2005 Barcelona Workshop: Abstracts

SEPTEMBER 17–22, 2005


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An Economic Analysis of Professional Privileges:
Corporate Compliance and the Professional Privilege
of Lawyers, Auditors and Reporters
Hamburg University

Professionals constantly stress the importance of confidential communications and claim that the contribution of their profession to society will be harmed if confidentiality is abrogated. Lawyers claim confidentiality increases communications and candor and promotes justice, auditors assert confidentiality promotes legal compliance and journalists contend confidentiality encourages the flow of information to the public. Legal systems recognize the importance of confidentiality by granting testimonial privileges to certain professions with varying strength and scope.

The objective of this doctoral thesis is to analyze, from a Law and Economics perspective, the role of professional testimonial privileges in the efficient functioning of lawyers, auditors and reporters in corporate compliance in capital markets. The thesis consists of three parts.

The first concerns lawyers. The analysis employs existing models of lawyer-clients privilege and extends them to incorporate the corporate principal-agent problem. Behavioral and empirical insights are used to strengthen the observation that the corporate lawyer's privilege is not as socially beneficial as claimed. It is postulated that unbundling the corporate legal services of ex-ante legal advice and ex-post legal advice (litigation advice) and granting the privilege only to ex-post legal monitoring services will reduce social loss caused by the privilege when it protects communications that would have occurred without it.

In the second part, behavioural insights are used in order to suggest that auditors, who generally enjoy no privilege, could improve their gate-keeping and whistle-blowing functions if supported by an absolute privilege to protect confidential sources within their audited-clients.

Finally, a model of the source-journalist interaction is developed to demonstrate the effect of reporters' privilege on the flow of information from corporate-insiders to the public. Since corporations can invest in ex-ante monitoring for leaks or in ex-post litigation against leakers, upholding the reporter's privilege by courts does not necessarily increase the flow of information to the media but it can affect the value of the leaked information. Cases of corporate litigation against journalists are analyzed to assess the social cost of this privilege.

Tenure Insecurity, Transaction Costs in the Land Lease Market,
and Their Implications for Gendered Productivity Differentials
Mintewab BEZABIH
Göteborg University

The paper deals with the impact of tenure insecurity and transaction costs on land leasing behavior of Ethiopian farmers. We hypothesize that heterogeneities with respect to tenure security and ability to enforce the terms of contract lead to differing intensity of leasing out between female and male landlords. Lack of recognition of female family heads as farmers might lead to tenure insecurity, and as a response to it, to a high tenant turnover. Similarly, compared to male landlords, female landlords might find it more difficult to enforce optimal level of effort from the tenant and to protect their land from being mismanaged. As a result, they might go for other suboptimal labor arrangements which would lead to systematically lower productivity of female plots.

Pricing Under Asymmetrical Information:
A Case Study of Hong Kong's Housing Market
Lennon H.T. CHOY
Hong Kong Polytechnic University

The housing market in Hong Kong is characterized by the existence of asymmetrical information in the primary and secondary markets.  Apartments sold in the primary markets are usually "uncompleted" units, hence inspection of property would not be arranged to the prospective buyers normally.  On the contrary, buyers in the secondary market can inspect the properties and obtain rather extensive information from the public sources.  Generally speaking, the sellers vis-à-vis the buyers in the primary market possess more information than the situation in the secondary market.

This study attempts to investigate whether the housing developers can take advantage on the asymmetrical information in their pricing strategies? If they can do so, the housing market is said to be inefficient according to Fama (1970)'s weak form test. This study proposes a pooled cross-sectional analysis on selected housing developments in Hong Kong so as to testify if there exists any structural change of value on various housing attributes (e.g. size, floor level and views etc.) over the primary and secondary housing markets. 

The null hypothesis of no significant change on hedonic price parameters over the primary and secondary markets, however, is being rejected in an empirical study.  The study found that instead of exercising "overpricing" strategy, the housing developer had persistently "underpriced" some housing attributes. Typically, these attributes are with inferior qualities but had yet made known to the general public. To explain this pricing behavior, a detailed investigation on the underlying institutional arrangements has been carried out.  This study suggests that the housing developer had "voluntarily" underpriced the inferior housing attribute so as to discharge some her legal obligations at the margin.  On the other hand, the marginal buyer is also "willing" to let go his rights to sue the developers by pocketing the profit he could make in the secondary market.  In equilibrium, the housing attribute should be underpriced so as to equate the housing developer's marginal saving in litigation and compensation costs to the marginal gain of the first hand buyers who sell their apartments in the secondary market shortly after the first sale. The findings of this study can be generalized to explain the underpricing behaviors of public companies during the IPO exercises.

