Douglas North - Effect of Institutions on Market Performance at FCC

hi I'd like to thank you all to coming to our first chief economist Distinguished Lecture series today we have we're very lucky to have Professor Douglas North with us doug is a professor of washington university we're in st. louis where he teaches both economics and history and also lauren economics it turns out doug was awarded the one of the co winners of the 1993 Nobel Memorial Prize for his pioneering work in economic history and to quote from the Nobel Committee with along with Robert Fogel his co winner for having renewed research in economic history by applying economic theory and quantitative methods in order to obtain economic and institutional uh knowledge with explain rather than obtain economic and institutional change that's our job to obtain it so Doug was part of the revolution that became known as clear metrics which is the application of advanced statistical and econometric techniques to the study of historical data and institutions Doug's early work was on the model of growth and what led to the rapid development of the United States and in particularly focus covered the importance of free trade and the exports and in particular that the cotton industry early on his later work focused on the development of economic institutions including booked institutional change and economic growth that was co-authored with his student Lance Davis who's one of my colleagues in fact my senior colleague at Caltech so his subsequent work focused on the role of institutions in economic performance and in a series of path-breaking books the first of all postulated died pollicis that the development of economic institutions would be endogenous changing over time as people discovered more efficient ways to organize the structure of society he's ladle work somewhat question his earlier work and has focused on the role of transactional costs and culture factors and what might lead to sort of bureaucratic or institutional inertia something that I imagined we would find difficult to conceive of around here so I'm going to keep it short so here we have Doug I just have one request given that after us he has to speak to the IMF could we table questions until the end of the formal talk thank you thanks Simon that's nice I debated a little while on on how to talk to you now it's not because of innate shyness which nobody's accused me of it's because the work that I've done I started out as an economic historian and Simon said and most of the work since then in the last ten years has been in economic development and I spend a lot of my time running around the world playing God which means you go on a twig give advice on economic development and so you're a little different audience but that doesn't mean that the new institutional economics and the kind of work that we're trying to build and is is not relevant for in fact quite the reverse it strikes me that that the kind of tools we're trying to develop right up the alley of things that would be useful to you so what I'm going to do is I'm going to give you about 40 minutes of talk on a little background and then the new institutional economics and then I want to open it up for discussion and I should warn you that if I can't get any to ask questions I'll ask you questions so you better be ready now as Jonathan said Simon said sorry it all began when I was an economic historian getting out of Berkeley and I I began to try to develop the tools to to make sense out of history and the first set of tools was Clio metrics that is we applied neoclassical theory and quantitative methods to history and it did revolutionize economic history and you know I say it's called Clio metrics and and it it certainly transformed economic history and this were satisfied me for a while but when I switched from American economic history to European economic history I faced a puzzle and that is that American economy history was always concerned with relative rket economy and while it was a lot of self-sufficiency you could translate that easily enough into the tools that neoclassical economics had but when you got the European economic history it didn't make any sense the weren't markets had self-sufficient economies feudalism you had all kinds of things that didn't make sense and so I began to ask myself what kind of tools we need to develop to make sense out of economic history neoclassical economics didn't do it now neoclassical economics had and still does have to a major degree deficiencies that not only are relevant for me but they're relevant for you too first of all it's static it's concerned we're modeling and theorizing about an economy at an instant of time second of all even more important for you it's frictionless that is it implicitly and sometimes explicitly assumes perfect markets no information costs and therefore since you don't need them no institutions no government all that is a is irrelevant now it's true in the last 25 years we began to modify it in a sort of an ad hoc fashion by adding transaction and so but as soon as you add transaction cost economics you you really opened up Pandora's box and you have because it doesn't fit you don't necessarily get efficient markets you automatically have all kinds of impediments to to how markets work and indeed since I was interested in how markets evolved over time you had the problem of why they didn't why he didn't exist to begin with and it's at this time that I met Ronald Coase and Ronald when I matter-of-fact got honorary degrees together at the University of Cologne in 1988 and I can still remember that Ronald gaya got up and talked about these two famous articles the one on the theory of the firm and the woman problem with social cost and I got up following him and I said well now the really interesting thing about what professor Coase has been telling you is that it has revolutionary implications for why you get economic development why you fail to get economic development I said because the transaction costs that he's talking about and theory of the firm and so on imply that the kind of economy that you get don't necessarily evolve these things ronald came up to me afterwards and he said you know said i never thought about that and I said well let's think about it together and we've been thinking about it together ever since and indeed what we did we started back in about 1995 or 1996 the International Society for the new institutional economics it's now a big flourishing affair we we meet internationally we have more members than what we know what to do with more than we can ever get into the meetings that we have we're going to meet in Budapest this September and we're already we have room for 500 people and we have a thousand people trying to get there so and the reason why is very straightforward the kind of theory we're trying to develop it's directly concerned with the kind of problems that either an economic historian or somebody concerned with the questions that you're concerned with should be right up their alley and it should be right up their alley because we're concerned with overcoming the problems of frictionless modeling we're concerned with with time rather than static theory and one thing more which I haven't mentioned which is like we're