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New Institutional Economics : Identifying social capital-II

Integrating social capital into New Institutional Economics framework to derive the NIE+ framework in order to analyse public and social policy issues

In the last article, we had discussed the various theories of social capital and their critique. We had also suggested a working definition of social capital so that it could be operationalised while analysing public policy and social policy questions. Let us now see how the concept of social capital can be integrated into the NIE framework and arrive at the NIE+ framework.

Integrating social capital

The first in this integration would be to look at the definition of institutions proposed by Douglass North. According to Douglass North, the institutional environment is the 'humanly devised constraints that structure political, economic and social interactions. They consist of both informal constraints (sanctions, norms, taboos, customs, traditions and codes of conduct) and formal rules (constitutions, laws, property rights).' There is also a distinction between the macro-level, which includes the institutional environment and the micro-level which deals with institutions of governance such as contracting and managing transactions.

North also makes a distinction between institutions and organisations. Institutions, as we have seen above are formal and informal constraints on human behaviour and create opportunities in a society and provide an incentive structure. Organisations are structures that are created to take advantage of these opportunities. The interplay between institutions and organisations determines the path of institutional change.

For our purposes here, we need to look at the informal constraints that North spoke of. These include norms, customs, traditions etc. as noted above. These are nothing but forms of social capital which we discussed in the last article. Recall that social capital can appear in various forms, namely: trustworthiness, a source of information in social relations, norms and sanctions. Hence, North had already included social capital in some form in his analysis of institutions, though this may not have been his focus. We can build on this to arrive at the NIE+ framework I have spoken of before.

The inter-play

Before going on, it is important to clarify a few things about social capital and institutions. We have seen above that social capital includes norms and is more a characteristic of the group. We have also seen that North's definition of institutions includes formal and informal constraints. Informal constraints include norms, among other things. Indeed, some of the studies even interpret institutions to be a form of social capital. It is, therefore, necessary to understand that there seems to be an overlap and analysing the two concepts would require a lot of care. If this is not done, empirical and quantitative analysis involving the two variables (social capital and institutions) would become extremely complex and even untenable.

This problem can be solved by simply treating the two variables as distinct, with norms being the bridge connecting the two variables. Norms can be included in the definition of social capital as we have done above. Indeed, this is what Woolcock did in a paper in 1998, where he defined social capital as 'norms' and 'networks'. As Philip Keefer and Stephen Knack note in their paper of 2005, Woolcock's definition corresponds roughly to Uphoff's (1990) distinction between cognitive (corresponding to norms) and structural (corresponding to networks) manifestations of social capital.

Institutions can be interpreted in the manner that we have done above in discussions of New Institutional Economics. Recall that institutions are constraints-both formal and informal-on human behaviour and create the incentive structure for various actors. Institutions reduce uncertainties and unpredictability thereby lowering transaction and information costs.

At this stage, it would be useful to recall the important components of New Institutional Economics and then see how social capital fits into each of these.

Transaction costs: In the neoclassical world, entering into transactions or contracts is costless. Further, enforcing the contract is also cost less. However, in the real world, contracts are not made, executed and enforced without costs. Coase (1937) first pointed to this lacuna in the neoclassical framework and suggested that firms exist to internalise these transactions. Williamson (1975, 1991, 1998) has also looked at such problems and incorporated the ideas of uncertainty, bounded rationality and opportunistic motives ("self-seeking guile" in his words) of decision-makers. He has argued that these ideas are necessary to understand why firms internalise transactions. In other words, why is a hierarchical organisation within a firm better suited to minimising transaction costs relative to the markets (Miller 1992).

Economics of imperfect information: The neoclassical model assumes that there is free information flow across the economy. In other words, 'everyone knows everything'. This assumption doesn't hold in the real world and NIE relaxes this assumption. This branch of NIE had its origins in the insurance industry and focuses on two problems: adverse selection and moral hazard. These correspond to Miller's (1992) concepts of hidden action and hidden information. These problems are basically a result of the asymmetric information witnessed in the market for goods and services and within organisations.

Property Rights: Property rights is closely related to the work on transaction costs and is important in public and social policy analysis. The structure of property rights is crucial for the success of any public policy. Recall that in the neoclassical model, a good had only two dimensions, namely price and quantity. Consequently, the assumption that property rights over a good were unattenuated either by the state or any other agency was implicit. However, this is rarely the case in the real world. The delimitation and enforcement of property rights involves transaction costs. Hence, property rights affect the traditional analysis in political economy in two ways: one, the role of the state becomes important in defining, delineating and enforcing property rights and two, customs, norms, and traditions (North 1990) become important in the respect of these property rights.

