Social Capital and Economic Development (Fundamentals of Development Economics)

Social Capital and Economic Development

This immensely readable book by Patrick Francois provides an original insight into the increasingly fashionable topic that is social capital. Social capital is shown to be both caused by and a cause of economic development, and Francois has enlivened the debate on development strategy, explaining why some countries have stalled with low productivity and seemingly low social capital, whereas others are rich in both. In a unique, original book, Francois emphasizes trustworthiness as a vital feature of social capital and argues that standard economic treatments of this phenomenon are inadequate. Social Capital and Economic Development’s richer evolutionary treatment of this is embedded in a neoclassical model. This book will prove to be essential reading for economic development scholars, as well as those interested in development studies and economic thought in general. Also available from Routledge: Social Capital Versus Social Theory by Ben Fine. Patrick Francois is Associate Professor at Tilburg University, The Netherlands.

Fundamentals of Development Economics Edited by Kaushik Basu Cornell University

Volume 1 Institutions, social norms, and economic development Jean-Philippe Platteau Volume 2 Social capital and economic development Patrick Francois

Social Capital and Economic Development

Patrick Francois

London and New York

First published 2002 by Routledge 11 New Fetter Lane, London EC4P 4EE Simultaneously published in the USA and Canada by Routledge 29 West 35th Street, New York, NY 10001 Routledge is an imprint of the Taylor & Francis Group This edition published in the Taylor & Francis e-Library, 2005. “To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.” © 2002 Patrick Francois All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data A catalog record for this book has been requested ISBN 0-203-16661-2 Master e-book ISBN

ISBN 0-203-26136-4 (Adobe eReader Format) ISBN 0-415-27133-9 (Print Edition)

To my teachers: Stella, Pat and Ashok

Contents

List of figures Acknowledgements

ix x

1

Introduction

1

2

Culture and economic development

6

2.1 2.2 2.3 2.4 2.5 2.6 3

New Institutionalists or culturalists 3.1 3.2 3.3 3.4 3.5 3.6 3.7

4

Culture, social capital and the operation of markets 7 Trustworthiness: the cultural variable that matters 9 Does trustworthiness rule out homo economicus? 10 Japan and cultural versus institutional explanations 15 Conclusions 17 Appendix: cultural variation documented 17

What does production look like in LDCs? 22 Industrial networks 25 Neoclassical networks reconsidered 27 Case studies of networks 30 Shared ethnicity and social bonds limit trade 35 A sociological account 37 Summary 39

Accounting for characteristics 4.1 4.2 4.3 4.4

20

Evolutionary models 42 The problem with biological analogies for culture 43 A cultural model of preference transmission 47 Summary 52

42

viii Contents 5

A model of trustworthiness in production 5.1 5.2 5.3 5.4 5.5

6

7

The basic model 54 Steady state 62 Non-technical summary 75 Conclusions 79 Appendix: some proofs 80

The anatomy of development success and failure 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8

54

83

Development and welfare 83 Modeling development 86 The effect of openness on steady states and welfare 88 A failure of development 93 Policy 97 Discussion of simplifying assumptions 103 Non-technical summary 107 Conclusions 111

Conclusions

112

Notes References Index

115 122 129

Figures

5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9

Effect of p on entrepreneur’s profits Effect of p on relative returns to trustworthiness Evolutionary forces for different values of pt Phase diagram for β Phase diagram for pt Steady states Divergence when starting in vicinity of (β B , pB ) Convergence when starting in vicinity of (β A , pA ) Convergence paths in interior Convergence paths to all steady states Effect of trade on profits Effect of openness on returns to trustworthiness Effect of openness on p Downward shift in the p = 0 locus An upward shift to the left in the p = 0 locus New and old steady-state configurations when downward shift in p = 0 locus New and old steady state with upward shift in p = 0 locus A complete dismantling of social capital due to openness Sequential shifts in p = 0