concerned with the fact that it's a non air ghatak world now before you run all out they can look look in your dictionary to find out what the word air Ghatak means it's easy air Ghatak means that there's a fundamental underlying structure to whatever it is you're trying to model so that if you confront a new problem you go back to fundamentals you go back to by reductionism you go back to the basic unit and then you build a theory to try to deal with that problem and when Paul Samuelson the father of a modern economic theory did his foundations he said it was an air ghatak world and it was very crucial for him Bob Solow came along his colleague and said the implication of an air ghatak world is that this fundamental underlying body of theory and if you know it all you got to do is have it and you can solve any problem and Bob doesn't believe that neither do I it is a non-organic world we live in a world and this is very important for you which has no there's nothing like it in the past now that does not mean you understand that say price theory which I find obviously an invaluable tool is not crucial it does mean that we face new and novel problems all the time and as we do we've got to ask ourselves how useful the body of theory is for trying to solve the kind of problems that we're confronting and that everyday is confronting us with new problem and as a matter of fact from a viewpoint of an economic historian who's written about ten thousand years of economic history I find civilizations have all fallen apart eventually they've all misunderstood what was happening to them and collapsed so it's not a trivial problem and I even despite the fact that I find all kinds of wonderful right-wing outfits that want to tell me that we we now have growth built into the world and we're going to go on forever that's a lot of apple butter as I hope to demonstrate to you so if we're going to do this and we've got to start not all over again but we've got to start by understanding that somehow we've got to confront the problems of frictionless model building status static analysis and being concerned always that it's an on-air gothic world well a frictionless one is easy that's what institutions are all about institutions are the way in which human beings structure human interaction now when I say structure human interaction what I mean is that we start out as human beings in a world where uncertainty is ubiquitous and if you look and indeed well if you look at the kind of work the Piaget and other people have done looking at how children evolve an understanding of the world around them you begin to gradually build up an understanding you get it from two kinds of things you get it one from human experiences until you get it historically from your family from schooling and indeed broadly speaking something that economists don't concern themselves with but should from the cultural heritage of a society which of the beliefs norms and institutions that you here inherited from the past which are the framework within which at any moment of time you exist now this is crucial because and crucial for you too because if it's a if you have this kind of framework then the degree to which you can change the way the game is played is always limited by the fact that the inherited set of beliefs norms and institutions you have constrain the choice set to use our standard economic model building which constrain the choice set fundamentally so that while you can change at some margins a lot of margins you can't do now I've found this out in the hard way Jeffrey Sachs found it out the hard way - as a matter of fact and that is when you go to a third world country and you try to improve things you want you know what what we know a lot about what makes for economic growth you know new growth economics and all that jazz we know all kinds of stuff we don't know how to get it and we don't know how to get it because it we don't have any dynamic of the process of change but particularly when you go and you say you know how do i improve productivity at this margin or this margin how do I get technological change or increase human capital kind of standard things that the new growth economics has to say you say to yourself I don't know how to get it now part of the problem is that you face an inherited set of institutions and beliefs that are have built into them vested interest so I'll be right up your alley if there's anybody but when each group that I don't know about vested interests that are doing you in you are you guys on it and the vested interests obviously are in organizations that once you've built institutional structure then that provides the organizational structure that gives rise to organizations and their survival depends upon an institutional structure and if their survival depends on it then if you come along and try to change that I'm always doing in third world countries you're stepping on a lot of toes so that what you're looking at therefore when you look at institutions you're looking at at a set of rules of the game that have evolved over time and that therefore set the constraints now what institutions are I'll say this over and over their incentive systems that's all institutions are we say that again institutions are incentive systems so that what they are as well negative and positive incentives whether by and so they're made up of formal rules like constitutions laws rules and kind of things you're all familiar with informal norms of behavior which supplement formal rules and which define really go beyond the formal rules they extend the formal rules to solve specific and mediate problems and enforcement characteristics and let me say that again they're formal rules they're informal norms of behavior convention codes of conduct and norms of behavior and they're in for and their enforcement characteristic let me give you an illustration from something that all should be familiar to all of you professional football our professional football is the exact analogy to what I'm trying to get at if you look at professional football is made up of formal rules what you can and can't do the football players it's made up of informal norms of behavior which say for example you shouldn't deliberately break the quarterbacks leg on the opposing team and it's made up of referees and umpires that are designed to see that the formal rules informal norms are lived up to now if you're the Oakland Raiders you win games by playing dirty you break me for the quarterback team because these st. Louis Rams I know the only they only got one person who's where two people are worth a damn if you can do them in you've got the game one so that what you see therefore in the way in which any professional sport is played it's played with with a set of rules of the game which are only imperfectly enforced now to the degree that you have referees and umpires and you make the penalties high enough you'll note you get tend to get the game played more more closely to what at least it was intended by the way in which the rules were defined but to the extent of course that you have imperfect enforcement and you're willing to incur all kinds of penalties in doing it then in fact the game was played very differently well I'd same true in society politically economic