How Can Corporate Social Responsibility Affect Development?
Athanasios G. CHYMIS
University of Missouri-Columbia

The purpose of this study is to examine one method businesses affect development: corporate social responsibility (CSR).  Can CSR be a method of promoting economic development?  If so, how, and why?  This study will consist of three essays.

The first essay will use NIE to reconcile opposing views of Friedman and advocates of CSR.  The essay will show that the differences between Milton Friedman and CSR advocates stem from different assumptions the two sides make about market.  I will show how NIE can inform the debate because of its emphasis on realism of assumptions, as argued by Coase.

The second essay will use the KLD index for CSR and the Herfindahl index for market structure to examine empirically the relationship between market structure and socially responsible actions of firms.  Firms in competitive industries might have an incentive to engage in CSR as a signaling device, but they will be constrained by normal profits.  Firms in highly concentrated industries will not have an incentive to engage CSR either, although, ironically, they may have the financial resources to do so.  If we imagine a continuum between perfect monopoly and perfect competition I would expect a maximum of socially responsible behavior (ceteris paribus) somewhere in the middle.

The third essay will model the impact of CSR on development through two paths.  The first path is direct, through profit maximization, while the second path is indirect, through the building of trust to lower transaction costs.  It is not clear what the direct impact ought to be; Friedman would argue that the impact is negative because it reduces firm's profits whereas CSR supporters would argue the opposite.  If the direct impact is negative it can be in part outweigh from the positive indirect impact.  However, in light of the first and second essays I will be able to make a case for a positive direct impact under conditions.  The indirect effect, however, is expected to be positive.  CSR can be shown to affect social capital (trust), which will in turn have a positive impact on development.

Economic Growth, Institutions and Markets:
The Case of Transitional Countries
University of Debrecen

My research question is how competition affects economic growth through institutional change in transitional countries. Although it is widely recognized that fundamental institutions like property rights, the rule of law, and even beliefs and norms affect economic development, we know less about the relationship between economic growth and micro institutions. One can argue that given the fundamental institutions enforced by the state, the parties will find the most efficient contracting institutions. At the same time, New Growth Theory has shown that the level of competition has an effect on growth rate and that effect is ambivalent. But this theory does not pay attention to the change of institutions.

My hypothesis is that economic growth rate is affected by the change of contractual institutions, but it is competition that enforces that change. I will argue that competition affects economic growth indirectly through institutional innovation and imitation. This latter is probably more important in transitional countries.

To investigate this question empirically, I have to begin with the definition of the level of competition which can be interpreted in a changing environment. This is why, I will argue, the level of competition should be defined here as freedom to contract. As this is the notion on which the Economic Freedom of the World Index is based, I will examine the effect of competition on economic growth by running regressions between this index and the GDP growth data of transitional countries. By the help of this analysis one can answer the question, whether the effects of competition in transitional countries differs from that in the other countries. This analysis will also focus on the components of the index mentioned above, because the components can be interpreted as levels of the institutional mix. Using this index also makes it possible to differentiate between the effects of fundamental institutions like property rights and the level of competition. This quantitative analysis should be complemented by some comparative research concerning how institutions change in countries with different levels of competition.

Driving Forces for Unwanted Reforms: The Case of Ukraine
Vladimir DUBROVSKIY, Janusz Szyrmer, William Graves III, and Sergey Kokovin
CASE Ukraine

We develop the multi-agent "arbiter-clients" model to explain how societal and technological progress can result in the contraction of rent seeking through economic reforms even in a rent-seeking society; and use it to explain the course of events in Ukraine since 1950s, including escape from the type of "partial reform" equilibrium described by Sonin (2003), and Hoff and Stiglitz (2002, 2004).

We consider a two-sector economy, where the rent-seeking sector initially prevails over the value-adding one.  In the rent-seeking sector, an arbiter (a ruler, an Olson's "stationary bandit") can compensate for weak property rights and weak social capital, and prevent the overappropriation of rent ("overfishing") by using his discretionary power to coordinate the rent-extracting agents. That same power allows him either to extort rent from them, or to buy their loyalty, thus making them his clients. Unless the people restrain the arbiter's power, he expands the rent-seeking sector, primarily by protecting the monopoly rents. In turn, under the prevailing regime of rent seeking the people tend to treat any non-primitive economic activities as a "zero-sum game," thus SUPPORTING the arbiter's redistribution activities.

