Contribution of the New Industrial Economics to the understanding of the Problems of Developing and Transition Economies and Evaluation of the Quantitative Measures of the Content of Legal Rules and the Performance of the Legal Systems under the World Ban

Abstract

The New Institutional Economics (NIE) can be looked in to as assisting the development of the economies in two different ways; first through its part that deals with the relationship between the governance and growth provides the framework for various types of institutional reforms. Secondly the NIE advises the ways in which the developmental assistance can be provided. Unlike old institutional economics, while the NIE covers the changes in the economy as well as the interactions of the individuals, it also encompasses the economic activity that is plagued with transaction costs and collective action problems.

Such transaction costs include uncertainties about the trustworthiness of sellers and borrowers The NIE provides the ways by which the transactions costs that are uncertain could be mitigated and the scope for the markets can be expanded.

This offers a definite scope for the developing and transition economies to establish appropriate institutions. These institutions represent formal written rules enforced by the state and unwritten informal rules which are enforced by the groups within the society. With this background this paper presents an evaluation of the quantitative measures that can describe the content of the legal rules and the performance of the legal system within the developing economies.

1.0 Introduction:

According to the International Society for New Institutional Economics, The New Institutional Economics (NIE) is an interdisciplinary enterprise combining economics, law, organisation theory, political science, sociology, and anthropology to understand the institutions of social, political and commercial life, It borrows liberally from various social-science disciplines, but its primary language is economics. Its goal is to explain what institutions are, how they arise, what purposes they serve, how they change and how they can be reformed if it is necessary.  The other way to look at the New Institutional

Economics is as a concept that answers the need to align the incentives of agents with the interests of the principals in both economic and political spheres so that good governance can be established in providing complete solutions for problems of economic development. The NIE recognizes that good governance is the essential ingredient that might catalyze the human capital, liberalization and privatization into a thriving economy.

In fact NIE is about establishing sustainable regulatory and legal framework and government rules and structures that  make banking systems, corporate governance and tax collections work effectively to foster the economic development in an accelerated pace. This is especially true in the case of developing countries where there are evidences to prove the liberalization and privatization measures without adequate backing of the regulatory and legal frameworks have resulted in serious instability, inequity and inefficiency.

This paper envisages making a report on the problems being faced by the developing and transition nations and the contribution of the NIE to mitigate these problems. The paper also makes a critical evaluation of the use of quantitative measures of both the content of legal rules and the performance of legal systems under the World Bank’s ‘Doing Business’ project along with the selected indices reported by some developing nations.

1.1 The New Institutional Economics (NIE) – An Overview

The NIE developed by Oliver Williamson considered to be a revolution emerged with Coase’s 1937 article ‘The Nature of the firm’. The NIE is a vast and relatively multidisciplinary field that includes aspects of economics, history, sociology, political science, business organization and law. The ‘Transaction Cost’ is the root word of the NIE. It considers the transaction costing that is basically determined by the institution and institutional arrangements present in an economy.

Transaction costing is the key to and determines the performance of the economy. Based on this ideology NIE argues that institutions like its legal, political and social systems present in a country determines the economic growth of the country and it is also so that the efficiency of these very institutions foster the growth of that economy.

The phrase New Industrial Economics was coined by Williamson as distinguished from the ‘old institutional economics’ which was pioneered by Commons and Veblen. The old institutional school stopped with identifying the institution as a key factor in explaining and influencing economic behaviour; but they didn’t contain any analytical `rigor or theoretical framework to take further the role of the institutions towards the economic development. Whereas, the approach by Williamson was involved the underpinning the role of the ‘institutions’ in the economic development.