62 64 65 66 67 68 70 70 71 74 87 88 89 90 90 91 92 94 99

Acknowledgements

The theoretical part of this book grew out of earlier work with Jan Zabojnik to whom I owe a large debt of gratitude. I have also benefited greatly from discussions with and comments from Jim Anderson, Sherry Anderson, Jan Boone, Lans Bovenberg, Mukesh Eswaran, Chris Ferrall, Catherine de Fontenay, Joshua Gans, Simon Grant, Rachel McLaughlin, Jim Minifie, Jean-Phillipe Platteau, Andrea Prat, Marisa Ratto, Rodney Roche, Dirk Snelders, Valter Sorana, Harald Uhlig, Dan Usher, and the comments of seminar participants at the Australian National University, Melbourne University, Sydney University, Queen’s University in Ontario, Bocconi University in Milan, Tilburg University in The Netherlands, University College London and the North Eastern Universities Development Conference (2000) held at Cornell. I am also grateful to the series editor, Kaushik Basu, for suggesting the book, and Huw Lloyd-Ellis who encouraged me to work on this topic despite my unfamiliarity with much of the field. I am especially grateful to Siwan Anderson, who read and extensively commented on an earlier version of this manuscript, and who was a critical influence in the development of the ideas contained within. I also talked about this work at length with Ashok Kotwal. As is usual, he provided a number of crucial insights that had an immense impact on the final outcome, though in his typically generous way, seems to have no recollection of having done so. Much of the literature discussed in this book goes beyond standard economic readings and hence beyond my area of expertise. I am aware that stepping outside one’s field increases the chances of misrepresenting previous work, and I hope that I have been diligent enough to avoid this. However, I apologize in advance if I have not, and also for any remaining shortcomings, which are my fault alone.

1

Introduction

This book is about the degree of trust among members of a given society, and its relationship to the process of development. In the standard economic view, trust means that someone will act in a manner consistent with the things he or she promises, but only as long as it is in their pecuniary self-interest. This kind of trust is an inference about situational logic. In the context presented here a more sociological and introspectively plausible notion of trust takes center stage. According to this view, in order to trust someone it is not necessary to know much about their situational logic, but rather to know that they are trustworthy. Trustworthy individuals are not calculating. They are simply individuals who do what they promise to do, because they have promised it. In modern production, when agents are vulnerable to opportunism on the part of their trading partners, such trustworthiness facilitates mutually beneficial economic interaction. The book will forward this trustworthiness as a way of making economic sense of the increasingly popular term “social capital.” There is a great deal of literature, surveyed later, arguing for the importance of social capital in production, and many writers have suggested a central role for it in development. However, there has never been a development framework that allowed explicit analysis (Barret 1997). The lack of an analytic framework has led to the treatment of this characteristic as entirely exogenous and allowed only one direction of causation to be explored – how trustworthiness affects production. The framework developed here allows causation to be explored in the other direction as well – how production affects trustworthiness. Modern industrial production and trustworthiness are shown to be mutually reinforcing and self-sustaining phenomena. Trustworthiness is analytically treated by using techniques drawn from a subbranch of evolutionary economics which is concerned with the evolution of preferences. These tools provide a tractable and simple way of modeling the determination of type. However, they are not without controversy. In particular, evolutionary models in economics are drawn from biology where successful types are those that manage to leave behind the most offspring. This is positively related to the amount of resources that a type can obtain, or their fitness. The natural economic analogy of such biological fitness is payoffs. Preferences that remain present in an evolving population are those that allow their owners to generate payoffs at least as high as with other preferences. However, it has been argued