However, the cost of control and coordination of the rent-seeking sector limits its size. A power-maximizing (totalitarian) arbiter should earn enough rent to cover this cost. A rent-maximizing (authoritarian) arbiter further optimizes his scope of control for reasons similar to Coase's theory of the firm. Thus, the problems of principal-agent relationships and optimal allocation set natural limits to the proliferation of rent seeking.

Furthermore, such costs tend to increase with time due to long-term factors (like technological progress) that are mostly exogenous to the model. This increases the principal-agent difficulty, and complicates the coordination. If the arbiter's rent does not increase correspondingly, he has to downsize the rent-seeking sector, most often in response to some threat or crises; and enhance the efficiency of the value-adding sector as an ultimate source of rent.

In this way the market institutions may proliferate although no major politically represented social group is interested in them. However, when the rent-seeking sector contracts enough, public choice eventually takes force in support of market institutions.

The Impact of Women's Schooling on Property Rights
and Decision-Making Within the Household:
Evidence From a Natural Experiment in Sudan
Buthaina ELNAIEM
Juba University

Girls' access to schooling varies across regions of Northern Sudan.  In some cases differential access of today goes back to choices made by British colonial administrators. Since female illiteracy remains high in many areas today, this historical circumstance provides a natural experiment to examine the long-term impact of female access to schooling on institutional features, including decision-making and property rights within the household.

This topic is important because our knowledge concerning how the education of women changes the rules of the game is limited, especially so in strong and deeply rooted traditions like that of the Arabic-Islamic culture of Northern Sudan.

The paper documents the differential historical patterns of female education in two selected areas with similar cultural and institutional background features except for the differential availability of girls' schooling. It selects samples of 125 women of ages 25-50 and 15 older women (above age 60) in each geographical area, addresses issues of sample selection bias, describes the survey instrument and survey technique, and analyzes survey data for systematic differences in the intra-family property rights and decision-making authority across these two areas. Changes over the 25-year cohort will also be examined. The concepts and techniques of new institutional economics and a combination of qualitative, quantitative and case study methods will be used for this analysis.

The Effects of Political Competition
on Horizontal Accountability:
The Case of the Independent Courts of Accounts in Brazil
Federal University of Pernambuco

What are the factors that explain the great variance in the effectiveness of the control exercised by the 33 state level Tribunais de Contas ("courts of accounts") in Brazil? Current explanations of the effectiveness of horizontal accountability involving independent control institutions give great emphasis on such factors as professionalism, political insulation, patterns of recruitment, and the role of the media and civil society. This paper explores a connection that has been rarely tested in the literature: the role played by political competition. In states where political competition is more intense, control institutions perform better. The paper tests the hypothesis that this is the key explanatory factor. Current explanations of control institutions face a formidable methodological problem: the effectiveness of their actions cannot be analyzed with reference to the number of frauds they report, because this would underestimate their deterrence impact. By suggesting innovative methodologies to bypass this problem, the paper also makes an important contribution for the analysis of these institutions. The paper draws on original survey data on the 33 institutions and reports the results of an ordered logit statistical test which gives support to the hypothesis that competition is a key explanatory variable.

Political Horizons and Corruption
Harvard University

We study how corruption that occurs between the State and the private sector is organized. By exploiting differences in the political and industrial organization across states in Mexico, we explore how party permanency and industry structure determine the extent of corruption. Using micro-level data on extra-official payments made by firms, we find that the political clout exerted on a state government affects corruption in a non-linear manner. Specifically, corruption is higher for high and low levels of party permanency, and lower for intermediate levels. Moreover, we also find that firms that accrue more rents are those willing to pay more bribes, except when permanency seems unlikely.

We relate these findings to a combination of horizon and capture effects. In the first, politicians have incentives to prey more intensively on firms as their window of opportunity shortens. In the second, entrepreneurs have incentives to bribe government officials over long and "feasible" policy horizons, indicating firms' long-term vision when buying out politicians. Finally, we also find an important rent effect, where firms endowed with larger rents are more likely to corrupt officials in exchange for economic shelter.