Transaction costs are the costs that are involved in operating an economic system in general. They are in such a state that can be related to a measurable input of the real resources. “Examples of such costs are search and information costs, the costs of supervision and implementation of contractual obligations, costs of quality control, production planning and supervision, procurement and elaboration of relevant data, and the costs of the further development of laws, the supervision of their observance and their implementation (Furubotn and Richter 2000)[1]

While acknowledging the important role of institutions in an economy NIE argues that such role is always subject to analysis within the framework of the neo-classical economics. The basic parameters or assumptions of neo-classical economics like the existence of perfect information, zero transaction costs, full rationality and the like are relaxed to the extent necessary to undertake such analysis. However, it retains the assumption of self-seeking individuals attempting to maximize an objective function subject to available constraints. Under the NIE framework, institutions become an additional constraint than those already existing.

The purpose of the NIE is both to explain the determinants of institutions and their evolution over time, and to evaluate their impact on economic performance, efficiency, and distribution.

 The relationship between the institutions and economic growth are twofold. On the one hand, institutions by their profound influence on the economic growth really foster it, while on the other hand the development and the resultant economic growth often necessitates changes in the economy’s outlook on the institutions by bringing about continuous changes thereon. The second part of this hypothesis can be explained by the fact that the growth in the international trade and the globalization of businesses have necessitated the need to develop official and internationally recognized grades and standards.

However one point needs to be remembered that is that all institutional changes may not result in a beneficial way for the economic growth. For instance, the influence of the transaction costs and co ordination possibilities may also operate in the negative direction resulting in retardation of the economic growth. In fact this is the very reason we have economies and institutions with varying and different orientations all through the world.

1.2 Institution under the New Institutional Economics:

The most commonly agreed upon definition for institutions is: “Institutions are the humanly devised constraints that structure human interaction. They are made up of formal constraints (rules, laws, constitutions), informal constraints (norms of behavior, conventions, and self imposed codes of conduct), and their enforcement characteristics”. (North, 1993)[2]

Thus institutions can be construed as the basic incentive structure of a society. The variants of institutions like political and economic institutions can be regarded as the determinants of economic performance. By having an influence on our behaviour, the Institutions tend to affect the outcomes such as economic performance, efficiency, economic growth and development. It is important to note that NIE operates at both macro and micro levels. Under macro level NIE defines and deals with the Institutional environment.

The institutional environments described under macro level encompass the rules of the game which affect the behaviour and performance of the economic actors and in which the organizational forms and transactions are embedded. Williamson (2000)[3] states that “the formal features of the institutional environment—the laws, polity, judiciary, bureaucracy—are crucial in examining the development of nation states and for making intertemporal comparisons within and cross-national comparisons between nation states.”

 The Institutional arrangement on the other hand is dealt with the micro level analysis. Institutional arrangement takes care of the institutional governance which also forms the basis of the NIE.  These, according to Williamson, refer more to the modes of managing transactions and include market, quasi- market, and hierarchical modes of contracting. The individual transactions and the organisational forms and structures form the central theme of the institutional arrangements.

Thus an institutional arrangement is basically an arrangement between economic units that governs the ways in which its members can cooperate or compete with each other. For Williamson, the institutional arrangement is probably the closest counterpart of the most popular use of the term ‘institution’.

It is also useful to distinguish institutions from organizations. Organizations can be defined as a structure of roles. Many institutions are organizations; for instance, households, firms and co-operatives. Other types of institutions, on the other hand, are not organizations, such as money or the law. Likewise, there are organizations (for example grass-root organizations) that are not institutions.

1.3 Branches of the New Industrial Economics:

With the advent of time the modern day economists in addition to studying their traditional branches of economics like prices, quantities and fluctuations also study the governance structures and dispute resolution mechanisms of societies. Thus the NIE has taken the shape of the theoretical integration of the social sciences under one overreaching study.

Law, politics and sociology may be viewed as the primary branches of the NIE. While the ‘new economic history’ and the ‘public choice school’ can be regarded as the branches at the macro level to deal with the institutional environment , the ‘transaction cost economics’ and the ‘information economics’ may be regarded as the branches at the micro level to deal with the transactions and the various forms of governance.

