New Institutional Economics

New Institutional Economics was developed as a reaction against neoclassical theory. It contended that the latter focused too much on efficiently allocating resources and Pareto optimality. According to New Institutional Economics, some unrealistic neoclassical assumptions were:

™ Efficiency and optimization problems can be solved independent of institutional variants.

™ Its models are based on the assumption of perfect information and perfect foresight.

™ All information is contained in relative prices, and they are the most important instrument for regulating markets.

™ Transaction costs do not exist.

™ The institution can be relegated to, and considered as, a black box.

The central tenet of New Institutional Economics is "institutions matter for economic performance". Let's now take a closer look at New Institutional Economics assumptions.

New Institutional Economics Assumptions

Furubotn and Richter (1998, 2-8) arranged the central assumptions of New Institutional Economics accordingly.

1. Methodological individualism: People are different and have different tastes, preferences, goals, intentions, and ideas. Therefore, it is necessary to analyze the behaviour of individuals to explain existing economic phenomena.

2. The Maximand: Individuals pursue their own interest and try to maximize their utility within institutional limits. All choices are based on the maximization of individual utility.

3. Individual rationality: There are two possible approaches - perfect or imperfect individual rationality.

a) In the perfect variety it is assumed that decision-makers have stable preferences, which determine their behavioural choices.⁵⁴

b) In the imperfect those preferences are variable and not always known.

(North, 1978, 972).

The latter also assumes that transaction costs are unavoidable (Williamson, 1975, 1993, 1996). What's more, people are subject to "bounded rationality" (Simon, 1957), which makes it impossible to process all available information because much information is lacking and due to lack of processing skills. Kahnemann and Smith (2002) - the first a Nobel Prize winner in economics - have also shown that in many instances people do not behave rationally. They make decisions that they would not have done in a rational mood.

4. Opportunistic behaviour: Williamson⁵⁵ (1975) indicated that humans pursue their own interests and, therefore, tend to demonstrate opportunistic behaviour. If this is so, as he and Kreps (1990) contend, then people cannot be trusted⁵⁶ and, therefore, "complete contracts" cannot be written, let alone enforced.

5. Economic society: A society consisting of individuals who share a common set of norms and values, awards property rights, and can force these on each member of that society.

Property rights give people the right to use objects and intellectual property, enjoy the advantages of these, and promote specific behaviour in others. These rights are transferable.

The concept of property rights is necessary to understand the implications of running an organization (see Section 4.2.3). They are determined and guaranteed by governance structure.

54 "A completely rational individual has the ability to foresee everything that might happen and to evaluate and optimally choose among available courses of action, all in the blink of an eye and at no cost." (Kreps, 1990b, 745).

55 Williamson (1975, 48): "self-interest seeking with guile"

56 It is important to note that the concept of trust has not been discussed in connection with this. Williamson considers trust irrelevant. But according to others, trust does indeed play a role (Nooteboom, 1999, 2000). "Trust is a slippery concept, but it can be rigorously defined, analyzed and tested empirically." (Nooteboom, 1999). The trust issue will be dealt with below.

5. Governance structure: Set up to run an organization, it is all about authority and making sure that decisions can and will be taken, and followed up on. Authority implies the power to make and enforce decisions, and applying sanctions when not complied with. By court order if necessary.

7. Institutions: It is not easy to define an institution.⁵⁷ Institutions are established primarily to guide the individual behaviour in specific directions, thereby decreasing uncertainty (North, 1990, 239). Institutions are the rules of the game without the players themselves, and their functioning is dependent on the individual usage. In Popper's view (1957, 66), this implies that: "You cannot construct foolproof institutions. Institutions are like fortresses. They must be well designed and properly manned".

8. Organizations: Are comprised of institutions plus people (North, 1990). Arrow (1970, 224) defines a formal organization as "a group of individuals seeking to achieve some common goals, or, in different language, to maximize an objective function". He therefore calls the problem of "organizational control" as order⁵⁸. Since this does not happen automatically, resources are involved. The use and costs of these resources are called

"transaction costs".

