The Central Role of Institutions 1.2.2 Change in Institutional Arrangements for Asset Exchange

Similar considerations of path dependence, power and the wider environment influence the formation of institutional arrangements, but these are also influenced by the nature of the particular assets or transactions with which they are concerned. It is helpful to consider two related functions of institutional arrangements, to support asset exchange between transacting parties, and to support asset coordination amongst those holding, buying or selling similar assets.

In asset exchange, we may identify three broad forms of institutional arrangement between transacting parties. Spot transactions (the impersonal free market ideal) are one extreme form of contract, contrasting with non-market transactions, which are embedded within personalised, long term social or organisational relations without any market exchange (clan relations and commercial firms are both examples of this form of arrangement). Intermediate forms of contract might involve longer term or non-standard forms of market contract which involve both market and personal relationships (long term supplier relations or share cropping, for example).

Asset coordination is beneficial where people obtain relatively small individual gains from holding, buying or selling assets (due to low unit value or to small scales of activity), and the associated transaction costs have a high fixed cost element which is incurred irrespective of the scale of the holding or transaction. Considerable savings can then be made in the costs of holding or exchanging an asset if the scale of holding or exchange can be increased through coordination or consolidation. This might apply, for example, for forest dwellers resisting encroachment by a logging company, for small scale irrigators allocating water between themselves, or for small scale urban entrepreneurs buying inputs or selling finished products. Coordination may be achieved through private, state or collective arrangements which in turn consolidate asset holding (or buying or selling) at three levels: management, use and ownership. Thus forest dwellers might adopt collective management arrangements to work together to defend their forest, a state irrigation department (with state ownership of water resources) might allocate water rights to small scale irrigators, and small scale urban entrepreneurs might set up a co-operative or use the services of private market agencies to sell their products on commission (involving collective or private coordination of asset use).

Actors’ preferences for different contractual arrangements depend upon the benefits, transformation costs, transaction costs and risks associated with each set of arrangements. Analysis of these costs enables understanding of the relative performance of different institutional arrangements under different conditions. Thus well defined property rights (with a well developed institutional environment and appropriate asset characteristics) tend to disproportionately decrease parties’ transaction costs for market based and private arrangements. Transaction risks, however, tend to increase with such arrangements (as the parties have less access to and information about each other), and the importance of risk to contracting parties varies with

• risk aversion (often related to poverty and to livelihood or income diversity),
• the extent to which investments or their benefits will be lost if the transaction fails (known as asset specificity and often affected by technology, for example investment in specialist equipment or buildings), and
• the scope for opportunistic behaviour by other parties to renege on agreements.

Scope for opportunistic behaviour depends upon the institutional environment, power relations of the different parties, and the characteristics of the asset concerned. Particular difficulties arise where resources are mobile, not easily differentiated (according to owner), and dispersed (common characteristics of ‘common property’ natural resources) or where quality is variable and difficult to monitor. Institutional arrangements are often crafted to constrain opportunistic behaviour. Collective institutions and non-market and intermediate forms of contract, for example, tend to rely upon expected future gains from repeated relations between parties as incentives to fulfil agreements, with transaction costs and risks and scope for opportunism reduced by building up personal relations, knowledge, and longer term co-operation.

An important conclusion from this analysis is that if a set of actors face major transaction risks, then institutional arrangements that are apparently non-competitive and/or inequitable may be more efficient than and preferred (by all parties) to competitive market arrangements. There may then be a role for the state and for development agents to support institutional innovation and the development of conditions that promote such institutional arrangements. (See Box 2)

Institutional arrangements evolve, however, to match not only the interests of the different contracting parties’ but also their relative power, considered in terms of market power (the gains parties can achieve from alternative uses of their resources, outside the transaction) and non-market power (social, legal or illegal pressures or threats that each party may use to influence the other).

As the poor often engage in transactions from a position of relative weakness, then a shift in power relations (through an expansion in their market power with the development of alternative asset uses, or through a change in non-market relations) may offer scope for changing contractual arrangements to their advantage. However, if changes merely restrict the market or non-market power of the entrepreneurs with whom the poor transact (for example traders, money lenders, employers or landowners), care must be taken that it does not weaken these entrepreneurs’ gains to the extent that they withdraw from these transactions altogether, reducing the livelihood options for the poor.