit institutions such as law) in their
interests. Consequently, the institutions that are prevalent at any point in time
may lag behind environmental, technological and social changes.
Patents, copyrights, regulations of communication industries (radio,
television, newspapers, internet and the like) determine the behavior of the
agents and firms in those industries. George Stigler (1911-1991) described a
“capture theory of regulation.” (Stigler, 1971, Published first in 1962 with
Claire Friedland) He argues that when an industry is regulated, it is in the
interests of that industry to capture the regulatory agency and influence its
policies. The communication industries have a greater incentive to influence
the policies of the Federal Communications Commission (FCC) than the
average person. Recent actions by the FCC have allowed greater concentration
of news media. Companies that publish music have more interest in the laws
regarding the ownership (copyrights) and royalties to music than the public:
the “Napster” incident on downloading music files from the Internet is an
example.
The insurance, pharmaceutical, hospital and medical industries have more
interest in the social institutions that influence the delivery of health care than
individuals. Health insurance emerged in the mid 1930’s as a solution to the
problems of random, catastrophic health care costs and how hospitals and
doctors would receive financial payment. The insurance and health care
providers (doctors, pharmaceutical, hospitals and insurance industries and
firms) have a vested interest in maintaining the system that maintains their
sources of revenue.
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4.2 Institutions and Costs
The vested interests have an incentive to shape the formal and informal
institutions that relate to their activities.
4.3 MORALITY, JUSTICE AND A STABLE SOCIETY
Institutions reduce the costs of the allocation process. Additionally,
justice, an orderly society, tranquility, security, peace are objectives that are
commonly held in many societies. Adam Smith (1723-1790) is used to express
these ideas here since he is generally regarded as one of the first writers to
advocate a system based on morality, markets and law. He wrote the Theory
of Moral Sentiments in 1759 to describe his view of the role of sympathy and
empathy in human behavior. He argues that justice is essential for an orderly
society. On the first page of Theory of Moral Sentiments , Smith writes:
How selfish man may be supposed, there are evidently some principles
in his nature, which interest him in the fortune of others, and render
their happiness necessary to him, though he derives nothing from it,
except the pleasure of seeing it. Of this kind is pity or compassion, the
emotion which we feel for the misery of others, when we see it, or are
made to conceive it in a very lively manner. That we often derive sorrow
from the sorrow of others, is a matter of fact too obvious to require any
instances to prove it: for this sentiment, like all the other original
passions of human nature, is by no means confined to the virtuous and
humane, though they perhaps may feel it with the most exquisite
sensibility. The greatest ruffian, the most hardened violator of the laws
of society is not altogether without it. (Smith, TMS, p 47)
Smith continues on the role of society in the formation of individual values:
Were it possible that a human creature could grow up to manhood (sic)
in some solitary place, without communication with his (sic) own
species, he could no more think of his own character, of the propriety or
demerit of his own sentiments and conduct, of the beauty or deformity
of his (sic) own mind, than of the beauty or deformity of his (sic) own
face. All these are objects which he cannot easily see, which naturally
he does not look at, and with regard to which he is provided with no
mirror which can present them to his view. Bring him into society, and
he is immediately provided with the mirror which he wanted before. It is
placed in the countenance and behavior of those he lives with, which
always mark when they entered into, and when they disapprove of his
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4.3 Morality, Justice and a Stable Society
sentiments: and it is here that he first views the propriety and
impropriety of his own passions, the beauty and deformity of his own
mind. (Smith, TMS, p 204)
Smith continues:
It is thus that man, who can subsist only in society, was fitted by nature
to that situation for which he was made. All the members of human
society stand in need of each other’s assistance, and are likewise
exposed to mutual injuries, Where the necessary assistance is
reciprocally afforded from love, from gratitude, from friendship, and
esteem, the society flourishes and is happy. All the different members of
it are bound together by the agreeable bands of love and affection, and
are, as it were, drawn to one common centre of mutual good offices.
But though the necessary assistance should not be afforded from such
generous and disinterested motives, though among the different
members of society there should be no mutual love and affection, the
society, though less happy and agreeable, will not necessarily be
dissolved. Society may subsist among different men, as among different
merchants, from a sense of its utility, without any mutual love or
affection: and though no man in it should owe any obligation, or be
bound in gratitude to any other, it may still be upheld by a mercenary
exchange of good offices according to an agreed valuation.
Society, however, cannot subsist among those who are at all times
ready to hurt and injure one another. (Smith TMS, p 166)
. . . Society may subsist, though not in the most comfortable state,
without beneficence: but the prevalence of injustice must utterly
destroy it. . . . Justice, on the contrary, is the main pillar that upholds
the whole edifice. If it is removed, the great, the immense fabric of
human society, that fabric, if I may say so, to have been the peculiar
and darling care of nature, must in a moment crumble into atoms.