These New Institutional Economics assumptions show that it is not possible to foresee all possible conditions. Therefore, incomplete contracts⁵⁹ are the rule to which there are no exceptions. Under some conditions this creates the need for auditors and arbiters to assess the correctness of information provided and assess whether the terms of the contract have been met.

The parties (to a contract) will quite rationally leave out many contingencies, taking the point of view that it is better to "wait and see what happens" than to try to cover a large number of individually unlikely eventualities. Less rationally, the parties will leave out other contingencies that they simply do not anticipate. Instead of writing very long-term contracts the parties will write limited-term contracts, with the intention of renegotiating these when they come to an end. (Hart, 1987, 753)

Given this incompleteness of contracts, enforcement is also conditional. Building in ex ante guarantees against ex post opportunism is desirable, but will lead to transaction costs (see below). It is important for internal auditors to understand the notions of "incomplete contracts" and "bounded rationality". We will address that further in Section 4.6.

57 Schmöller (1900, 61) came up with the following definition: "a partial order for community life which serves specific purposes and which has the capacity to undergo further evolution independently. It offers a firm basis for shaping social actions over long periods of time; as, for example, property, slavery, selfhood, marriage, guardianship, market system, coinage system, freedom of trade."

58 This consists of a set of operating rules "instructing the members of the organization how to act" and a corresponding set of enforcement rules "to persuade or compel them to act in accordance with the operating rules".

59 Much use of the word "contract" is metaphorical. Agreements do not necessarily have to be written to be contracts. An arrangement between two people to meet for dinner could be deemed a "contract".

How can New Institutional Economics be applied?

New Institutional Economics models institutions and economic behaviour. But how can New Institutional Economics be applied and to what extent? Williamson provided the following diagram (1998, 26 and 2000, 597):

Embeddedness:

Figure 6: Applicability of New Institutional Economics

These levels are already explained in Chapter 1. According to Williamson, New Institutional Economics focuses on levels 3 and 4. Agency Theory and Transaction Cost Economics are theories that slot into New Institutional Economics. While New Institutional Economics sees the firm as a nexus of contracts (Furubotn and Richter, 1998, 152) though, Transaction Cost Economics sees it as a governance structure.

Property rights

The concept of property rights is essential for a good understanding of both Agency Theory and Transaction Cost Economics. According to Roman law, the most important characteristics⁶⁰ of (absolute) property rights are the rights to use physical goods (ius utendi), benefit from the revenues coming from those goods (ius fruendi), and the power to manage them and the possibility of alienation (ius abutendi). It is also possible to separate those rights: meaning that parts of the above can be alienated.

The way property rights are assigned within an organization influences optimization problems: not only the amount of transaction costs and efficiency, but also the distribution of

income and power between contracting parties. Individuals will, therefore, try to set up their property rights in a way that maximizes gains from transactions. Thus when individuals are pursuing their own interests there is no guarantee that revenue maximization or cost minimization for the organization will be achieved⁶¹.

Contract Theory

Since contracts are an important issue in both Agency Theory and Transaction Cost Economics, contract theory will be briefly discussed in this section. A contract is influenced by transaction costs in relationship with Information Asymmetry and transaction specific investments. This creates a mix of contractual and information problems⁶² that need to be solved.

First, information can be incomplete at various stages of the contract. For instance, ex ante, before drafting the contract. Crucial information might be missing while executing the contract and even ex post, after having the contract has been completed. Further, one party might have the information, but is unwilling to share that with the other party or parties (Information Asymmetry). Or worse, some distortion and other forms of deceit might be afoot. Information that might not be favorable might be distorted to serve the interest of one party at the expense of the other (s) (moral hazard, opportunism). These problems are dealt with by what is called "incentive theory". How do we create the best incentives to overcome Information Asymmetry and moral hazard or opportunism?

Second, even if there is a lack of critical information, one could still try to deal with that problem. The easiest solution to the problem is avoidance. Price mechanisms, proverbial economic wisdom has it, are one way out. All information is in a way "embedded" in the price of goods. Thus one needn't bother about specifics and the costs involved. The price says it all.

