3 Electronic Market System Framework
3.1 The Institutional View on Electronic Markets
3.1.2 Institutions
3.1.2.1 Classification of Institutions
The importance institutions have in the coordination process can be best understood, when the fundamental economic problem of society is reflected. In his critique Hayek argues that the efficient allocation of resources is not the economic problem, but the communication of dis-persed knowledge about the agents’ characteristics (Hayek 1945). Due to the natural disper-sion of knowledge, coordination of individuals appears to be difficult. Coordination – under-stood as the act of working together harmoniously – requires information about the other agents, either by communicating or by sensing. An efficient coordination requires that the interacting agents quickly economize on information. Economizing on information often means that only few pieces of information (signals) are sufficient to recognize complex pat-tern of information in the behavior of the other agent. This is only possible if those few sig-nals, e.g. an action, follow a predictable recognizable order.
In abstract terms “order means that various elements in a system remain in a recognizable and predictable interrelationship” (Kasper 2002, 35). As an example for order refer to steps of a staircase, which represent the elements of the system staircase. As they are arranged in equal height, they are in an order, which is recognizable and predictable. Essentially, the de-gree of order determines the effectiveness of actions: For instance, walking down a staircase with equally high steps is easier to get down than one with varying step heights (Kasper 2002).
If the signals are in this context interpreted as actions, order refers to a recognizable sequence of actions that is obeyed by all agents. In a specialized economy the effectiveness of actions depend on some order or consistency in the behavior of other agents. For example, a manufac-turer only produces a good, if he can expect money from a consumer for this good. In social life, some order or consistency always must prevail: Without order, i.e. chaos, individual ac-tions are difficult to pursue, as the acac-tions rely on certain predicted behavior of the other agents. When this behavior is chaotic, the effectiveness of individual action tends to be low:
Hayek describes this as follows: “Living as members of society and dependent for the satis-faction of most of our needs on various forms of co-operation with others, we depend for the effective pursuit of our aims clearly on the correspondence of the expectations concerning the actions of others on which our plans are based with that they will really do”(Hayek 1973, 36).
Hence, order becomes manifest in rules of human conduct whose violation usually entails some sort of sanctions, e.g. fines (North 1991a). Those rules of human conduct are defined as institutions. In the words of Douglass North, “Institutions are humanly devised constraints that structure political, economic, and social interaction” (North 1991a, 1). They consist of both informal constraints (sanctions, taboos, customs, traditions, and codes of conduct) and formal rules (constitutions, laws, property rights”), and the enforcement characteristics of both.
If institutions are meaningful, they delimit the set of possible outcomes without making one particular outcome certain to evolve (Kasper 2002). At least institutions confine individual behavior to a specific pattern, which can also reduce transaction costs. For example, the insti-tution can ban opportunistic behavior; transactions intended to aggravate such a behavior are then no longer necessary, which results in lower transaction costs. At the bottom line the qual-ity of institutions are defining the overall transaction costs of an economy.
The range of all possible humanly devised rules is naturally very large. A solid analysis and understanding of institutions is fundamental for grasping the essence of electronic markets.
Institutions can be classified according to two criteria origin of the institution and their en-forcement (see Table 4).
Origin of Institutions
Spontaneous Evolution Planned Design Formal
Institutions Planned Feedback
Example
A professional code of con-duct, which is enforced by an administered authority.
Example
Legal code, which is enforced by authority, e.g. constitution or trading rules as market insti-tution.
Enforcement
Informal Institutions
Spontaneous Feed-back
Examples
Customs, usuances and man-ner, which are enforced by social feedback.
Example
Legal code, which is enforced by spontaneous feedback mechanisms, e.g. electronic markets with reputation mechanisms.