societies are made up of these three things and they don't ever work exactly the way they were intended in fact they work very far from it the poorer enforcement is for example at certain margins the more likely people are going to get away with doing all kinds of thing so what we want to look at therefore when we look at how institutions work is we want to look at how how the formal rules work how the informal norms work and how effective enforcement is now that takes me into a into something I'm only going to deal with very superficially but it's right up the alley and I'm going to come back to at the end because it's right up the alley of things that I think will be of interest to you but suffice to say that institutions are always imperfect incentive mechanism even in the best well and indeed it never it wouldn't be it wouldn't be worth it to try to have perfect enforcement because at the margin the costs of having a policeman at every corner to watch that what everybody did would exceed the benefits so and you deliberately in societies don't don't have imperfect enforcement of institutions but the degree of imperfection is obviously of great interest to all of us and should be let me talk very briefly about the static nature of it time is a dimension in which human beings learn and in that sense what we mean by by that is over time we see that institutions evolve over time as human learning gets them to modify the way the game is being played and in fact if you want to look at the heart of the model process I don't have a blackboard here so I'll uh I'll have to make it up but what you have is initially you have people's you have something called reality out there which nobody knows what it is because only in your head and reality is a like how you regulate televisions stations or whatever it is that you think is reality and then you construct it in your mind beliefs about how it works that's all in your head and indeed one of the things that it's very hard for for particularly neoclassical economists who somehow plain think that their discipline is scientific is to understand that the whole structure that we're talking about is in your head both and therefore the beliefs you have in turn translate into a set of institutions that define the way the game is played but beliefs at least of those people in the in the position of creating the institution I'm going to come back in just a minute now the institutions then spawned organizations and the organizations are the players in the world and his organizations are made up of firms trade unions pressure groups politicians and so on and they are players in the sense that they are interested parties in the way in which the game is being played and what they try to do of course is they're always in competition and Jiri straightforward economic theory is sensible and that is it's a world of scarcity and therefore the organizations are always in competition with each other now the effectiveness of competition the degree to which the competition is is powerful dictates that organization will continually try to change the way the game to get an advantage even happens in universities which are not very effective organization with respect to competition well you'll know much more effective than European universities which have no competition at all but every organization in competition and to the degree they are there they're the innovators in the sense and here it's sort of a Schumpeterian model at organizations in competition with each other innovate and that and you innovate by trying to change at the margin the rules of the game and modifying it over time okay now that's so far very simple but at this point let's introduce one more thing and that is that I'm going to come back to you and that is that the who makes the rules and who can change them well now the rules are made up what you want is the way in which we aggregate choices in the society and that's politics and politics is you have various ways by which you aggregate choice making in a society and who makes the choices in a democratic society it's presumably the individual voters by representation to the representative bodies and the representative bodies delegation like you all but whatever it is you're very interested in that organizational structure because it's that organizational structure that's defining who makes the rule and particularly you know the way in which you influence who changing the rules is by changing it is by influencing that aggregation so we're going to come back to that one now I've talked a little bit about institutions a little bit about time well not too much I'm going to come back to it let me talk a little bit about human intentionality well in economics we say that the the behavioral model we use is the rationality model and by rationality we mean people are logical consistent and broadly speaking they know what they're doing and therefore act accordingly now that's a lot of apple butter - we are imperfectly informed almost all the interesting issues that we have are ones in which we have imperfect knowledge and not only is the knowledge perfect but the feedback on what we do is imperfect now herb Simon who was responsible for the Social Sciences beginning to think intelligently about this use the term bounded rationality which I don't like in herb and I used to argue at endless endlessly about it before he died and the reason is that herb you said that the bounded character was essentially that it was like playing a chess game it was it was so complicated that nobody could know all the possible alternatives and therefore it was founded in that sense that's not the only sense I agree with her but it's much more than that is the fact that we we simply don't know what we're doing we have don't we don't have answers to a world of uncertainty in which we confronted with new and novel problems all the time and even when we do do things we get imperfect feedback on on how well they work I in in the book I'm just finishing I have a long chapter dealing with the rise and fall of the Soviet Union one because the rise indicates the heir interesting dilemmas of how human beings try to construct out of de novo an institutional framework that would deal with them their beliefs about how the world should work and the fall because it dealt with the with the inability of a society over time as it gets more rigidify Daz it the interest groups get more entrenched to be able to modify itself in the face of increasing transaction costs and boy the transaction costs really grew increasing transaction costs that would enable them to get around the problems that they had that had evolved well we're always concerned with that so we're interested and the way in which people perceive the world now I'm not going to spend any time on this but it happens to be my major interest these days I'm interested therefore in how human beings understand the world around them and what makes them understand it in different ways over time as learning takes place and that's cognitive science and the reason why and I think it should be of interest to you but it's a it's something that I don't have time to talk about here invite me back another time and I'll talk about it and that is by cognitive science I'm interested in how the