When purchasing a car all one has to do is compare prices, and c'est ça. But, surely, this solution is only viable in markets where prices are comparable. Unfortunately, there are many where that is not at all the case. That's when specific contracts need to be drafted and coordination costs need to be incurred.

There is also the problem of assigning property rights. This was already touched on in the section above. Contributors to this issue are Alchian (1969), Demsetz (1967), Klein, Crawford and Alchian (1978), and Furubotn and Pejovitch (1972).

Some subsets were developed within contract theory to deal with the above-mentioned problems.

1) Incentive Theory or Agency-contract theory 2) Incomplete Contract Theory

3) Transaction Cost Theory

61 The famous example of the problem of the commons whereby a community has a meadow and the issue is from a maximization of outputs point of view, whether it is better to make it community owned or split up the meadow in small privately owned parts. The solution is that the latter is preferred since every individual within the community will add sheep or cows to the meadow as long as his incremental outputs will be positive although this might decrease the output of the meadow as a whole. This is one of the explanations why any communist or socialist system will fall short compared to the capitalist system.

62 See Brousseau and Glachant (2001) for an overview.

Incentive theory

Information Asymmetry⁶³ leads to adverse selection ex ante - the less informed party is inherently disadvantaged - and moral hazard ex post. It is expected that the more informed party will act in his own best interests, and if possible and necessary, to cheat to reach his objectives. Especially when he deliberately withholds important information. Therefore, contracts are designed in such a way that agents are stimulated to behave according to the best interest of principals. The focus is on reward and incentive systems. How do we as principals

"guide" agents in the direction we want them to go? This is also of interest for internal auditors. They need to be aware that reward and incentive systems will be used to influence their behaviour and that it drives the efforts of agents. This will focus their efforts on assessing the adequacy of information and behaviour in the context of a contract.

Incomplete contract theory

If it is impossible to determine whether contractual obligations have been lived up to, the issue of contract fulfillment becomes yet another negotiation. Because of this, contracts often contain a clause giving one of the parties the right to determine ex post what the actual achievements were and the other party the right to dissolve the contract if he does not agree (Telser, 1980). The focus is on clauses necessary for arranging renegotiations and default.

Such contracts, which are called self-enforcing (Frank, 1992), and are used in situations where the possibilities of inspecting for contract fulfillment are more than usually limited. In such cases, obviously, the opportunities for legal redress are nil.

Transaction cost theory

The assumptions are the same as in incomplete contract theory. In these cases the contract allocates decision rights to one party, both parties (negotiation), or a third party (judge). The latter may seem a sound idea. But since courts do not have the proper knowledge, expertise and skills to absorb all the information (bounded rationality) their ability to assess the achievements of the contract is limited. Supervision and coercion are then the mechanisms.

Williamson speaks of private ordering. In situations of private ordering internal auditors of both parties could make important contributions to the process.

63 Information Asymmetry is an often used term within Agency Theory. It describes a state in which someone has more information than someone else. In this case the agent more than the principal. In the literature, Information Asymmetry is almost always dealt with as the asymmetry of information between insiders (company officers) and outsiders (analysts, shareholders, regulators, etc.). This "external" Information Asymmetry has been widely researched by many. This Asymmetry is measured by such proxies as R&D expenditures and spreads between bid offers. By contrast, "internal" Information Asymmetry - say, between top and lower management - has scarcely been dealt with. One exception to the trend is a study by Jaworski and Young (1992) among marketing managers. They measured Information Asymmetry by asking marketers to assess on a scale of 1 to 5:

how well they knew what was expected of them; how familiar they were with their tasks; how much knowledge and understanding they had of their jobs; and whether they knew the performance objectives and the most important variables to monitor. They were also asked how they thought their bosses would answer the same questions. The author concluded that: "more work needs to be done to refine the measures of information asymmetries" (1992, 31). Their questions were used – in an adjusted format - in the survey described in Chapter 6.