Economic Governance today: The Credibility Problem and the Clarity Problem

By Jens Prüfer

About 25 years ago, Avner Greif and his co-authors set out to study how the rise, mechanics, and decline of certain institutions in the European middle ages can be explained by the help of game theory (Greif 1989, 1993; Greif, Milgrom, and Weingast 1994). Soon it became clear that the theoretical insights gained do not restrict applicability to – notably fascinating – historical institutions and organizational forms. They were applied to other, more modern cases and questions as well.

The key questions studied in this growing literature were, how can opportunistic behavior be avoided in social dilemma situations, where the joint payoffs of the players are maximized under mutual cooperation but it is individually rational to defect and thereby to maximize one's own payoff at the expense of others? As a consequence, how should institutions be structured such that the incentives of individual players to free-ride on their companions' efforts are mitigated?

A major innovation to this literature was contributed by Avinash Dixit (2003b), who constructs model where a continuum of traders is distributed over a circle representing the economy. The distance between two players, who repeatedly face opportunities to transact with new and unfamiliar business partners, captures socioeconomic differences, which can be interpreted widely, for instance as geography, the degree of shared knowledge, or kinship. Thereby, Dixit addresses the long-standing criticism of sociologists that economic models lack social structure and the integration of social relations (Powell 1990, Nee 2003).

Scott Masten and Jens Prüfer (2014) propose a classification of commitment mechanisms in such social dilemma situations, which allow players to credibly signal their partners that they will cooperate and forego the temptation to renege on their contractual obligations. This classification ranges from internal value systems - players cooperate because it reinforces moral self-perceptions - to public courts - players cooperate because they want to avoid high penalties or imprisonment. Between these extremes, there are several types of communities or private ordering mechanisms, all of which enforce cooperation by threatening defectors with ostracism. Both informal social networks, which have received a lot of scholarly attention (e.g. Kandori 1992, Greif 1993, or Ellison 1994), and formal associations (e.g. Milgrom, North, and Weingast 1990, Klein 1992, Greif, Milgrom, and Weingast 1994, Kali 1999, Dixit 2003a, or Prüfer 2016) constitute communities within this classification scheme.

Dixit (2009:5) defines the common denominator behind such social dilemma games as economic governance, which is “the structure and functioning of the legal and social institutions that support economic activity and economic transactions by protecting property rights, enforcing contracts, and taking collective action to provide physical and organizational infrastructure.”

Because the credibility of transactors’ claims to act honestly and keep up with their contractual obligations has been central to this literature, Robert Gibbons and Rebecca Henderson (2012) call it the credibility problem.

Lately, however, a related but different function of economic governance institutions has caught scholarly attention: to define what the terms of an agreement between two players mean (Bernstein 2001). Bentley MacLeod (2007: 596) underlines that “the evolution of successful informal agreements depends upon a number of interlocking elements, including a mutual understanding of the events that determine contract breach.” Gibbons and Henderson (2012) coined the term clarity problem. In the same spirit, Gillian Hadfield and Barry Weingast (2011, 2012) study the capacity of legal orders to serve as a coordination device distinguishing acceptable from unacceptable behavior, thereby serving as a classification institution.

From an economist’s perspective, this latest development is both interesting and relevant because it is usually implicitly assumed in economic models (including nearly all cited above) that players who enter into an agreement understand each other perfectly. Consequently, in such a world there is no need for an institution to specify what it means if trader A promises to deliver a good, say cotton, of quality X to trader B. But reality is more involved – a fact that legal scholars, for instance, have understood earlier. It may be time for economists, too, to shift focus and to study the effects of imperfect clarity about the details of an agreement, the (in)significance of such details, and which institutions may be suited best to solve the clarity problem in a given situation.


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