Measuring the Transaction Sector in the Polish Economy,
1996 – 2002
Patrycja GRACA
Warsaw School of Economics

This paper forms a part of a larger research project on the transaction costs in the transition economies that I do together with Professor A. Sulejewicz at our Department and which is financed by KBN (the Polish Ministry for Science). The paper was presented this year at the BASEES Conference in Cambridge.

The article of Wallis and North (1988) is one attempt to provide a measure of transaction costs in the national economy. Their attempt is to define "transaction sectors" and relate the levels of output (i.e. costs incurred) in such sectors to the level of gross national / domestic product. Apart from the original research concerning the US, there have been very few studies describing other economies (e.g. Australia, Argentina). The paper joins the discussion on macroeconomic interpretation of transaction costs started by Wallis and North. While we had hoped to trace the evolution of the transaction sectors as well as the pattern of transaction activities in non-transaction sectors as defined above, the availability of data prevented us from accomplishing ambitious research tasks. This paper is basically a replication of the study Wallis and North did for the US and B. Dollery and Leong did for Australia albeit for a much shorter time span (seven years). It contains a short description of the methodology used by these authors, the application of the method to the data on the Polish economy in the 1990s and 2000s. We compare the findings with Wallis and North, Dollery and Leong and provide some preliminary interpretation of the results.

New Institutional Economics and the Social Costs of
Domestic Violence Legislation in Puerto Rico
Catholic University of Puerto Rico

The Commonwealth of Puerto Rico was one of the first countries in the world to enact a comprehensive "domestic violence" law two decades ago.  This law, enacted in August of 1989, is referred to in Spanish as "Ley 54", or Law 54.  In summary, Law 54 broadly defines what acts constitute domestic violence and authorizes the courts to issue protective orders to victims of domestic violence.  Moreover, Law 54 commits the Commonwealth to reduce domestic violence as a matter of public policy.  Nevertheless, despite the existence of this law and the creation of new institutions to implement the law (specialized family courts, police units, and the Puerto Rico Commission on the Status of Women), preliminary empirical studies show that the amount of reported domestic violence disputes under Law 54 continues to increase two decades after the law was passed. 

Law 54 thus raises a number of questions that can be analyzed under the new institutional economics.  First, if legislation is seen as the result of competing rent-seeking interest groups, how are we to explain the passage of a law like Law 54?  Second, if Law 54 led to the creation of new institutions to deal with the problem of domestic violence, why hasn't the rate of domestic violence started to decline or level off yet?  Third, to what extent is the increase in domestic violence the result of "strategic behavior"; that is, to what extent do "victims" (both men and women) use the provisions of Law 54 strategically to preemptively obtain child-custody rights or to impose non-market costs on spouses they suspect of infidelity?  Fourth, is there an "optimal" number of domestic violence disputes; that is, is a certain number of domestic violence cases, like car accidents, unavoidable under any legal system?  And last, what then is the appropriate institutional response to the problem of domestic violence?

I shall attempt to answer these questions using the framework of the new institutional economics.  I will have completed my data collection and my preliminary findings prior to the workshop in September of 2005.

The Entrepreneurial Theory of the Firm
Jian-qiang JIANG
Fudan University

The paper attempts to provide some rationale for the existence of the Schumpeterian entrepreneur in the theory of the firm.

Within the last few decades, the theory of the firm has become one of the fastest growing areas in applied microeconomics. And yet, surprisingly, we can find the Schumpeterian entrepreneur everywhere in the real world except in the modern theory of the firm. Usually, the "entrepreneur" has been understood as the one to coordinate the production in order to save transaction costs, to avoid shirking behavior by monitoring, or to secure the ownership of the relevant assets to reduce opportunism through integration. Thus, questions remain as to how and why the entrepreneur-innovator suggested by Schumpeter was neglected by the theory of the firm.

Basically, the theory of the firm is rested upon either of the two assumptions: the product space is given, and the transaction costs of intangible idea of product innovation are trivial. If it is the former in question, the product innovation activities cannot be explained theoretically. If it is the latter, then all Coasian firms can buy any intangible ideas of product innovation from the open market. Although the dynamic characteristics of product space can be explained, the Schumpeterian entrepreneur is ignored and left unexplained. Because the owner of innovative ideas does not need to establish or go into a firm to appropriate his rents, alternatively, he can profit from selling the idea directly to the Coasian firm.

