__________________________________________________________________ Mauricio Zachrisson Girón Informal Institutions , Stars and Increasing Returns We are just an advanced breed of monkeys on a minor planet of a very average star . But we can understand the Universe . That makes us something very special . I . Introduction . — Stephen Hawking A shared characteristic among economists is the need to make assumptions about the world in order to simplify their models and be able to draw certain conclusions from them . It is a tradeoff economists must make between realism and simplicity , and most of the time they are led to the latter . One of the sacrifices that have been made out of necessity is the institutional environment where individuals transact and make decisions . The purpose of this paper is to understand how this institutional environment — which most economists take as given — actually functions . As will be shown , institutions have a certain characteristic that makes them more dynamical than has been noted , namely , that institutions have increasing returns . Individuals live in a world that has rules and conventions that influence their decisions , and sometimes these various “ rules of the game ” compete with each other . This paper will not follow the typical economic methodology of optimization and static equilibrium analysis , but it will instead use a simpler and more intuitive style , an analogy . This tool will allow us to use a comparative analysis to highlight and understand how increasing returns affects the dynamics of institutions . Using an analogy has its setbacks , and one in particular is when the analogy is taken too far . The literary figure is used only as means of explanation and to facilitate understanding , and at no point should it be interpreted that stars and individuals act alike . The structure of the paper is as follows . Section II will explain what institutions are , and how contemporary economists have dealt with them . Section III will introduce a specific kind of increasing return that has been found in technology research : network externalities . Section IV will apply the concepts in section III to informal institutions , followed by a simple model for understanding its effects in section V . The astronomical analogy will be used in section VI to see some examples of the model in the previous section , followed by the concluding remarks in section VII . Mauricio Zachrisson Girón is a student at Universidad Francisco Marroquín , Guatemala . He is majoring in economics . __________________________________________________________________ Laissez-Faire 64

__________________________________________________________________ II . Institutions , Formal and Informal . “ Institutions matter ” is a phrase that has been recently expressed by many economists , and it is the reason why so much research has been done lately in this field . The study of institutions has existed for centuries , but only recently has it been incorporated into the field of economics ( the New Institutional Economics , NIE ). But what are institutions ? This is a question those same economists have been asking themselves . There are several definitions , though this paper will follow the lines of two economists in the semantics of institutions : Douglass North and Samuel Bowles . According to North , “ Institutions are the humanly devised constraints that structure political , economic and social interaction . They consist of both informal constraints ( sanctions , taboos , customs , traditions , and codes of conduct ), and formal rules ( constitutions , laws , property rights ).” 1 Bowles says , “ Institutions are the laws , informal rules , and conventions that form a durable structure to social interactions among the members of a population … Institutions influence who meets whom , to do what tasks , with what possible courses of action , and with what consequences of actions jointly taken .” 2 Although both definitions differ in some aspects , they give an insight into what constitutes an institution . These social mechanisms inform , assign and coordinate individuals in repeated social interactions . “ Institutions ” is a broad term , so it is of great importance to dis- tinguish what kind of institutions exist in order to understand their independent effect on individuals . Oliver Williamson has done a good job in identifying them . He separates them in four levels , which correspond to a different area of study . The figure on the following page ( from Williamson , 2000 ) illustrates the different levels , the frequency ( the amount of years needed for radical change of institutions ), and the purpose of the institution . 3 Most economic studies are focused in the L4 institutions , and have recently moved to L3 and L2 . Studies of L1 institutions have been relatively few , but there has been interesting research in this area , which will be mentioned throughout the paper . Williamson said , “ An identification and explication of the mechanisms through which informal institutions arise and are maintained would especially help to understand the slow change in Level 1 institutions .” 4 That is the purpose of this paper , to understand the functioning of informal institutions . With the help of current research in technology , and an analogy with the formations of stars , I attempt to give an insight on how Level 1 institutions are formed , on how they grow , and how they may disappear . An example of informal institutions is crucial for the understanding of the ideas presented in this paper . Long distance trading was a complex business in the past . During Roman times for example , when merchants imported grains , they faced a big problem , uncer – 1 Douglass C . North , “ Institutions ,” Journal of Economic Perspectives , 5 ( Winter 1991 ), p . 97 . 2 Samuel Bowles , Microeconomics : Behavior , Institutions and Evolution ( Princeton University Press , 2006 ), pp . 47-48 . 3 Oliver E . Williamson , “ The New Institutional Economics : Taking Stock , Looking Ahead ,” Journal of Economic Literature , 38 ( Sept 2000 ), p . 597 . 4 Ibid . __________________________________________________________________ Laissez-Faire 65