2

Introduction

that this provides too parsimonious a treatment of the evolution of preferences. Parents, in particular, are the primary socializing agents; therefore, elements other than payoffs (or pecuniary returns) should enter into the selection of preferences, because parents do not just consider payoffs when deciding on the values that they will inculcate to their children. Accordingly, a richer model of preference evolution, allowing for influences in addition to payoffs, will be utilized here. Others have argued that successful modern capitalist production depends on a form of social capital.1 The analysis here shows how the positive social capital embodied in trustworthiness is created by modern capitalist production. The very elements that trustworthiness is said to bring about – mutually beneficial interaction and trade even when there is the possibility of loss to opportunism – themselves provide the means by which such trustworthiness is rewarded and which thus engender it. The need for trustworthiness is relatively clear. For example, suppose that an entrepreneur contemplates upgrading to a modern, more efficient, production technology. This requires a fixed investment by the entrepreneur, but also necessitates the ready supply of an input, of particular quality, for the new production to work. The entrepreneur cannot write an explicit and binding contract with suppliers to deliver quality inputs, because quality is difficult to verify and non-contractible as a result. Given contracting limitations, there are likely to be gains to opportunistic suppliers who take the contract and then cut costs by reducing quality. Consequently, entrepreneurs are unlikely to enter production if they believe everyone is opportunistic. On the other hand, if entrepreneurs believe that the people they deal with are generally trustworthy, they are more prepared to begin the upgrading enterprise. Entrepreneurs are willing to risk losses due to opportunism when social capital is high. How modern production creates trustworthiness is less clear. When a successful producer comes into being it creates benefits to others, both down- and up-stream. Producers cannot price these benefits away when there are information asymmetries or incomplete markets; so success creates positive externalities for others. Since successful entrepreneurs are those who form networks with trading partners of the right type – that is, the trustworthy – the externalities they generate also accrue most extensively to the trustworthy. It is these externalities that provide the evolutionary returns essential to sustaining the economy’s social capital. Thus, evolutionary forces favoring the selection of trustworthiness can only exist if firms create externalities by taking the risks necessary to create modern production. The analytical framework developed here traces the links between these two complementary elements of modern production: the risk taking entrepreneurs, who must endure vulnerability to opportunism; and the trustworthy individuals, who make such entrepreneurship viable. This interaction implies that perfectly capable societies (i.e. those able to sustain modern production and high levels of trustworthiness) can be trapped in situations where neither occurs. The possibility of such a development trap is not new in the presence of complementarities. However, the simplicity of the model used here allows explicit focus on the dynamic

Introduction

3

forces which tend to both erode and support such traps. This dynamic treatment yields a number of surprising results. The first result relates to the supposed advantage of being a follower country (or late developer) relative to the West. It has generally been thought that an advantage of being a late developer is the possibility of leap-frogging technology levels to the frontier. Late developers do not have to reinvent the technologies that are the source of Western productivity, but can simply license their use in production. Even if licensing state-of-the-art technologies is prohibitively expensive, using slightly outmoded Western technologies, which are extremely cheap, still allow great possibilities for advance. However, the fact is that surprisingly few late (postwar) developers have been successful in such technological upgrading, and it is an open question “why.” The rapid growth and productivity booms of the East Asian economies are notable exceptions, but the puzzle is why they are the exception and not the rule. Short of conspiratorial postcolonial or marxist explanations, neoclassical economists are stumped by the modern world’s large and persistent cross-country productivity differences (see, e.g. Prescott 1998). The framework here explains why the chance to directly implement large productivity improvements appears attractive, but may actually lead to extremely damaging outcomes – both in terms of a society’s productivity and in terms of its social capital (or trustworthiness). Problems arise when modern technologies which, despite their benefits in terms of productivity, require too much vulnerability on the part of risk-taking producers. Habits are persistent, and preferences cannot be adjusted overnight. When a new more productive technology is implemented, it contains the seeds for growing more trustworthiness with it, but at the start, and for a time, trustworthiness levels remain more or less where they were. The more the new technology differs from the old, the greater the disparity between the currently existing level of social capital and the level needed for the new technology. If this difference is too great, the new technology will not be viable, entrepreneurs that introduce it will fold, and fewer entrepreneurs will risk modern production. Since evolutionary returns to trustworthiness require the externalities generated by successful entrepreneurs, this failure of entrepreneurs threatens the society’s social capital. If too many entrepreneurs pack up, evolutionary incentives start to favor opportunism: not only does the new, more productive technology fail, but also, any existing level of trustworthiness in the population is gradually eroded away by the collapse of entrepreneurial ventures. The failure induced by an attempted large change thus arises because of a mismatch between the society’s initial level of social capital and the social capital requirements of the technology. The view developed here is that the essential difference between late developers, and the early developers of Western Europe and the United States is that the latter experienced much more gradual change in the productivity of the underlying technology. This is because the technology itself had to be developed, implemented and diffused from a primitive level. The process of upgrading technology was gradual. This forced a gradualization of the changes and allowed social capital levels time to adjust. The dramatic mismatch between existing levels of social capital and the