(Smith TMS, p 167)
As society cannot subsist unless the laws of justice are tolerably
observed, as no social intercourse can take place among men (sic) who
do not generally abstain from injuring one another: the consideration of
this necessity, it has been thought, was the ground upon which we
approved the enforcement of the laws of justice, by
Smith recognizes that beneficence and morality cannot be the only
mechanism that creates order in society. He argues that:
This disposition to admire, almost to worship, the rich and the powerful,
and to despise, or, at least, to neglect persons of poor and mean
condition, though necessary both to establish and maintain the
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distinction of ranks and the order of society, is, at the same time, the
great and most universal cause of the corruption of our moral
sentiments. That wealth and greatness are often regarded with the
respect and admiration which are due only to wisdom and virtue: and
that the contempt, of which vice and folly are the only proper objects, is
often mostly unjustly bestowed upon poverty and weakness, has been
the complaint of moralists of all ages. (Smith TMS, p 126)
Smith is not the only writer to argue the importance of justice and morality
in the proper functioning of society. Plato, Aristotle, St Thomas, and a host of
writers argue the role of justice. At the same time, most recognize that
beneficence and cannot be the only motivating force in society.
The need for morality is based on biology and ecology: Joan Robinson
argues:
A society cannot exist unless its members have common feelings about
what is the proper way of conducting its affairs, and these common
feelings are expressed in ideology. (Robinson, p 3)
The biological necessity for morality arises because, for the species to
survive, any animal must have, on the one hand some egoism-a strong
urge to get food for himself (sic) and to defend his means of livelihood:
also-extending egoism from the individual to the family- to fight for the
interests of his mate and young. On the other hand, social life is
impossible unless the pursuit of self-interest is mitigated by respect and
compassion for others. A society of unmitigated egoists would knock
itself to pieces: a perfectly altruistic individual would soon starve. There
is a conflict between contrary tendencies, each of which is necessary to
existence, and there must be a set of rules to reconcile them. Moreover,
there must be some mechanism to make an individual keep the rules
when they conflict with his immediate advantage. (Robinson, p 4) . . .
Since the egotistic impulses are stronger than the altruistic, the claims
of other have to be imposed upon us. The mechanism by which they are
imposed is the moral sense or conscience of the individual. (Robinson, p
5) . . .
But observe, it is the honesty of other people that is necessary for my
comfort. (Robinson, p 6)
Justice and concern for others is an important objective that is often
reflected in the golden rule: “Do unto others as you would have them do unto
you.” Or to quote Ivan Hill,
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4.3 Morality, Justice and a Stable Society
Men of many ages have considered the Golden Rule to be the
fundamental moral imperative. Confucius once was asked, ‘Is there one
word which may serve as a rule of practice for all of one’s life?’ He
answered, ‘Is not reciprocity such a word? What you do not want done
to yourself, do not do to others.” (Hill, p 4)
A just and moral society where humans can live in a peaceful environment
is an objective held by many philosophers through the ages. Perhaps for
some, the history of conflict and war casts doubt on a human objective of
justice. Alternatively, perhaps conflicts and wars occur because of feelings or
injustice.
Tradition, customs, mores, and other social institutions are mechanisms
through which individuals acquire common values. The size of one’s family,
forms of marriage, responsibility for children or parents, expectations about
disposal of wastes, use of resources, obligations to care for less fortunate
people, trust, theft, voting, creativity, duty to family (country, etc) attitudes
about stewardship, are examples of values that may be generally held by the
members of a community. These values influence the choices that individuals
make.
4.4 AGENTS
A decision also implies the existence of an agent. An agent is an
individual who has the authority to evaluate, select, and act on alternatives to
achieve an end. The agent may act for themselves or on the behalf of a
principal. Agents choices may be based on intuition, habits (rules of thumb,
institutions), explicit rules or reason.
Any decision implies that there is an end, objective, or goal that an agent
wishes to achieve. Humans seek means to achieve ends. As suggested above,
decisions based on reason must have an objective. Intuition as a method for
making decisions also implies that a result is desired. Rules and habits (or
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4.4 Agents
social institutions) arise because there is some desired end to be
accomplished. The question is what is the origin and nature of the objectives.
Both the ends and means may be influenced or constrained by resource
endowment, technology, or social institutions (such as customs, traditions,
markets and law).
In the case of an agent or agents representing a principal, there may be a
conflict or incompatibility among their objectives. This is referred to as the
principal/agent problem. The agent has a conflict of interest. A stockbroker
acts as an agent for an investor: a doctor may act as the agent for a patient.
The lawyer acts as an agent for her client, the principal. The goal or end of the
investor may be to maximize earnings on their assets. The end or objective of
the stockbroker may be to maximize their commission. In the short run, the
broker may sacrifice the earnings of the investor to maximize commissions.
Hopefully, in the long run the broker will recognize that the short term
strategy will result in the loss of the investor as a client. The principal must
have some knowledge and information regarding the agent’s behavior. In a
complex world, this does not always happen. Enron is an example of the
principal/agent problem. The interests (ends) of the CEO and management
(the agents) were inconsistent and had priority over the goals of the
stockholders (principals).
In a complex world where it is difficult for principals to have information to
evaluate all the action of the agents, a code of conduct or code of ethics may
be important as a means to get the agent to act for the principal. The
Hippocratic oath is a social institution to insure the physician acts in the
principals interests. Accountants and lawyers are other examples of
professions that rely heavily on codes of ethics to resolve conflicts between
the principal and agent.