mind and brain interpret the external environment and how in turn out of that they construct they make choices empathy economics is a theory of choice and the trouble with the rationality assumption is it just assumed we knew everything and that's baloney we don't know everything and indeed in an on-air ghatak world which is the crucial part we keep on having to fumble around and try to find out what the world's like what the different parameters are that are changing and then try to evolve on analytical framework that will make sense and solve new and novel problems that we're facing all the time and so a lot of what I'm doing these days is interested in the in that in fact I'm going to a conference later on this month with Vernon Smith he and I are giving the economic part of it and a bunch of cognitive scientists are going to give there and it's a it's an interplay between economics and cognitive science and it's the beginning of what I think is going to be a very very rich interaction because we're beginning to understand a lot about how the mind and brain work and the implications just to give you one aside last fall I was invited by the Joint Chiefs of Staff to give a talk to them and here in Washington and what they thought they were going to get was a story about the development of the Western world and how it led up to the problems that they had what they got and was a why fanaticism exists if you think that the rational choice model will explain to you 9/11 you got another guest coming 9/11 indeed oh the world we live in is a world that is not perfectly rational not only a religion religions play a dominant part in the world but superstition beliefs all kinds of things like that our crucial part of them of the way human beings make choices and if we don't understand that we're facing some very very difficult dilemmas and so a lot of what we're doing in in science today is trying to understand why religions persist why belief system take the form they do what makes them acceptable and what makes them change over time I'm not going to talk about that but I want to raise it because it is of interest to you the kind of way in which your world that the world you're trying to contain evolves obviously has some relevance for the way in which religions and beliefs evolve over time now let me talk about how I think this applies to all of you directly your what you're interested in is efficient market now much as I'm fond of Milton Friedman I am fond of milk treatment less a fair is a bunch of baloney there's no such thing in the world unless a fair is anarchy every market and I say that very carefully every market that works well every market works well because it's structured to make it so you get the players to compete at those margins and only at those margins that will do what Adam Smith thought you'd automatically do that is individuals pursuing their own self-interest would improve social welfare but still our objective but to just show you that not so simple as it sounds when I when I was over advising Russia shortly after the breakup of the Soviet Union I had a friend of mine owns for some years of Russian Banker and I said Georgie I said now that you've got markets and you're competing with each other and in this wonderful world of a free market activity how do you compete Oh dougie says that simply said we kill our competitors he wasn't kidding if you've looked it out a number of bankers that the guy done in in the early 1990s it was up it was a favorite game in town now there's no necessary reason why human beings will compete at margins that are socially affected and indeed they don't in fact I cannot want to make this stronger every market whether it's a factor market or a product market has to be structured to make it work to compete at those margins that you want to have people compete at and to and this should be right up your alley that's going to change over time when you get changes in technology changing the political structure change in information cost changes and all those things are going to change how that market works so that a market that works well in time T is not going to be marketed to work well and time T plus one now the question therefore that you're interested in how do you get a market to to work the way you want it to well berry wine gas who's a very close friend on political scientists at Stanford and Steve Hebert and I are running a series of conferences we had the first one last summer on factor in product markets and how to get them to what what are the essential characteristics necessary to make them work well and there's two pieces to it one is the political structure and the second is the economic structure now the political structure is one that back when before we started getting deeply into political economy we had a view well politicians are interested in social welfare and uh and therefore they'll do efficient things well that to you knows a lot of apple butter what political markets are like is there always interested parties and from the days of the Federalist paper number ten on we have known that the fundamental dilemma about policies is the one that was in Federalist paper number ten which is that you get interest groups that evolved with it and if you have a polity that's strong enough to enforce property rights it's also strong enough to do you in and ever since the beginning of time that's what political things have been doing in fact most of the time in my looking at ten thousand years of human economic history policies have been nothing but the extortion devices they have not been concerned with welfare and indeed it would be surprising if they were one of the things that as my friend barri wine gas work keeps reminding me said dougie said you've got to remember all the time that all those things that markets can do well the things that are left over for politics are things where you have high cost of transacting or where the players and listen carefully where the players find that they can do better through the political market that they can't pen through the economic market and therefore these things get not just relegated but become the ways by which a polity works and so one of the things we're interested how do polities structure various kinds of markets now i'd like to be able to tell you that political economy which is what we're all doing these days is enough of a discipline so that we could model how policies work with the kind of rigor which we'd like to have so we'd be able to deal with we do in a matter of fact there's a lot of very exciting work now going on in political economy in which we're beginning to understand how policies work why they work the way they do and specifically in terms of your interests why the kind of interest group pressures that you get produced the kind of results you have and when we've been doing as we're doing is just started doing this a study of different kinds of markets one of the things of course that we're most injured we did well on international capital markets last summer and we're going to do one on on land markets this January and then labor markets then we're going to come to an individual product market but when we do that why it's obvious if the kind of structure that evolves reflects the interplay