In the real world, however, transacting intangible knowledge is more difficult and costly than any other tangible goods. Based upon the transaction cost approach, it seems to be economical to forgo any direct pricing of this intangible knowledge as an input, and to price its tangible output instead. That means the innovator can appropriate his rent by building a firm and selling his new product to the market if selling the idea is too costly. In this sense, the firm can be interpreted as an indirect pricing mechanism of intangible knowledge, and thus the role of Schumpeterian entrepreneur is justified in the theory of the firm.

Sovereign Risk: Constitutions Rule
University of Warwick

This paper models the executive's choice whether to reschedule external debt as the outcome of an intra-governmental negotiation process. The executive's necessity of a confidence vote from the legislature is found to provide the rationale for why some democracies may not renegotiate their foreign obligations.

Empirically, based on a sample of 59 developing countries with access to private capital markets, I find that parliamentary democracies are indeed less prone to reschedule their foreign liabilities and accumulate arrears on them and only parliamentary democracies have been able to significantly reduce their debt/GNP ratio without a 'credit incident'. The effect of a Constitutional requirement of confidence on the executive is statistically and economically significant: it is equivalent to an increase in reserve holdings sufficient to finance eight months of imports. Moreover, countries with stronger political checks on the executive and lower executive turnover have a lower rescheduling propensity. The results persist if Latin American countries are excluded from the sample.

These results suggest that North and Weingast's account of the evolution of institutions in 17th century England gives substantial mileage in understanding the international debt markets in the contemporaneous developing world.

Multinational Firms' Ownership Structure Choices
in Politically Risky Countries:
An Integrative Strategic Management Approach
University of Illinois

The field of strategic management has theoretically and empirically addressed the phenomenon of the entry mode choice of multinational firms as they expand into international markets.  Yet little empirical research has been carried out that illuminates the complex relationship between the choice of governance structure on the one hand, and the firm-specific attributes of the investing multinational and the institutional environment of the target country on the other.  This gap in the research literature is especially pronounced when the host country's institutional environment, the set of fundamental political, social and legal ground rules that define the nature of carrying on business in a society, is not well specified or simply unfamiliar to the investing firm, thus exacerbating the multinational enterprise's foreignness and presenting it with a difficult -- and costly -- challenge.

Drawing upon transaction costs and new institutional economics theories, I propose to investigate the effect that political, social, and legal institutions have on economic activity across countries. Specifically, I seek to answer the following question:  Which choice of ownership structure --- wholly owned subsidiaries or equity joint ventures --- do U.S. manufacturing firms tend to choose for their overseas investments when environmental volatility is high, given the multinational's unique set of attributes and the differing host-country institutional frameworks that influence each ownership structure decision?

The empirical context of this study, an original sample of U.S. manufacturing firms that have operations in thirty-five countries rated as the most politically unstable, affords a unique opportunity to examine firms' governance choices in a subset of countries that researchers have not previously isolated for empirical examination.  Extant empirical work has observed that hybrid governance structures often dominate as the more efficient solution in transition economies characterized by institutional hazards, but this research finding may not hold for investments in other types of economies that exhibit high levels of uncertainty, especially when considering the transaction's idiosyncratic nature. Moreover, this study attempts to contribute to the growing debate concerning the relationship between transaction costs theory and the increasingly important role that the host country's complex institutional environment has in informing firms' strategic objectives.

Neither Group Nor Individual:  Unresolved Conflict in the Transition From Common Property to Individual Property
in Kajiado District, Kenya
Consultative Group on International Agricultural Research

In the early to mid-1980s, Maasai pastoralists of Kajiado district in southwestern Kenya began subdividing their collectively held and titled group ranches into individual parcels for distribution among registered members of the group ranch. Out of a total of 57 group ranches, 39 resolved to subdivide. 23 of these subdivided and obtained titles. 6 did not. Instead, they have been entangled in distributional disputes for longer than a decade. Their transition to individual property has stalled. Why?

A strict economic approach has dominated the analysis of how property rights emerge and evolve. But this approach is increasingly augmented by distributional concerns and the role of politics in animating change. Because a new property arrangement affects the distribution of wealth in a society, the process of transition is often the focus of intense competition by individuals seeking to influence outcomes. Power asymmetries have been suggested as one avenue in which distributional conflicts among competing interests are resolved (Knight, 1992). Individuals with greater bargaining power force weaker parties to comply with their preferred property rights. When this fails, however, they call upon the state to coerce compliance (Firmin-Sellers, 1996).