4

Introduction

state-of-the-art technology could never arise, because the technology was designed to be used in the very social situations to which it was applied. This, of course, is not the case in developing economies today. Quite apart from the large differences in the institutions of law, contract and enforcement, cultural differences in business practices are enormous. Successful production networks in less developed countries (LDCs) tend to rely heavily on bonds of kinship and familiarity within relatively small groups, in order to overcome vulnerability to opportunism. Advanced industrial production today is simply too complex for this to work. It requires the inputs of too many specialized traders, services and components to be undertaken within such small groups. Trust between largely anonymous trading partners plays a critical role. The New Institutionalist strand of development economics has focused on more formal elements relating directly to incentive compatibility, in explaining productivity differences across countries. This book, in contrast, focuses on cultural differences, and in particular, trustworthiness levels and the degree to which these support business practices. There is value in both perspectives; each gives rise to different insights and different policy implications. The New Institutionalist approach emphasizes improvements at the institutional level, notably improved enforcement of property rights. By contrast, the approach taken in this book de-emphasizes that factor and instead privileges the role of trustworthiness in business interaction. This approach is strongly consistent with the lessons from case studies in the business literature. These case studies show that, while formal enforcement plays an important role in mitigating risk (as evidenced by the prominence of lawyers in modern corporations) the law on its own does not sustain successful relationships. If the law has to be evoked, the relationship is effectively over. The business studies literature thus emphasizes, even at the corporate level, the ability to trust the good intentions of one’s trading partners. It is the breadth of this locus of trust that restricts the amount of vulnerability entrepreneurs are willing to bear. A narrow focus, limited to family and friends, is unlikely to provide the confidence required to sustain the myriad interactions that mark modern production. A conclusion then, is that even if all elements of law and its enforcement could be transplanted, together with the new technology, it would fail without the ability to broadly trust. This leads to a number of policy conclusions. The analysis here suggests that technically advanced means of production can erode a society’s social capital. Policy makers should recognize that temporary support of elements that sustain social capital can be valuable. In particular, entrepreneurs are in danger of being excessively exposed to vulnerability. Limiting that, by temporary subsidy or support can help. Policies such as infant industry protection can play an important role. A second, and more challenging policy consideration appreciates that trustworthiness can be directly encouraged, and as it creates externalities, policy should seek to support it. The third, and another potentially beneficial policy is to gradualize change, although it comes at the cost of immediate improvement. By introducing

Introduction

5

smaller incremental improvements in a timed sequence, it is possible to engineer changes that give social capital time to catch up. Like all social explanation, this is not a hard and fast rule. The complexity of any society, and any system of changes, will frustrate attempts to use one causal factor or one model to predict outcomes. In particular, the book excludes important elements that have traditionally been the focus of much attention, for instance those relating to incentive compatibility. This book seeks to provide a glimpse of the forces that are possibly (and, I will argue probably) active when changes are implemented. Whether these end up being part of a package of changes that herald successful development, or whether they are swamped by other forces that do not even feature here, is an empirical matter not resolved here. The book proceeds as follows. Chapter 2 defines the term trustworthiness, argues that it is the cultural variable of most interest for economic phenomena, and that there is a substantive distinction between the sociological and the economic views of it. Chapter 3 then argues why trustworthiness might matter for production, especially in LDCs. This reviews the literature relating to production which argues that modern, high productivity production does not occur without trading partners who are trustworthy. A number of previous authors have examined the concept of trustworthiness (using different terminology). It has been identified as essential to a much larger phenomenon – the rise of the West – but I will not go that far here. This chapter simply establishes that such trustworthiness seems to play a vital facilitating role in modern production. The task of Chapter 4 is to establish a tool for analyzing individual preference formation which is the source of trustworthiness. An argument for why standard evolutionary models are not suitable for the present analysis is made there. The model that is favored is based on recent work by Bisin and Verdier (2001). Chapter 5 shows that using such a tool of individual preference formation provides new insights into the process of development. This is the technically formal part of the book which establishes, in a simple way, relatively weak sufficient conditions that generate analysis of the complementary interaction between trustworthiness and modern production. This draws heavily on an earlier model jointly developed with Jan Zabojnik.2 Chapter 6 develops the results relating to disadvantages of late development, elaborated above, and policy implications. These implications provide a new interpretation of policies currently being implemented. Chapters 5 and 6 conclude with nontechnical summaries of their technical parts to aid noneconomists. A concluding discussion, suggesting broader applications, is provided in Chapter 7.