between the economic characteristics of that particular thing technology and so on of it and information aspect with the way in which political pressure groups interest groups remember I said institutions spawn organizations and the organizations are always interested players trying to structure the market in ways that will be of interest to them so what the first thing we want to look at is how polity is therefore structure the market then after that you've got to do something that and here I I think we economists have really fallen flat on our face even though I owe sort of touches on the edges of it doesn't correct to get directly at it what are the characteristics economic characteristics of a market the kind you want now I face this every day when I go to third world countries and what I do in third world countries is to try to find out what what kind of how they work I go and do a series of exercises on how how costly it is to get spare parts for machinery or how long it takes to get a telephone installed or how how I can get a agricultural loan to grow rice or whatever it is I have a whole series of these and after I get the information which is the transaction cost of that market I find out that get a spare part it may take 18 months to get it or with three bribes I can get it in four days and I do that to all kinds of once I find that out then I ask myself why don't as I go around about what are the institutions that produce that structure now you'd be surprised well you shouldn't be but you how little we know about those things when you go to a third world country and I get talked to the economy they talk about broadly about markets and so on but I don't talk about the interstices of how a market works and particularly the the inter interplay between the institutions an organizational structure and markets that is what the heart of what you need to know now well I thought that was just true for third world countries but when I asked my colleagues who are in IO in this country how particular market works I find they have clues to it but that a systemic work on the structure of market you know what is the combination of things of the technology and information costs and so on that go to make up a particular market have very imperfect knowledge of and indeed this doesn't seem to be a part of what what we need what we learn and certainly in economics and political science now there's a lot of different disciplines involved in this political theory social theory economic theory all of which deal in some part for example social theory has done some very interesting work as helped me out with network analysis now network analysis is nothing more than finding out the connections that are made when you have a particular piece of economic activity how do you what kind of different groups do you have to connect with and from my friend of mine woody Powell at Stanford has been looking that with genome projects and taking a look at how complicated it is the inter in interrelationship between various individuals groups and so on that are necessary to make that make a a genetic project workable and it turns out it doesn't look anything like the kind of simple firm structure market that we talked about in economics and the result is that we're beginning to try to understand the inter Ceci's the connections that are made so what we need to do and which it seems to me is relevant for you is we have to look at not only how the communications market works at a moment of time and yours is a very complex market because it has all kinds of kind of thing but for you a much more difficult problem because you're in the midst of a world of the most radical technological change probably of any sector in the world and that technological change is making itself an industry that might have been natural monopolies some years ago now as a competitive industry who knows where we'll be tomorrow by the time you integrate all of the kinds of radical technological change now that poses in my view and I said sure in your game some very interesting problems it not only means that you've got to understand the structure of that market at a moment of time the technology and communication information things and a networking analysis that you need to know to understand properly how that market works and is essential if you're going to regulate it properly but you've also got to have understand how its evolving over time and I think this is important for you can tell me if I'm right it would seem to me that it's always crucial that the kind of rules and regulations that you evolve in time T shouldn't force you from permitting the kinds of changes you want in time T plus one and that's got to be doubly difficult for all of you because you don't have a free hand you're you're not only are trying to understand the economics of this but you have political pressure groups that are interested in preserving the structure that you created in time T and will prevent you from making the essential changes in time T plus one so all of that it seems to me is the reason why you all ought to be the new institutional economists if you're not you should be because we haven't developed our Theory far enough and we've gone a lot further than I have had time to talk to you about in 40 minutes I've been talking but we need to do and build a theory about institutions and the way they change both formal rules and informal norms and I haven't had time to talk about how important informal norms of behavior are in modifying the transaction cost in particular market and how enforcement works and then apply it to your field and then particularly deal with the political economic issues of how how well it works in a moment of time and how it changes over time and as I said over time we get into fundamental and I'll end up with just a hacks one piece of advice which I always liken hi axe my favorite economist of the 20th century and that is what Hayek said what you always want to do is you want to is you want to maximize the choice set of the players so that you never get yourself at a dead end you don't you don't end up with a set of interest group pressures that prevent you from continually modifying the way the game is played to take advantage of changes in technology and new rules and regulations so on when I look at my story about the rise and fall the Soviet Union is a very simple one rise and fall of Soviet Union simply had no variety of choices open to the players you had choices being made by one individual or small number of individuals and if they failed and they do in an on-air Kotik world you fall flat on your face and they did what you want and what I would think was crucial for a regulatory agent be very self conscious about is being aware of the changes that are going on and technology and so on your field but then to build into the regulatory system not only the kind of regulations at time t they'll do what you want with respect to performance characteristic but also ones that as well as you can given the pressures you have from the political world that you work in front permit you to be innovative and creative and not get stuck with with the kind of rigidify pressure that interest groups are always going to try to impose on you that's got to be a really tough