But not all property rights conflicts are so neatly resolved. Sometimes conflict may recur and new property structures fail to be assigned. While Knight (1992) recognizes the possibility that weaker parties might have marginal influence over the direction of change and thereby sustain the conflict, the conditions under which this occurs remains largely unexplored. Why state coercion or power asymmetries among bargaining parties may fail to resolve social conflict over the assignment of rights is yet to be more fully explained.  My research addresses this concern. Beyond contributing to an enhanced theoretical understanding of the limits of social conflict to the evolution of property rights, this research raises important policy concerns. The current status of these conflicting group ranches is indeterminate (neither group nor individual property) and a possible disincentive to investment in livestock development and sustainable land management.

Why Do Informal Small-Scale Enterprises Stay Informal? Estimating Cost of Doing Business
in Food Vending Enterprises in Tanzania
Estomih NKYA
Mzumbe University

The purpose of this study is to answer the captioned question through estimating the cost of doing business in food vending ventures in informal and formal sectors in Tanzania. It is argued that the high cost of doing formal business (registration and staying formal) encourages informality. In institutional economics, institutions are humanly devised constraints that shape human interaction and determine the cost of doing business. Cost of doing business entails time and money cost of measuring attributes of the object of exchange, given information asymmetry, cost of monitoring and protecting property rights, and cost of enforcing agreements.

Informal micro enterprises are small-scale units that are not constituted as separate legal entities independent of the individuals that own them. Small-scale enterprises in Tanzania are important because they create more jobs at lower costs, meet local demand for appropriate goods at affordable prices, require less sophisticated managerial skills, and their widespread ownership structure provides for more equitable distribution of income.

Case study methodology was adopted to capture the actor's viewpoint and societal contexts. Case study method allows in-depth inquiry into a social phenomenon in which a variety of sources of evidence are deployed. It involves a large number of variables and limited number of cases. Purposive sampling was employed to select sixteen cases of small-scale formal and informal food vending enterprises in Morogoro and Ilala Municipalities. Systematic within and cross-case analysis provided range and mean values of resources (time, money and energy) deployed in starting and operating a business.

Preliminary findings indicate wide variations in monetary cost and time spent by entrepreneurs for registration and staying formal. There are variations also between large and smaller urban areas. Cross-case analysis provided a range of between 3 weeks and 8 months for registration and 11 and 41 hours annually for the cost of staying formal. Monetary cost of doing business ranged between US$ 89 and $562 annually. Besides bureaucratic gridlock, the variations are also explained by "hidden" or "informal" costs of doing formal business embedded in societal norms, fear to expose wealth in society, poor or non-consequential enforcement, and indirect revert to informality.

Institutional Differences and Unforeseen Transaction Costs
on Global Projects
Ryan ORR
Stanford University

Study 1. How do global project managers learn to cope with unfamiliar institutions—beliefs, values, norms, rules and laws? One way is by trial-and-error. With institutional theory as a starting-point for interviews, this inductive analysis of 23 "critical incidents"—situations where managers at firms like Bechtel, Walt Disney and the World Bank report unforeseen costs after failing to understand unfamiliar institutions—led to a set of propositions and a generalized model. The findings contribute to theoretical knowledge of how "institutional exceptions"—misjudgments, misunderstandings and conflicts—are triggered and resolved, by illuminating a recurring pattern of ignorance, sensemaking and response and by identifying four main categories of "unforeseen transaction costs" that arise in this process, i.e., money costs, time costs, relational damage, and reputation damage. The findings also contribute to practical knowledge of how managers learn to navigate, and can be trained to better manage, unfamiliar institutions.

Study 2. This quantitative hypothesis-testing study responds to three research questions: How salient are unforeseen transaction costs for firms that enter global projects in unfamiliar institutional environments? How much do these costs increase as relations with local entities become more interdependent and institutionally diverse? And how much are these costs lessened when an entrant has global experience, local experience, and recurring relations with local entities? The data concerning relational attributes and unforeseen transaction costs was collected by structured-interview with managers and engineers employed by international contractors and consultants on nine large global infrastructure projects in five countries in Asia. The data collection instrument offers a fresh, replicable approach to collecting empirical data for transaction cost analysis. Five types of dyadic entrant-to-host entity relations are examined: formal regulatory relations, formal market relations, formal client relations, informal project relations and informal community relations. The empirical findings confirm the salience of relational friction, conflict and unforeseen transaction costs for foreign entrants, which extends the transaction cost view of foreign market entry and re-confirms the value of an embeddedness perspective in international business and economics.