__________________________________________________________________ tainty . They had to purchase grains from far lands , from people who they did not know and never would , wait for a boat that carried their goods , with no information of their whereabouts , and hope that the amount and quality of the grains were what they expected . These problems are still faced today , but in a lesser degree due to technology advances such as the Internet and satellites , but to the Roman merchant these were problems big enough to stop importing . Merchants tried to face these problems through various means , including trading with family only . But the demand for grains grew to the point where they needed to deal with strangers . An informal institution was developed , the endorsement of a merchant by a knight or senator . If a senator were satisfied with the results from the merchant , he would endorse him and even recommend him to other businessmen . For this to work , the merchant had to be sure that other senators would accept another senator ’ s endorsement , and that other merchants would be competing for __________________________________________________________________ Laissez-Faire 66

__________________________________________________________________ a senator ’ s endorsement . The bigger the network of senators and merchants that accepted the endorsement mechanism , the greater assurance the marginal merchant would have over the acceptance of his endorsement . The more people were part of the institution , the more attractive it would be to an outsider , and when an additional outsider joined the network , the attractiveness of the institution would grow even more . This means that informal institutions have increasing returns , something that has been pointed out by many economists , including North and Bowles . But why do they have increasing returns ? What made the senatorendorsement mechanism in Rome have increasing marginal returns when an additional merchant got involved in the institution ? To answer these questions , I turn to a helpful tool in understanding increasing returns in technology . III . Technology and Network Externalities . Robert Metcalfe , the creator of the Ethernet , was the person who first established the term “ network externality .” Metcalfe believed that the value of a network depends on the number of users in it . The more people used a certain network , the more possible connections existed between individuals , which increases its value . For example , if only three people used the telephone for communication , there would only be six possible connections , but if there were four people using the telephone , there would be twelve possible connections . Therefore the value of the telephone network is proportional to the number of nodes made possible by the number of phone users . Let M be the value of a network in a Metcalfean way , we then have : ( 1 ) ( ) Mi ≡ f ni f( ni)= ni ( ni −1 ) where ni is the number of the users in the network i , and is therefore restricted to positive values . As we can see , f ( ni ) is positively correlated with ni , which means than the value of the network is increasing with the amount of users . Now consider the sensitivity of the value of the network i ( Mi ) to a change in the amount of its users . Taking the first and second order derivatives we get : ( 1 . 1 ) dM i dn i d 2 Mi 2 dni = 2n i −1 = 2 The first order derivative is always positive . The second order derivative is always positive at any given ni , which means f ( ni ) is a convex function . We can now see there is a marginal increasing network value with an increase in the number of its users . This is the main point in Metcalfe ’ s idea of the value of a network ; not only is the value of a network a direct and positively correlated function of the number of users , but it is marginally increasing . This is what is called the Metcalfe Law . Consider now how network externalities , explained by the Metcalfe Law , work in an institution , for example the institution of money , and in this case gold . This institution provides a means of exchange between numerous individuals . The value of gold as a means of exchange depends on the number of people who use gold for this purpose . If there are only ten people using gold , there would be 90 __________________________________________________________________ Laissez-Faire 67