2

Culture and economic development

Sociologists have long emphasized the role played by culture in facilitating economic interaction and recently economists and historians have joined in. Many are vague about the precise element of culture that matters, but pronouncements for culture as a key to development (and even the key, as suggested by Landes 2000) are now increasingly common. Attempts at formalization and measurement have been made. Although difficult to precisely define, the term social capital has been forwarded as a catch-all phrase to encompass the economically relevant aspects of culture. Generally, the notion is of a societal stock of goodwill that helps cooperation emerge in situations where individual and collective goals are not perfectly aligned. Measures of this stock have been attempted through, for example, survey responses, or membership in voluntary organizations, and its economy wide variation used as an explanatory factor in cross-country growth differences. However, the exact role played by such factors is usually not precisely spelled out. In this chapter it will be argued that the economically relevant gist of terms such as culture and social capital is trustworthiness. By trustworthiness is meant the degree to which others can be relied upon to perform promised actions that may or may not be in their own pecuniary interest. Trustworthiness seems to be an inference about a person’s inherent type or personality disposition, rather than their circumstances. But this is not typically the view that economists take. Observed systematic variation in supposedly trustworthy behavior is usually thought to reflect variations in incentives and enforcement rather than variations in type. Sociologists and economists generally fall into separate camps on whether behavioral differences are mostly due to type differences (sociologists) or incentive differences (economists). The position taken on this matters for the analysis of economic development. If incentives are what matters, then economic development requires getting incentives right, suggesting a standard set of policy prescriptions. In short, these are: that prices should be free to vary; that governments should not intervene except where externalities lead to prices unreflective of social values; and that governments should provide public infrastructure and the institutions necessary for the functioning of markets – laws, courts and enforcement. However, if types are what matter for development, then development requires nurturing the right sort of types. This may or may not require getting incentives

Culture and economic development

7

right and can, as will be argued later, argue for distortions that help the right ones survive. As already indicated, the type that will take center stage here are the trustworthy. These are people with a behavioral disposition towards acting in accord with previous promises. Formally, there is nothing about neoclassical analysis that precludes such a disposition from the analysis, but the typical disposition of homo economicus is opportunistic. “Explaining” behavior, according to an economist, is not about identifying individual level personality aspects that make sense of actions, but instead identifying differences in incentives, for a somewhat universal person type, that would make sense of actions. The role of the present chapter is to further delimit these two different views of the individual – the one representative of economists (sometimes called rationalist) and the other of sociologists (sometimes called culturalist). In some ways this is a false dichotomy, neither discipline is necessarily dogmatically attached to a single view of the individual. Some have argued that the New Institutionalist research paradigm within economics is an attempt to encompass views similar to the ones I characterize as sociological. Notwithstanding these research efforts, I will argue that a significant difference in views does persist. Once these views are delimited, it is then necessary to decide which is the correct one to use. Though it may appear so, this is not a discussion about which view of individuals is correct in terms of realism. Personality dispositions differ, so the economist’s view of a single, largely opportunistic, type is a nonstarter. However, treating people as similar in their personality dispositions may be a good enough operating assumption to explain economic phenomena. It will be argued here that this depends on what is being explained. For explanation of development and underdevelopment, the answer is not clear. Some empirical examples are then considered.

2.1

Culture, social capital and the operation of markets

The recent resurrection of interest in culture’s effect on the working of markets is reminiscent of earlier contributions. Both Marx (1971) and Weber (1905) argued that the effective functioning of capitalism required particular characteristics of market participants. Marx emphasized acquisitiveness, individualism and a desire to trade leisure for income. Marx’s emphasis on culture was minor in comparison with Weber’s protestant work ethic which became perhaps the most celebrated culturalist theory of development. He argued the Calvinist belief in “predestination” elevated material progress, not as an end in itself, but as a sign of virtue and indication of reward in the after life. Instead of encouraging fatalism, he argued that this acted as a motivating force for proper thoughts and behavior. Goodness became a plausible sign that one had been chosen. According to his analysis, this underlay the rise of modern capitalism in Germany. A similar “Confucian work ethic,” though based on different beliefs, has been posited to explain postwar South East Asian development (Khan 1979; Berger 1987; Berger and Hsiao 1988; Tai 1989; Redding 1990).3