2.0 Legal Institutions under NIE:

In order to promote development of the economy, it is important that the government ensures the law enforcement as an essential tool for protection of property rights as well as to ensure that the operation of trade in general results in a positive outcome. A well defined administration of law and legal systems which clearly describe impartially interprets and consistently enforces the rights and privileges of merchants and other citizens is an essential prerequisite for the promotion and growth of an economic activity.

While creating law can be viewed as a simpler task the evolution of a legal system which will exclusively be governed by laws and not by men who made it, seem to be a complex task that is at the root of the economic development.

However it must be noted that the mere existence of any law is not sufficient but the way in which such law is enforced is what matters for the economy to show a positive trend. “In all likelihood it is the enforcement of good commercial laws rather than mere existence which encourages lenders to trust others with their money” (Omar Azfar 2002)[4]

Thus the existence of good laws and their enforcement encourages merchants to enter into spot transactions and thereby enhances the magnitude of the existing capital market. By having a positive effect on the capital market and developing it, law enforcement independently effects the economic growth. However it is observed that due to absence of empirical data covering the issue, it is not possible to substantiate the theory that efficient law enforcement enlarges capital market, although this effect has been visualized in some countries. Similarly it is also not possible to precisely point out which law will be effective in this direction.

Another factor which needs attention in respect of the laws and legal systems with respect the economic development is the speed with which the cases are heard and judgments passed. The delay in deciding the cases by the courts has been attributed as the reason for poor economic performance and the persistent poverty for some time in India.

The next aspect to be considered is the nexus between the legal systems and the political development in the arena of economic development. It can be easily seen that both are interlinked with each other in such a way that the reliable law enforcement may underlie genuinely contested political markets and vice versa. “More generally, in societies where the quality of public services is uncertain and people rely on personal favors, the government can unduly influence people in the media, judiciary and opposition and undermine the effectiveness of formally democratic institutions.” (Omar Azfar 2002)[5]

2.1 Role of Legal Reforms in Economic Development:

“Laws and legal institutions feature prominently in this new intellectual terrain.”(Kevin Davis)[6] The main reason for this phenomenon is the diversion of the focus of the economists to the potential economic functions of the legal institutions in the developing economies. There can be no commercial transaction without the backing of a valid contract law and the protection of the property rights. The existence of these set of legal regulations encourages investment and exchange of properties.

Similarly on the political front also all the existing political arrangements in the form of democracy, human rights and the concept of welfare state have been backed by well defined legal norms and institutions. The chief among them is the constitution of the country and the various interpretations given by the courts thereon.  All these insights have led to a situation that the overall existence and the quality of the legal institutions is an important determinant of the economic development.

In short this can be expressed as ‘Rule of Law’ is an essential pre-condition to development.  Motivated and inspired by this consensus on the importance of the contribution of the legal institutions, multilateral institutions and developed countries have shifted their focus to the major reforms in the legal institutions in the developing countries. However academic academic observers have also expressed scepticism as to whether improvements in the law will necessarily yield better economic outcomes (Davis and Trebilcock 2001)[7]

3.0 Institutions and Economic Development and Growth:

“A great deal of economic research in recent years suggests that institutions are vital for economic development and growth” (Hali Edison)[8]

The institutions can be defined in terms of the degree of property rights protection, the degree of application of the laws and regulations at a fair level and also the extent of corruption if any. A broader definition of institutions includes formal and informal rules that govern the human interactions.

By assessing the economic development of various developing nations, the economists have arrived at a decision that the development of these economies has a close relationship with the quality of the institutions. Various studies in this direction have found that the institutional quality does have a significant effect not only on the level of income but also on the growth of the economy and also on the volatility of such growth.  In order to measure the quality of the institutions, the analysts have established different measures so that the development of the economies can be assessed more precisely.

However according to Hali Edison these measurements basically depend on the subjective perceptions and assessments of country experts or the assessments made by residents responding to surveys carried out by international organizations and nongovernmental organizations.