Table 4: Institutional Matrix (cf. North 1987)
The criteria origin of institution raises the question how institution or – in the terminology of Hayek – order can be created (Hayek 1967; Hayek 1973). According to Hayek, there are in general two ways of coordination human behavior. Coordinating human behavior requires the ordering of interdependent action:
• Spontaneous Evolution of institutions
Institutions or order can arise spontaneously. Institutions are formed as a result of a cul-tural-evolutionary process on the basis, which institution can solve best the coordination problem (Foss 1996). Apparently, it is a social process that let institutions evolve. Agents believe that they “ought to keep to” institutions based on their moral beliefs. However, there is no super-ordinate, independent concept that would provide a rational foundation of these beliefs. Rather are those beliefs also result of the same process of evolution as the institutions itself (Hayek 1967; Hayek 1973; Sugden 1989).
Comprising, order arises spontaneously. Those institutions reflect patterns of behavior that are self-sustaining. Evolution means that those patterns guided by the institutions replicate themselves successfully (Elster 1989; Sugden 1989).
• Planned Design of institutions
Institutions or order can also be consciously imposed. A planner or designer can come up with a pattern of behavior and implement it from top down. In most of the times designed institutions are written down. The rationale for this is that those imposed institutions are not endogenous constructs that have evolved other time, but exogenous and must be taught to the agents of a society (Kasper 2002).
Comprising, order can be imposed by a planner or designer. The institutions reflect pat-terns of behavior, the designer deemed to be adequate.
The question arises, what genesis of institutions is more desirable, spontaneity or design? Phi-losopher Sir Karl Popper empirically observed that “only a minority of social institutions are consciously designed while the vast majority have just 'grown' as the undesigned results of human actions” (Popper 1964, 65). As Popper understood conscious design of institutions as the delimitation of freedom, he argued against such a “social engineering”. Nonetheless can the design of institutions result in a decrease in the transaction costs. Electronic markets have emerged because of their ability to reduce transaction costs by the provision of consciously designed institutions. As electronic markets implement institutional rules, they require written rules. Either those written rules are reflecting the institutions that have evolved over time in non-electronic markets or they are consciously designed. As the latter can refurbish traditional institutions and thus reduce transaction costs, they have a greater potential. Furthermore is it doubtful, whether a translation of institutions prevalent in non-electronic markets to electronic markets is possible at all. Consider that all institutional rules are dispersed in the minds of the participating agents; institution descriptions are thus without design impossible. Throughout this book electronic markets pertain to planned or designed institutions.
Institutions are only effective if they are somehow safeguarded. Comparable with the origin of institutions enforcement can be performed either by spontaneous feedback of the society or by planned enforcement. These two forms of enforcement are usually addressed by the dis-tinction into formal and informal institutions.
• Formal institutions
According to North (North 1990) formal institutions are usually written down, e.g. consti-tution. As such, those written rules form the basis for enforcement. All violations or mis-demeanors are enforced by authority according to written – planned – sanctions, which are also part of the formal institution. Authority is not limited to the government but could stand for an arbitrary organization as well.
• Informal institutions
Informal institutions are usually not written or at most partially. The crucial point is that enforcement is not specified in advance. Instead spontaneous feedback of the society
“punishes” the violators.
Electronic markets embody both formal and informal institutions. Electronic markets with inherent formal institutions are those with planned enforcement, i.e. based on written rules.
Electronic markets with inherent informal institutions are – following the abovementioned line of argumentation – also written, however, they differ in terms of the enforcement. Instead of planned enforcement, sanctioning depends on spontaneous feedback by the other agents.
This important issue of enforcement will be discussed in more detail in chapter 3.1.2.3.6.
Combining those two criteria, origin and enforcement, with two dimensions each yields the 2
× 2 matrix depicted in Table 4. Accordingly, electronic markets essentially belong to designed institutions. Note that spontaneous evolving electronic markets are impossible, as they mini-mally need an electronic infrastructure: The mere translation of the “spontaneous developed”
institutions from non-electronic markets into electronic markets is basically a design process.
Changes in the institution can also not evolve without a designed adaptation of the infrastruc-ture. Depending on their enforcement electronic markets can be either formal or informal. In summary, as electronic markets must be designed, institutions – without further explanation – are in the sequel of this book referred to intentionally designed or planned institutions.