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4.5 Organizations and Agents
4.5 ORGANIZATIONS AND AGENTS
Organizations are another way that the cost of economic activities. North
distinguishes between institutions and organizations. Both provide structure to
human interactions. Ronald Coase (1910-) sees both as mechanisms to reduce
the costs of transferring ownership. (Coase, 1937)
The crucial difference is that institutions are part of the rules of the game
and organizations are participants in the game. The firm (or any organization)
arises because there are costs to using the “pricing mechanism.”
What the prices are have to be discovered. There are negotiations to be
undertaken, contracts to be drawn up, inspections to be made,
arrangements to settle disputes, and so on. These costs have come to
be known as transaction costs. Their existence implies that methods of
co-ordination alternative to the market, which are themselves costly and
in various ways imperfect, may nonetheless be preferable to relying on
the pricing mechanism (market? Author’s question) , the only method
of co-ordination normally analyzed by economists. It was the avoidance
of the costs of carrying transactions out through the market that could
explain the existence of the firm, in which the allocation of factors came
about as the result of administrative decisions.
In the “Nature of the Firm” I argued that in a competitive system there
would be an optimum of planning since a firm, that little planned
society, could only continue to exist if it performed its co-ordination
function at a lower cost than would be incurred if co-ordination were
achieved by means of market transations and at a lower cost than this
same function could be performed by another firm. . . .
I argued in “The Nature of the Firm” that the existence of transaction
cost leads to the emergence of the firm. (Coase 1995, p 8-9)
The firm (or any organization) comes into existence to create a small
“planned society” and to use administrative decisions to allocate resources
because it would be more costly to use market exchange. Firms (or
organizations) may be for profit, not-for-profit, cooperatives, sole
proprietorships, partnerships or corporations. There are many ways of
categorizing organizations.
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4.5 Organizations and Agents
Within a firm the CEO, Board of Directors, shareholders, Vice-President of
Marketing, Vice-President of Production and the assembly line workers may
have competing objectives that will be resolved by authority, contract, or
some other social institution. There are managerial techniques that might be
used to coordinate the activities of the diverse groups in a firm.
In a family, the parents may have different ends than the children. There
are parental “instincts,” love and social expectations as well as laws that
insure the parents act in the child’s interests.
Within an organization, the principal/agent problem becomes important.
Usually a manager (CEO) makes administrative decisions that affect many
other groups. Their administrative decisions may be guided by general policies
and guidelines established by a Board of Directors who in turn is constrained
by the shareholders (or owners). The objectives of the shareholders may or
may not be reflected by the decisions of the manager. The manager may have
a different set of objective and the shareholders may or may not have
information (or control) over the decisions of the manager. Kenneth Lay and
the management of Enron is an example of the principal/agent problem.
4.6 OBJECTIVES
An objective, goal or end is something that an individual or group of
individuals hopes to achieve. There may be many alternatives that will
potentially achieve the end or goal. Some alternatives have a higher
probability of success. The alternative that is selected, through reason, rules,
habits or intuition, is the means.
It is not always clear how humans create their objectives or ends. One
hypothesis is that they are capable of thought and can imagine alternative
states or conditions. If the alternative state is perceived as preferable to the
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4.6 Objectives
existing state, the alternative state becomes an end. This process necessarily
requires a subjective valuation or ranking of alternative states or conditions. I
am hungry. I can perceive or imagine myself not being hungry. Not being
hungry is preferable to being hungry so the objective or end is to reach the
preferred state. The mind is capable of recognizing an incongruity between
what is and what I imagine can be. I may seek the means to satisfy my
hunger through reason. Intuition, rules or habitual patterns of behavior may
also suggest means of satisfying my hunger.
Many substances will satisfy hunger. Geographic differences and resource
endowment may alter what people choose to eat. Inuit people eat whale and
sea lion. In the southwestern United States pinto beans, corn and chili peppers
are favorites. In France, escargot is a delicacy. Individuals often develop a
“taste” or preference for a food they ate as a child. As a result, we often think
of foods as representing different social of ethnic groups. Italian, Chinese,
Mexican, Indian are examples of ethnic foods that represent different social
groups from different locations.
Hunger is a physiological stimulus so it is easy to recognize the incongruity
between being hungry and not being hungry. Other events are more complex.
I have shelter that is adequate (a 700 square foot shelter that has plumbing
and heat) but can imagine a larger house (3000 square foot with a den and
multiple bathrooms) that I would prefer. If the 700 square foot house is
adequate, why is the larger house preferred? Is it because I perceive that my
neighbors (the community) associate the bigger house with status? Do the
values of the community influence my preferences? If my objective or end was
to acquire status, the large house was the means to achieve that end. If my
objective was to have enough room for a large family, the large house may be
the means to achieve that end. To the casual observer the acquisition of a
large house may incorrectly be seen as the desired end.
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4.6 Objectives
Economics is a study that is based on scarcity of the means to achieve
objectives. As a result, choices must be made on the relative values that are
placed on the competing objectives. To repeat from above, Warren Samuels
argues that the “economy is a process of valuation…. That to behave an