8

Culture and economic development

In postwar development economics an early body of literature did give culture a prominent role, see for example, Hoselitz (1952). As the title of one of the prominent journals in development economics suggests – Economic Development and Cultural Change – which also started in the 1950s, this was seen as a fruitful area of development research. Such explanations fell out of favor amongst economists in the 1960s because protagonists had a tendency to promote a nonrationalist view of participants in LDCs. Schultz (1964) in particular was highly influential in arguing that the same precepts of rationality and acquisitiveness attributed to actors in industrialized countries should be accorded to those in LDCs. This view remains pervasive amongst economists today. The current resurgence of interest in cultural factors and development, which will be considered further in this chapter and the next, has touched on neither rationality nor acquisitiveness. Instead the recent rebirth of culture as a serious topic to study has focused on factors that limit acquisitiveness in order to sustain market interaction. Some prominent examples are: Putnam (1993), who studied the role of social capital in comparing the south of Italy with its north. A measure of such social capital was posited by him to be the number of voluntary civic institutions. He found these to be greater in the North and argued that social capital illustrated the dramatic income differences in the two regions. Recently, Putnam (2000) has applied the same notion of social capital as measured by voluntary organizations to the United States, and argues it is experiencing a precipitous decline. Harrison (1992), in comparing the successful case of Japanese development with poorer performing LDCs, has highlighted the extensive “radius of trust” that characterizes Japanese society. He argues the existence of such a broad group of individuals, to whom some obligation is owed, supported the extensive network of subcontracting relationships so characteristic of modern Japanese production. Platteau (1994a,b; 2000) has argued for the importance of a “generalized morality” in allowing trade to occur in situations where formal sanctioning is not present. He contends that without the presence of such a generalized morality, trade is restricted to occurring within localized communities and groups, limiting the gains from scale and specialization in modern production. This contrasts with the “amoral familism” that Banfield (1958) argues pervaded the case study he conducted in the southern Italian town of “Montegrano.”4 This amoral familism involved neither trusting nor acting in a trustworthy manner towards anyone other than a direct kin member. His study depicts the destructive role played by this attitude; Basu (2000) has focused on the role of a “rationality limiting norm,” which, by ruling out some forms of opportunistic behavior, allows players to receive higher payoffs in prisoner’s dilemma type games.5 A final example is Seligman (1997) who has resurrected Durkheim’s (1933) notion of “generalized reciprocity” and argued its central role in modern, role differentiated societies. This is in contrast with pre-modern societies where the stability and uniqueness of roles allowed adequate functioning with only immediate reciprocity.6 Though differing in details, the notion behind the terms “social capital,” “generalized morality,” “locus of trust,” “rationality limiting norms” and “generalized

Culture and economic development

9

reciprocity,” is that for markets to function effectively, and for capitalist economic development to occur, the pursuit of self-interest must somehow be restrained. As a cultural explanation of underdevelopment, these authors emphasize a form of benevolence as lacking and thus thwarting beneficial economic interaction. This is almost the converse of the pre-1960s cultural view arguing that apathy was prevalent and thus undermined desire for economic interaction. In accordance with this contemporary renewal of interest, an empirical literature attempting formal measurement of these concepts at the country or community level, has taken root. The question of measurement is not of central relevance here, but a discussion of these is in the appendix to this chapter. Other-regarding behavior has received some attention in formal neoclassical analysis. A large part of the New Institutional economics has been concerned with explaining such a phenomenon. I will argue in this chapter that though valuable, this neoclassical attempt to bring into consideration richer behavior has not done full justice to the culturalist concepts. This requires a more radical departure from the neoclassical view of the individual than that embodied in the New Institutionalists approach. Before proceeding to consider that, it is necessary to further narrow down the cultural terms above. It will be argued that trustworthiness sufficiently captures the economic importance of these terms.

2.2

Trustworthiness: the cultural variable that matters

An intuitive and representative definition of the term culture is provided by Harris. Cultures are patterns of behavior, thought and feeling that are acquired or influenced through learning and that are characteristics of groups of people rather than individuals. (Harris 1971, p. 136) Such a definition is broad. Narrowing the focus to situations requiring joint action orients it towards the social sciences. Social capital, as defined by Fukuyama (2000) as “an instantiated set of informal values or norms shared among members of a group that permits them to cooperate with one another” is helpful. However, one still wonders which values or norms, precisely constitute social capital and why they matter for production. A common feature to all positive definitions of social capital is an element of regard for others. It is valuable when relationships cannot be fully circumscribed by contract but when trade would be, nonetheless, beneficial. When individuals are confident that trading partners will not exploit noncontracted contingencies to their detriment, they are willing to trade even when the division of benefits is ill-defined. It remains to establish the importance of such ill-defined trading opportunities for the process of development (the role of the next chapter), but I would contend that this captures social capital in economic contexts. Such individuals who refrain from seizing opportunities which, though personally beneficial, are to the detriment of their partners are “trustworthy.”