assignment and I know you're all up to it aren't you ok now let me remind you if you don't ask me dirty questions I'm going to ask you questions there's one yes like that someone you don't have a formal rule we have to change question one is do you agree with that or social norms and change and second if you do agree do you think another good that's good questions and you'll get a lousy answer the reason why it's difficult is informal norms have varied variations in the degree to which they change but let me start off with saying that informal norms are crucial when I've done I in with one of my students I did measure the transaction sector in the American economy from 1870 to 1970 and incidentally of interest to you by now it's quite clear that more than half of GNP in American society goes to transacting that is most people don't produce anything what you do is your lawyers accountants economists other ilk like that but you take more and more of the resources go to integrate the economy now when we look at a particular market one of the things that we find is a big variable is the degree to which social norms lower the cost of transacting if you have norms of honesty integrity in certain markets they make it easy so that you don't have to have a lot of formal rules you don't have to have big lot of enforcement mechanisms rather the social norms do that for you and on the other hand where you have the reverse and I which I see it in lots of third-world country enormous amounts of resources have to go to enforcement mechanism so you're very interested in social norms and how effect if they are but we don't know how to change them at least in the short run we don't know how to change now in the long run where I've had some practice doing what you try to do to change norms that you think are antithetical to to a efficient structure you try to change the formal rules in such a way that they make a big premium to certain kinds of social norms evolving and gradually over time that happens but the speed with which it happens varies radically from one group to not but you ought to be very concerned with social in particularly it seems to be with with what you all do because obviously a lot of the costs of transacting are going to be vigorous significantly influenced by the degree to which people believe in the rules and regulations they haven't conformed to them and to do something that we observe a lot of time punished informally people who violate those social norms and therefore allow the the norms to make for low costs of transacting and so you are very interested I talk a lot more about it but I'd get off into but it's a very important subject I think of interest to all of you yes I'm in the International Bureau of the FCC and we often get approached by other countries who are setting up their regulatory institutions and we of course tell them that just like the FCC you need to be independent of your regular T's you need to be independent of the political process of course you're sure I full heartedly believe that on but as you have pointed out there are a lot of local differences that have to be taken in account and what would you suggest that what kinds of questions should we ask of them or what kinds of questions should we suggest they ask of themselves as they are trying to set up these kinds of institutions in their own markets well that's an interesting question I the World Bank a few years back did a big study of the efficient effectiveness of regulation and telecommunications around the world and they they looked at Jamaica Philippines Argentina of Britain I've forgotten one but and I was an advisor to the project so I learned more about telecommunications than I ever wanted to know but one of the things that we found of course was that the enormous variation in in the effectiveness of regulation reflected two very different patterns you either had and this gets back to norms and transaction costs you either had regulatory agencies that broadly speaking was a substantial degree independent of direct political pressures and where you did the most effective regulation turned out to be one in which you allowed a lot of degrees of freedom of flexibility the regulatory agency to modify the game as technology and things like that change in the other countries and Philippines were the worst example we had you didn't want to give any latitude to the regulatory agency because the regulatory agency was obviously just under the thumb of the interest groups at the time and therefore you never got the changes you wanted so one of the things we out of this and the World Bank study it which it was published I think last year it tries to generalize a little bit on what what kind of structures you want but you'll note that there isn't an answer there's an answer that depends upon the the nature of the polity in a particular society and how it works with the problems that you face and that those are so different that in Chile where you had relative or in Britain where you had relatively well well-defined and well behaved regulatory agencies you wanted to give them a degree of flex so that they gave responded the kind of changes in pressures do you want whereas in the Philippines you didn't want to give many latitude at all and that's not a very good answer but that's I'm going to get it is in terms of the following up on your point about the desirability of giving regulators a degree of flexibility this is sort of a cross between a comment and a and a question there a variety of people here today who have been working on the Commission's biennial review of media ownership regulations which was conducted pursuant to a statutory provision that every two years the Commission review all of its media ownership rules and there are other provisions that require periodic review of other of other rules so in some sense this is sort of an illustration of your point about the importance of flexibility and ensuring that you know rules adopted at time T are also appropriate to the extent possible after time has passed and technology has changed but I'm wondering if you have any you know any thoughts on sort of what you know whether this is an appropriate and appropriate mechanism or sort of how in any way of figuring out sort of what the right interval is between reviews of a particular set of rules and obviously we know I don't think we want to be spending a hundred percent of our time reviewing particular rules well this is something I think that probably all of you are better at them than I am you all are familiar I'm sure where the studies that George Stigler really started on the degree D of George always thought that regulatory agencies would be captured by the interest groups and of course in a lot of empirical study we've done we found that's not really completely true is partially true but not completely true and indeed what we what we find is all kinds of mixtures of it but again going back to the question that the lady asks back there it's certainly much less true in the United States them in the Philippines or in lots of third world countries where regulation is just is schemed to to do in the public and make the the interest groups more inefficient than they already are not true in the United States it but it certainly varies and