4.0 Application of New Institutional Economic Theory:

The application of NIE to finance and development of economies is broad based. Omar Azfar (2002)[9] States that Social structure—itself affected by the structure of production, climate, colonial origin and inequality—may have affected the development of political institutions. The commercial laws and their enforcement get affected by the impact of these political institutions which in turn have helped the development of debt and equity markets. Thus the NIE indirectly has contributed to the development of the economies through the development of capital markets.

 NIE has also important insights in to the education sector answering questions like whether the schools should run for profits or should be run as state institutions as non-profit making organizations.

In the sphere of decentralization also NIE can help identify the extent of improvements required in the public service delivery.  Further involvement of NIE can be traced in detailing the functions of the local governments and thereby brings out the microstructure of the local governments including the accountability and efficiency in the functioning of the local governments in the quality of public service delivery.

Omar Azfar(2002)[10] adds further that “Insights from NIE are also directly relevant to how foreign aid should be provided. Should donors provide it directly, through private firms or through NGOS?” The contribution of the NIE in the area of foreign aids can further be extended to modern day foreign direct investments also and thus a meaningful analysis of the ways in which this source can be organized and controlled to make a better use of this resource for the development of the economy can be observed from the role of the NIE.

The content of legal rules and the performance of legal systems are greatly represented by the existence and growth of the various institutions as detailed above. As enumerated by World Bank ‘Doing Business’ [11]Project the performance of these institutions in various spheres of economic activity in furthering the economic growth can be found in starting a business, dealing with licences, registering property, getting credit, protecting investors, paying taxes and enforcing contracts as these economic activities represent the content of laws and the legal framework necessary for the promotion of the business and thereby enhancement in the economic growth.

As per the ‘Doing Business’ Project the World Bank has identified quantitative indices to measure these performance and rank the countries according to their performance in all the economic spheres.

These quantitative indices provide a better base to assess the economic performance of a country and the economic climate that exists in the respective countries to promote further investments by third countries on the basis of an assessment of these indices.

5.0 Saudi Arabia and the Economic Development:

The traditional ways of living in the Arab Gulf state of Saudi Arabia have been greatly influenced by the political intervention of other nations as well as by the rising economic standards resulted from the oil industry. While Saudi Arabia stands at the 38th place out of 175 countries in respect of ease of ding the business, the economic progress of Saudi Arabia in the various fields of activities as indicated by the World Bank ‘Doing the Business’ Project can be analysed as below:

Starting a Business:

While a high ranking on the ease of doing business index indicates the conduciveness of the regulatory environment the ‘starting a business’ index identifies the bureaucratic and legal hurdles a new firm has to overcome in setting up and registering its business in the respective economy. This index takes into account the procedures, time and cost involved in launching a new venture of prescribed size.

As per this index Saudi Arabia stands at 156th place signifying that starting a new business in the country would take considerable time and money and is not an easy task for any foreign firm. This  is due to the local ownership of almost all business ventures and the government’s attitude in not encouraging the foreign firms to set up new business in the country. Moreover the lethargy existing in all the government departments act as a barrier for pushing any legal step forward at a faster pace.

Dealing with Licences:

Under this head the World Bank estimates the time and costs to build a warehouse including the procedures, obtaining necessary licences and permits, completing required notifications and inspections. It also estimates the time and cost involved in getting the utility connections like electricity, water and telephone.

As per this index Saudi Arabia is placed in 44th place indicating that arranging a warehouse or getting the utilities connected is not taking much time in Saudi Arabia. Since the country uses oil for the generation of electricity and also since it has provisions for desalination of water getting these utilities connected may not pose a problem. Also a very efficient telephone system is functioning in the country providing for speedy telephone and other communication network connections.

Employing Workers:

As per the World Bank this project measures the flexibility of labour regulations. Saudi Arabia ranks 21st in this respect. Having most of the working force as expatriate labour in addition to the emerging local national workers, the country is able to exercise stricter controls on labour by drafting stringent labour law regulations.