10 Culture and economic development Additional features of trustworthiness have been highlighted. Lyons and Mehta (1997) note the risk taking, or vulnerability, that must accompany it. A definition of trusting behavior has to include the possibility of behavioral risk, that is, both parties know that the actions of one party can materially affect the other. Given the existence of behavioral risk, trustworthiness is defined as the attribute of a party who would choose to refrain from opportunism, and trusting is the behavior of an exposed party who believes the other trustworthy. (Lyons and Mehta 1997, p. 241) Note particularly that trustworthiness is an attribute, suggesting it resides permanently in an individual, whereas trusting is a behavior and thus more akin to an individual’s choice. People with this attribute behave consistently with their promises, even in the absence of external enforcement, and a verbal statement of promise is not even necessary. Trustworthy individuals are believed to refrain from opportunism even when no such verbal, or even conscious, promise has been obtained. Such trustworthiness will be what is meant by social capital as I use it here.7 Trusting, on the other hand, as defined by Lyons and Mehta (1997) does not constitute the economy’s social capital, but is rather a reflection of it. Trusting in the presence of trustworthy individuals is nothing other than rationality, and could be equally well performed by a complete opportunist.8 The New Institutional economics research paradigm argues the same is true for trustworthiness. That is, that acting in a trustworthy way does not represent a real departure from the view of opportunistic individuals. Even though contracts are not sufficiently well specified to ensure compliance in all contingencies, rational individuals motivated entirely by their own pecuniary benefit, may still refrain from opportunism. The next section considers that position.

2.3

Does trustworthiness rule out homo economicus?

Dasgupta (1988) provides a standard economic treatment of trustworthiness in the New Insitutionalist vein. Individuals behave in ways that may entail immediate short-term losses, and can therefore be trusted, if the deferred benefits of such behavior are large enough to offset its costs.9 According to Dasgupta, and most economists, there is nothing intrinsic about trustworthiness, it is merely situational. All individuals are calculating. If they calculate a benefit to honoring their commitments, they will do so. If the institutions that make honoring commitments worthwhile, like contracts, laws, police and courts, are present then people can be trusted. They may still be trusted if informal mechanisms based on group level punishments and information sharing are sufficiently well established. Trustworthiness in such a setting simply corresponds to incentive compatibility of the explicit (or implicit) contract between the interacting parties. For contracts or explicit agreements this is straightforward. The agreements specify punishments under contract that make compliance worthwhile. For implicit agreements, such