Carrot or Stick?
An Experimental Study of Reputation Effects in Dictator Games
University of Arizona

This paper reports the results from three laboratory experiments aiming at separating reputation effects in an environment exhibiting salient fairness considerations and offers several explanations and interpretations of the results. The experiments were designed to pick up eventual differences in behavior of subjects towards strangers and individuals with conditional reputation reciprocity in three different dictator game settings with a strong social context.

Majority of subjects took money from a stranger. In the second treatment the conditional reputation of being a taker caused the average amount taken to increase, but this difference was insignificant. The second experiment allowed for strategic reputation building what produced significantly different outcomes than the conditional reputation treatments because subjects were concerned with how they would be perceived by the paired players. Such investigations are important in order to better understand the decision process of agents found in circumstances when the actions are intentions conditional because the traditional game theoretical predictions often fail. As the data suggest, neither conditional nor strategic reputation were significant in this particular game setting and behavior of high proportion of subjects was consistent with the self-regarding preferences model.

To investigate the effects of conditional reputation for generosity, the dictator game was modified in a way that only kind actions were feasible. The subjects responded to the information that the paired player previously sent a positive amount of money by sending significantly larger amounts to givers than to strangers. The statistical analysis of data also revealed that subjects with self-regarding first choice are less likely to change the behavior between the treatments in all three experiments.

Corrupt Elections: Incentives and Implications
Princeton University

In many developing countries, the institution of elections differs systematically from the idealized view of elections embodied in most current political economy work, with important consequences for accountability and governance. I study the incentives underlying corrupt elections. I begin by showing that the obvious view, namely that the goal of electoral corruption is to change who wins, cannot account for an important part of the empirical incidence of corrupt elections. The conventional wisdom associates electoral corruption with close contests and with small margins of victory. The logic is that electoral corruption is costly and risky and therefore should be pursued only insofar as it can change the outcome of the election, and only to the extent necessary to win. In fact, however, corrupt elections are often associated with overwhelming victory. In light of existing ideas on electoral corruption this is puzzling: Why engage excessively in the costly practice of electoral corruption?

I propose an answer based on the informational effects of electoral corruption. The key insight is that electoral corruption can play a critical role in suppressing political competition not only mechanically through, for example, the direct alteration of ballots but also, less intuitively, by influencing beliefs and expectations about the political process. The belief, for example, that the opposition stands no chance of winning can discourage opposition turnout. A powerful incumbent, such as Mexico's PRI in the twentieth century, may thus benefit from manipulating citizens' beliefs through public acts of electoral corruption or by establishing a precedent of corrupt and/or overwhelming victory. The informational mechanism is especially important in developing democracies, where the electoral playing field, while competitive, is often tilted in favor of powerful incumbents. I use a game-theoretic model to explore the conditions under which informational incentives give rise to electoral corruption as equilibrium behavior. I test observable implications of these ideas using a panel of 88 countries in the period 1975-2000 with an original measure of electoral corruption. I also use individual-level survey data to test the relationship between beliefs and turnout. I discuss my findings in light of recent elections in Venezuela, Mexico, and Ukraine.

Subnational Compliance
With Federal Balanced-Budget Institutions:
A Tentative Application of Rational Choice Theory
to Fiscal Federalism in Brazil
Federal University of Pernambuco

The purpose of this project is twofold. First, it connects important rational choice principles to the analysis of fiscal federalism. Fiscal choices of government units are seen as the final result of an ordering of preferences process in which politicians in office try to maximize their expected utility. Ultimately, political behavior is connected with the effectiveness of fiscal institutions. Secondly, based on an empirical study of the Brazilian fiscal federalism, attempts are made to test the hypothesis that the degree of compliance with federal rules of budget balance is substantially dependent upon political costs and benefits presented to subnational elected decision-makers.

Compliance with fiscal federal rules appears as a pivotal problem in modern federative systems, especially in developing countries that adopt intergovernmental controls over subnational public finances. In Brazil, the federal government introduced in the 1990's the current structure of top-down budget balance rules in order to lead state and local units to the pursuit of a better fiscal performance. Emphasis must be given on the Fiscal Responsibility Law – FRL, enacted in 2000, which has become a major source of hard budget constraints to the Brazilian states. We try to answer two questions: 1) To which extent has the Fiscal Responsibility Law – FRL influenced the deficit outcomes of the Brazilian states? 2) What costs and benefits did the state administrations expect in the event of compliance with the FRL?