Collective action, public goods and common property resource: The issues related to collective action grew out of the problem of supply of public goods initially discussed by Samuelson (1954). The theory of collective action was however developed by Olson (1965) wherein he demonstrated that large groups would have a problem in supplying a collective good because of the free-rider problem. The nature of the collective good being non-excludable, it would be difficult to prevent all members of the group from enjoying the benefit of the good. Further, collective goods are also characterised by jointness in supply. These characteristics of non-excludability and jointness in supply lead to the free-rider problem and lead to a failure to supply the good. The free-rider problem can be overcome if there is cooperation among the various actors. This has been analysed by Axelrod (1984), where he has used game theory to discuss how cooperation can evolve among various players.

Having outlined the four building blocks of NIE, let us see how social capital can be incorporated into this framework.

Social capital and transaction costs: Recall that social capital is basically the resources, real or potential, gained from relationships. These relationships, in turn, facilitate the action of individual actors. Social capital can appear in a number of forms: trustworthiness of the social environment (which means that obligations will be honoured), as a source of information in social relations (lowers information costs) and, as norms and effective sanctions (lowers monitoring and sanctioning costs). In other words, social capital is basically norms (cognitive aspect) and networks (structural aspect). We see immediately that a higher level of social capital in a group means that there are lower costs of contracting and enforcing such contracts. In other words, social capital levels are inversely proportional to transaction costs.

Social capital imperfect information: Social capital can lower information costs in a group and makes it easier for the group to overcome collective action problems. Higher compliance to norms and a larger network means a higher level of social capital. These attributes, in turn, ensure that information costs for the group are lower and information flow is smooth across the group. For example: imagine a fishing community with clear rules on times of fishing, areas of fishing, penalties for overfishing etc. In such a group, greater trust among members and greater compliance to the rules would lower information and monitoring costs for an individual fisherman.

Social capital and property rights: Property rights are closely related to contracts and transaction costs. The stabilised patterns of interaction that Calvert (1995), North (1990) and Libecap (1989) refer to are nothing but the respect that each individual has for the rights of others to own, use and sell specific assets (both tangible and intangible). It is precisely when these rights are not clearly defined and delineated (Barzel 1989), non-existent or defined in such a way that the respect for other's claims is scant, that we say that social capital levels are low. In such situations, robust institutions are needed to overcome such lacunae and the state has an important role in defining, delineating and enforcing property rights. On the other hand, if the social capital levels were higher (in form of norms encouraging compliance and higher trust), the state would still have a role but individuals would be less worried about being exploited, written contracts would be less elaborate and the overall transaction costs would be lower (lesser expenses on bribes and tax lawyers).

Social capital and collective action in supply of public goods/common property resource: We know that a public or collective good being non-excludable and non-rivalrous (one person's consumption does not subtract another person's consumption), it would be difficult to prevent all members of the group from enjoying the benefit of the good. The free-rider problem dominates and leads to a failure on the part of the group (or the government) to supply the good. Olson's ideas have been extended to extensive research in the area of common-pool resources. In particular, Ostrom (1990) and Oakerson (1992) using Olson's theory in conjunction with prisoners' dilemma and Hardin's tragedy of the commons have made a strong case for local institutions overcoming collective action dilemmas in managing common-pool resources such as fisheries, forests and irrigation. The main point of relevance here is that the level of social capital (in the form of trust and norms) is directly proportional to the likelihood of overcoming collective action problems in the supply of public goods and common property resources. Simply put, a higher level of social capital will ensure that the public good or the common property resource (forest, fishery or river water) will be supplied.


The concept of social capital, which may manifest itself in the form of trust, trustworthy behaviour, credible commitment or norms (or simply norms and networks) is important for many public and social policy issues around the world. In conjunction with the NIE framework, we have a powerful tool (which I call the NIE+ framework), which can be used in not only analysing such issues but also finding solutions. The members of a collective or a community or a country are faced with a number of collective action dilemmas with regard to a number of areas that affect every-day lives. Such areas range from global issues such as nuclear weapons control, managing global pandemics, climate change and trade disputes to community-level issues such as garbage disposal, forest conservation and sharing of waters. In these situations, coordination is essential to overcome collective action dilemmas. We are now ready to apply the NIE+ framework to many such public and social policy problems. In the next few articles, we will revisit some of such policy issues and address them with the NIE+ framework.

The writer is an IAS officer, working as Principal Resident Commissioner, Government of West Bengal

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