I suspect it varies in ways that all of you are much more expert than I and it varies with a degree to which you can get insulated to some degree from the kind of pressure groups that you have now you're all on the hot seat if I read the newspapers these days you're really on the hot seat and but to the I don't know the degree to which you're insulated really enough so that you can act with some degree of autonomy from from the from the kind of pressure groups I suspect you are certainly in other regulatory agencies that I've come to know over the years they've been a mixed bag but I don't think doesn't there's a simple answer to it I do think that however if I was running your agency and heaven forbid that I should ever get stuck doing that but if I was running your agency I'd be most concerned with the flexibility issue that is we've always being concerned that the kind of rules that I was putting in place would not hamstring me down the road when the game changes and if you at least were self-conscious about that all the time I suspect that would be the most important because you're going to make lots of mistakes and indeed it would be immensely surprising given the radical changes in technology going on in communications information cause if you didn't so what you want to be sure of is the mistakes you make you can get out of overtime remember it's an on-air Ghatak world I want to emphasize this because if you think that somehow or other it's it's one in which the lessons from the past will always solve your problems of it that's just not true and of all the groups that I know you guys are in the midst of the one that's most striking in this because we're evolving technologies in the information thing and new new ways of doing it that I were unimaginable 30 or 40 years ago or even maybe unimaginable 30 or 40 years hence I'm just finishing a book on upon entitled understanding the process of economic change and the last chapter in the books is concerned with how wide we can forecast the future now you will note that if if the world was one that was there Ghatak Paul Samuelson was right then what would happen is that we would try things out and to the extent that the feedback was fairly good we'd get the feedback and and I realized that the worked or didn't work if it worked we kept it if it didn't work we'd discard it and try something else and eventually we'd get it right and indeed economic theories implicitly implies that but that's Apple butter as I keep saying because we're changing it and there's no place where this is more strikingly evident that an information communication costs in the world where we're changing in ways and with technologies that are just unimaginable in the past and that therefore means that it's crucial all of you therefore try to devise rules and regulations that will allow you to get out of the mess you're going to make in the short run as you are you are going to make messes there are if you don't you're you're a god and none of us are God in this world even if there's some people some economist I know that think they are yes following up on that point from a historical point of view can you look to any examples that would give us some hope that we have some ability to achieve this task going forward well I'm tempted to give you the reverse which is a it's more but look at the history of railroad regulations America if you want a case study of having messed something up over time you know we started out in the in the in the 1880s where the federal government declaring the states couldn't regulate railroad rates and so we created the Interstate Commerce Commission in 1887 and look what happened to the railroads in the neck in 130 years since then you know it's what a mess you know now I can tell lots of stories like that you see but then if you ask me the story do we get we do get it right sometimes and indeed we get it right well enough so that we've managed to make a society an economy that despite all the messes we make and we make them all the time has managed to have economic growth for a couple of hundred years and that is extraordinary so that is an immense tribute now what underlies that was what I call adaptive efficiency that is having a set of institutions that allow for flexibility to allow for trial and error and not only allow you to have lots of different ways to try things out but also with bankruptcy laws and things like that have a way to eliminate the things that don't work which is 90% of them well we've done that nationally I think quite effectively I don't see will always continue doing it you understand but we've done quite effectively if you give me specifics I suppose I could go back and think about particular parts of the story that are like that and we have a lot of them we have a lot of markets that work quite well and they work well mostly because they've had that your market is a tougher one than all of them because your market is one in which you do have you guys you have to you have to have a structure the market in certain ways but that structure is going to be obsolete any way you look at it down down the road in a very short period of time and therefore from my viewpoint the heart of what would make that structure is your ability to be flexible and and innovate and try things out over time I've done a good answer you understand what that if you'd given me more time out and think about some market that it evolved that way yeah thank you it sounds like a difficult task are you suggesting on the one hand as an institution we need to allow for flexibility in our own rule so that they can change over time as needed but yet at the same time you can't have too much flexibility because you need some some level of stability and structure for the market itself right so are you suggesting we have to somehow paradoxically be flexible but not excessively so that's really exactly what I'm suggesting I thought that makes it much more difficult because if extreme flexibility means you need anything goes and that's worse than landing actually what if you look at the broader issues of the way in which the institutional economy is evolved one of the things that's given us lots of strength over time and as made for adaptive efficiency has been the informal norms of behavior no matter how much the formal rule some sometimes are ridiculous we've had norms of behavior that have broadly supported a dynamic change of supported innovation have supported hard work and low cost of transacting in markets and those have been very very powerful and I suspect they are for your agency too that they give you you know you can have formal rules that look maybe hard to to change and get it wrong but the informal norms gradually force changes in the formal rules because they're in it they're antithetical to it and to the degree we keep those kinds of informal norms the degree then will will make changes but there's you're quite right that you don't want to have complete flexibility but you just wait but you want to be self conscious that that's what you want tell that you you save yourself from all the mistakes that human beings are always making I'm just curious whether you have thought about the recent dynamic downturns in the telecom market and some of what might be considered