Our hypothesis is that the degree of compliance of subnational administrations with the FRL in Brazil has been substantially dependent upon the expected political costs and benefits. Contrary to the common sense that the Fiscal Responsibility Law was exogenously imposed, well beyond the powers of subnational units to reject it, our work suggests that the law is rather an intergovernmental institution through which the costs and benefits of compliance are presented to all subnational administrations, influencing their decisions regarding the level of deficit. Therefore, this work highlights the political dimension of fiscal institutions in federative countries.

Swiss Direct Democracy: The More the Better?
University of Basel

Breaking a last taboo Swiss Direct Democracy has recently being discussed more and more frequently and in an increasingly controversial manner. During the last century Swiss Democracy seemed to guarantee stability and to grant high participation. Therefore instruments of Direct Democracy like referendum and initiative were constantly developing during that time. Only in recent years these instruments came under pressure. One reason was the decline of voter turnout; also it seemed that instruments failed to meet the requirements of a dynamic globalization. Is the optimal scale of Democracy in Switzerland exceeded?

Other nations also know the institutional rights of initiatives (e.g. USA) and plebiscites (e.g. an increasing number of European countries). Nevertheless in its elaborateness and consequence the Swiss system is unique. Swiss Democracy is rarely the object of scientific analysis. If so, applied research is frequently focusing on federalism. Furthermore academic findings have very little impact on discussion on institutions in Switzerland. Although there are important similarities between the system of Direct Democracy in California and Switzerland, the American criticism of initiatives is not noticed in Switzerland. Moreover research results on communal level are frequently blindly applied to federal level.

The aim of my research project is to fill this gap. This aim will be achieved by answering several questions: How has Swiss Direct Democracy developed on all levels in its federalist system (communities, cantons and confederation)? What are the different characteristics of these levels and regimes? How can they be compared? To what extend can international results be applied to Swiss Direct Democracy in its particular situation? Is Direct Democracy in Switzerland unique?

For the first time the Swiss regimes will be investigated in such a systematic way. Not only to allow better application of international research, but also to build the foundation of a reform debate on Swiss institutions. In consequence of better comparability of Direct Democratic regimes the rich Swiss experience on this issue can fruitfully be used in the actual discussion about the international extension of Direct Democracy.

Does Transition Make You Happy?
Peter Sanfey and Utku TEKSOZ
European Bank for Reconstruction and Development
and University of Munich

This paper analyses the correlates of life satisfaction in transition countries using evidence from the World Values Survey. The paper demonstrates that individuals in transition economies on average record lower values of self-reported satisfaction with life compared to those in non-transition countries.

An econometric analysis shows that happiness is correlated with females, education and income, and declines with age until the early-fifties. Self-employed people in transition countries show a higher level of satisfaction relative to full-time employees, in contrast to evidence from non-transition countries. A comparison across time for a smaller sample of countries shows that life satisfaction levels have returned close to pre-transition levels in most cases, after a dip in the mid-1990s, and that satisfaction levels are highest in those countries where market-oriented reforms are most advanced.

Note: The views expressed in this paper are those of the authors only, and not of the EBRD.

Barriers to Water Markets
in the Heihe River Basin in Northwest China
Junlian ZHANG
China Agricultural University

Tradable water rights systems are becoming an important way to achieve distributive efficiency for water resources. However, it is not easy for countries or regions to set up the system and water markets due to the existence of various barriers.  In early 2002, the Ministry of Water Resources (MWR) of China initiated an experimental project to establish a water-saving society in Zhangye city in the Heihe river basin in northwest China.  This project was the first of its kind in China. The aim of the project was to establish a new water use rights (WUR) system with tradable water quotas and to reallocate water resources reasonably and efficiently through market-based instruments.

This report presents the research done on the system and water markets. It has been found that that the system is hard to implement well and that WUR trading is not popular. The barriers to implementing a WUR system are social and administrative in nature. Local farmers cannot be forced to limit their water use because they cannot endure losses caused by water shortage. Local water agencies have no incentive to restrain local farmers from using excessive water. On the other hand, WUR trading faces management, legal, administrative, and fiscal barriers. There are management risks for farmers in switching to low water-intensive crops. It is also difficult for water buyers to buy rights to land and water use from farmers with small parcels. Farmers are discouraged from selling water to the government whom they fear will reduce their water quotas, and divert irrigation water to other sectors. This report gives some policy recommendations to overcome these barriers.