Registering Property:

This index takes care of the steps, time and cost involved in registering the property assuming that the entrepreneur wants to buy land and building for business purposes in a business city. In this index Saudi Arabia ranks 4th. Previously it was almost impossible for any foreign firm to acquire property in Saudi Arabia. Now after recent liberlisation measures announced by the country it has been made easier for the foreign firms to acquire land and buildings for business purposes in Saudi Arabia.

Getting Credit:

Index under “Getting Credit’ provides the ranking on the basis of the credit information registries and the effectiveness of collateral and bankruptcy laws. In this area Saudi Arabia stands at 65th place. This indicates that Saudi Arabia doesn’t have effective legal system to control and monitor the provision of collateral securities and the country’s bankruptcy laws are also not that strong to provide an incentive to the new investor.

The other important indices which analyses the economic progress are the protection to investors, enforcing contracts etc which measures the efficiency of the legal content and the performance of the legal system in an economy

Afghanistan:

The economy of Afghanistan is placed in the 162nd place in terms of ease in doing business. While the country ranks 17th place in enabling a new investor to start a business in the country there is no place assigned in respect of dealing with licences indicating that it may not be possible to get anything worked out in the country with respect to organizing a warehouse or getting the utilities connected.

The country is ranked 74th in employing workers indicating somewhat reasonable flexibility in labour laws and in terms of registering property and getting credit the country occupies 169th and 174th positions respectively. The economy of the country is in such a state that doing business with the country is impossible.

United Kingdom:

The country United Kingdom, because of its established systems and procedures the country ranks itself at the 6th position in the aspect of ease in doing the business. ‘Starting a business’ is comparatively easier with the country ranking at the 9th position. United Kingdom has been placed in the 46th position as regards dealing with the licences, and in the 19th position for registering the property. The country’s economic progress as assessed by the World Bank is in a sound position and the country’s legal systems provide a very conducive atmosphere for the development of the economy by aiding new investments in the business field.

6.0 Conclusion:

From the foregoing analysis it may be observed that the contribution of the NIE relate to greater understanding of the alignment of incentives and benefits between the agent and the principal be it is in political arena or in the economic  sphere.  The NIE also helps in improving the information flows about actions and outcomes. In the political field the NIE explains the principal-agent relationship by establishing the relationship between the voter and the prime minister as a civil servant. In the economic sphere the relationship is well found to be in existence between the creditors, debtors, shareholders and managers.

As Omar Azfar (2002)[12] says “It also applies to clear property rights which give private agents sharp incentives to minimize on costs while maintaining quality and to solutions for collective actions like rewarding citizens who detect defectors.”  Establishment and enforcement of commercial laws for the development of the business and industry, corrections to the system of education, economic reforms and channelizing the foreign aid are some of the other areas where we can see further contributions from the NIE.

However the NIE also suffers from some inherent shortcomings which need to be addressed to take advantage of the application of the theory to the development of the economies. NIE assumes a plethora of economic incentives which are not the solutions by themselves for the problems being faced by the developing economies. Secondly it is not always be possible to get truly valuable outcomes and using imperfect proxies to measure these outcomes may not produce the results that can be of value and use. Finally NIE assumes the social structure based on human nature as the base for the creation of social capital which cannot be achieved due to complex nature of the human beings constituting the social systems. Social structures formed with the rigid human nature would not be of much help in transplanting the developed country institution to technically backward countries even as models for development.

References:

1. Davis, Kevin What Can the Rule of Law Variable Tell Us About Rule of Law Reforms? http://72.14.235.104/search?q=cache:ihLJ9Q5neAkJ:www.nyu.edu/fas/institute/dri/DRIWP/DRIWP14.pdf+What+Can+the+Rule+of+Law+Variable+Tell+us+About+Rule+of+Law+Reforms%3F&hl=en&ct=clnk&cd=1&gl=in&client=firefox-a

2. Davis, K & Trebilcock, M ‘Legal reforms and development’, Third World Quarterly, Vol. 22,No. 1, 21-36

3. Edison, H (2003) ‘Testing the Links: How strong are the links between institutional quality and economic performance?’, Finance and Development, June 2003. http://www.imf.org/external/pubs/ft/fandd/2003/06/pdf/edison.pdf