informal failures in playing by informal rules in certain corporations if you see it that way or if you have another explanation for what is changed so radically in markets in the past few years well that's a good question it gives me room to to talk a long time well I move talk along huh but if you take a look at the at the telecoms and Enron and world comm all those one of the things that clearly is going on and I have not I should emphasize that I'm not a specialist in dealing with it I'm sure there's lots that I don't know that I should know but one of the things is clearly gone as you had a wildly dynamic market in the 1990s in information technology I spend my winters out at Stanford so I'm surrounded by a Silicon Valley and while things are going on but what you did and this is a straightforward economic story is that you change relative prices with respect to the payoffs at different margins of doing things and what you evolved by the time you we get to these things is that the payoffs to doing things that were socially unproductive given both tax structure and and the kind of institutions and things that evolved made it so that there are much higher payoff to doing things that if you'll excuse the vulgar excited screwed the shareholder and others rather than having you competed those margins that were socially productive that happens all the time and indeed this is what I'm concerned with is that you get you get it you get it a an industry evolving over time and it's evolving in conjunction with it our connections with all kinds of other industries and as it evolved relative prices and therefore relevant profitability changes at various margins are going to change and as they do change they make it worthwhile to do things differently and what's happened with Enron and world comm and so on is it became enormous ly more profitable to engage in socially unproductive activities than it did in doing what we we think was there was there a vowed intended objective function and so that's an ongoing problem and it's and again it's another illustration of the fact that there's no way to have a market work overtime without changing it over time you've got to keep on modifying the market structure as relative prices and relative margins of profitability keep on changing which make it so that things that were not worthwhile or were not certainly problems in time T will become problems in t plus one and you got to do a deal with them that again requires and I hope I'm sure that all of you know a lot more about this and I'll ever know but it requires that in in your fields that you understand how these margins are changing what when you when you have the dynamic changes that you had in communication information in in the 1990s that you see what's happening at various margins with respect to two pressures on the players and therefore what you would expect the results would be with respect to alter or alternative polyp practices that they'll pursue which may or may not be socially productive and therefore you want to constrain but there's nothing that illustrates that better certainly than the radical changes that happened with with all those industries at the end and in year 2000 2001 2002 and present day I think I understand what a non gothic world means and maybe that makes sense as a as an economist but but as a historian also isn't there some search for fundamental truths laws of history and and you know people like I think Paul Kennedy has written about the rise and fall of nations and so on aren't you tempted to draw some conclusions based on use on your work no no I I don't think there's very many laws of history I think most of them like Kennedy's one which he thought was a universal which incidentally didn't turn out to apply very effectively - what - to a modern modern world I think that there are some Universal don't what's on I for example I couldn't do without price theory price theory is one of the most valuable tools of analysis we've evolved and certainly some lessons from history in the sense of broadly things that we've learned don't work and see it over and over again but relying on them in a world it never wasn't worth like the one we've evolved and if you if you had ever consumed as somebody and say 1700 you know what the world would be like three centuries later they'd have been mind-boggled now if you'd ask somebody in 1700 how how close they would be to the path it'd have been a lot closer to to the Year Zero than they would be the year 2000 because we've just changed the world in such dramatic fashion and what I'm aging is not that you don't that there aren't lessons from history there are but they're very limited and the world has changed in such ways that you have to be very very cautious and you know it's only a politicians and soothsayers that go around making lessons from history and therefore trying to get us entangled into these things we don't have very many of you commented on the relevance price theory but at the same time you commented on Milton Friedman Adam Smith and at least my understanding of price theory has to deal with competition and the neoclassical paradigm so could you explain within the context of Telecom and the dynamics of Telecom what do you mean by price theory and the relevance of it relevance of price theory since many of our activities here are concerned with perhaps what what the right price is well I'm not an expert but I'm very very leery about sneaking into your field to try to talk to all of you which know a thousand times more about the the interspecies of prices in your industry than I'll ever know but broadly speaking price Theory asks itself how prices are determined what supply conditions exist when what underlies demand which are institutional structures that define those and how they're changing which changes institutions which are shifting supply curves are shifting their elasticity and so on and that it seems to me is always relevant for you you're interested in in in that and indeed it's right it's got to be at the heart of what you want presumably you want the quiet you're interested in quality and price and all the margins that exist and this price is still a function of supply and demand which in turn or a function of institutions in the way they work and in that sense they're it's as relevant as ever all of you can tell me better than better than I can the specifics but I would certainly be concerned when I take a look at at some particular part of what you're interested in or some particular issue that you're interested in its implications in the short-run for price and quality it's as simple as that but also always be concerned with you particularly on on being having a weather eye up to the fact that you would you have such a dynamic changing world that you're always concerned with time and in a big in a big way because your world at the heart of it is all about the problem of time speaking of the problem of time I think it'll take I'll take this opportunity to wrap it up and I'd like to thank Doug for coming and I'm sure we all enjoyed it and thanks for coming

Channel: Federal Communications Commission

Views: 46,092

Keywords: Douglas, North, Market, Performance, FCC

Id: A2xhmlpUKd8

Length: 70min 34sec (4234 seconds)

Published: Tue Jan 26 2010