4. Furubotn, E.G. and Richter, R. (2000), Institutions and Economic Theory: The Contribution of the New Institutional Economics, University of Michigan Press, Ann Arbor

5. North, D (1993) Economic Performance through Time, Nobel Prize Lecture, Stockholm http://nobelprize.org/nobel_prizes/economics/laureates/1993/north-lecture.html

6. Omar  Azfar (2002)  The NIE Approach to Economic Development: An Analytical Primer  The IRIS Discussion Papers on Institutions & Development http://www.iris.umd.edu/Reader.aspx?TYPE=FORMAL_PUBLICATION&ID=70843195-11ce-426b-b8ff-bb0076128693

7. Williamson, O. E. (2000) ‘The New Institutional Economics: Taking Stock, Looking Ahead’, Journal of Economic Literature, vol. XXXVIII (3), pp. 593-613.

8. World Bank ‘Doing Business’ Project http://www.doingbusiness.org/

[1] Furubotn, E.G. and Richter, R. (2000), Institutions and Economic Theory: The Contribution of the

New Institutional Economics, University of Michigan Press, Ann Arbor

[2] North, D (1993) Economic Performance through Time, Nobel Prize Lecture, Stockholm http://nobelprize.org/nobel_prizes/economics/laureates/1993/north-lecture.html

[3]Williamson, O. E. (2000) ‘The New Institutional Economics: Taking Stock, Looking Ahead’, Journal of Economic Literature, vol. XXXVIII (3), pp. 593-613. [4]  The NIE Approach to Economic Development: An analytic Primer The IRIS Discussion papers on Institutions and Development  Paper No. 02/03

[5] Omar  Azfar (2002)  The NIE Approach to Economic Development: An Analytical Primer  The IRIS Discussion Papers on Institutions & Development http://www.iris.umd.edu/Reader.aspx?TYPE=FORMAL_PUBLICATION&ID=70843195-11ce-426b-b8ff-bb0076128693

[6] Kevin Davis What Can the Rule of Law Variable Tell Us About Rule of Law Reforms? http://72.14.235.104/search?q=cache:ihLJ9Q5neAkJ:www.nyu.edu/fas/institute/dri/DRIWP/DRIWP14.pdf+What+Can+the+Rule+of+Law+Variable+Tell+us+About+Rule+of+Law+Reforms%3F&hl=en&ct=clnk&cd=1&gl=in&client=firefox-a [7] Davis, K & Trebilcock, M ‘Legal reforms and development’, Third World Quarterly, Vol. 22,No. 1, 21-36 [8] Edison, H (2003) ‘Testing the Links: How strong are the links between institutional quality and economic performance?’, Finance and Development, June 2003. http://www.imf.org/external/pubs/ft/fandd/2003/06/pdf/edison.pdf

[9] Omar  Azfar (2002)  The NIE Approach to Economic Development: An Analytical Primer  The IRIS Discussion Papers on Institutions & Development http://www.iris.umd.edu/Reader.aspx?TYPE=FORMAL_PUBLICATION&ID=70843195-11ce-426b-b8ff-bb0076128693 [10] Omar  Azfar (2002)  The NIE Approach to Economic Development: An Analytical Primer  The IRIS Discussion Papers on Institutions & Development http://www.iris.umd.edu/Reader.aspx?TYPE=FORMAL_PUBLICATION&ID=70843195-11ce-426b-b8ff-bb0076128693 [11] World Bank ‘Doing Business’ Project http://www.doingbusiness.org/

[12] Omar  Azfar (2002)  The NIE Approach to Economic Development: An Analytical Primer  The IRIS Discussion Papers on Institutions & Development http://www.iris.umd.edu/Reader.aspx?TYPE=FORMAL_PUBLICATION&ID=70843195-11ce-426b-b8ff-bb0076128693