Culture and economic development

11

considerations can be formally modeled as a variant of the infinitely repeated prisoner’s dilemma game.10 In the game two individuals choose between either cooperating or cheating. Joint payoffs are maximized by joint cooperation, but cheating yields the cheater higher individual payoff at the cost of a proportionately greater loss to their partner. How is an individual then induced not to cheat? By the simple knowledge that such cheating, though of short-term benefit, will lead to cheating on the part of their partner (or partners) in future, or perhaps a disinclination to trade altogether. Cheating, thus, triggers actions by future trading partners that are costly to the cheater. If the costs are high enough, cheating is no longer attractive; selfish individuals, absent any regard for others, play the cooperative strategy. So, according to some definitions, such people are trustworthy.11 As the New Institutionalists have shown, standard tools, and in particular, standard conceptions of the individuals who are calculating and opportunistic can be used to explain such behavior. The basic difference in this New Institutionalist conception of the individual and that used here is also well described by Williamson (1993). Williamson distinguishes between calculativeness and trust. Economists, he argues, treat trust as a type of calculativeness. I know I can trust someone to fulfill their part of a contract if I perceive that the terms of our interaction, be they formal (as laid out in the contract) or informal (as inferred by the other party to be their likely punishment) ensure that compliance is in the other party’s self-interest. Trust, in the sociological tradition being forwarded here is instead a belief in the other party’s personality disposition. They will perform their obligation not because of a weighing up of costs and benefits, but because it is in their nature to do so. According to some, this distinction almost defines the difference in world views between sociologists and economists. Sabel (1993, p.155) argues this split between sociological and economic views grew out of Durkheim’s argument that the conditionalities inherent to trade, made iron-clad contracting impossible. A sense of mutual dependence and obligation between trading partners was needed. The culturalist, or sociological tradition, focused on norms of fairness and morality and the role of social networks in informing these. Sociologists see individuals as embedded in their cultural surrounds (groups and social networks) and to some degree constructed by those surrounds. The economist’s tradition, as recently reflected in New Institutionalists, similarly focused on fulfillment of duties; not as dictated by a norm, but to ensure one’s own well-being. Individuals follow norms of behavior, but only where these pass the test of individual rationality.12 New Institutionalists similarly evoke groups and social networks, but as a means of ensuring compliance (usually by punishing deviators from the norm) and not as means of inculcating values.13 According to Seligman (1997, p. 4) the culturalist emphasis on the pre-contractual instead of the calculative elements that give rise to order, renders them the opposite of methodological individualists. Culturalists believe that the whole is more than the sum of its parts. Whereas, economists view trust as emerging from the repetitive elements of interactions, culturalists

12 Culture and economic development view it as arising from something external to the interaction. Trustworthy behavior is part of the individual’s constitution. According to this view, some actions are simply not realistic choices. An example is what Taylor (1989) calls strong evaluations. Whereas, economists view all choices as similar in as much as these are not ends in themselves but instruments towards ends. Taylor argues for a fundamental difference between something like choosing to eat a banana instead of an orange, and choices over actions which constitute a central part of someone’s identity. For a “moral decider” these choices constitute his or her own self-conception and some choices that are physically possible are ruled out.14 Seligman summarizes: Strong evaluations are such strong self-reinforcing mechanisms because the very identity of the social actor is tied to them. This too is why familiarity, based on kinship or shared circumstances or shared religious beliefs, is such a strong provider of associational life: because the collective good that is posited as of equal (or sometimes greater) worth than the individual’s interests is not seen as an external preference (and so given to rational calculations), but as a constitutive part of the self. (Seligman 1997, p. 79)

2.3.1

Is trustworthiness a tautology?

The culturalist view seems almost mechanistic, and to deny individual agency: people act in a trustworthy manner because they are simply constituted to do so. But Granovetter (1985) argues against this. He calls this mechanistic reading, which he attributes to much of sociology, oversocialized. The oversocialized view is indeed tautological. He contrasts this with what he terms the undersocialized view of neoclassical economics which disallows any impact of social structure on individual behavior. To the economist’s undersocialized view, the institutions that emerge to solve problems of mistrust do not produce trustworthy individuals, but are a substitute for them. Granovetter criticizes this view for excluding the role of non-pecuniary components of individual satisfaction in supporting trustworthiness. In particular, New Institutionalists do not allow for the extent to which concrete personal relations and the obligations inherent in them discourage malfeasance. To him, these obligations cannot be understood solely in terms of the discounted lifetime pecuniary value of the relationship, as a neoclassical analysis would. They are, according to his view, inherent to the individual.15 But how does this not simply lead to the tautology of oversocialized views? His answer is to posit a more dynamic analysis. Both under and oversocialized views are essentially static and deterministic. Analyses should: make it clear that culture is not a once and for all influence but an ongoing process, continuously constructed and reconstructed during interaction. It not

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13

only shapes its members but also is shaped by them, in part for their own strategic reasons. (Granovetter 1985, p. 57) If the effective functioning of markets requires individuals constituted in just the right way, then it is also possible that the effective functioning of markets is precisely the sort of encouragement individuals need to be constituted in that way. Platteau (2000, ch. 8) maintains that David Hume was persuaded this would occur. But, more recently, both Elias (1938) and Foucault (1966) argued a “correct” individual type was necessary for the effective functioning of markets. They contend that a process of cultural conditioning and individual level change preceded the emergence of the market and was in turn reinforced by it. Similarly, Parsons and Smelser (1956) argued that certain normative patterns of fairness were important for sustaining market interaction. Healthily, functioning markets then recreated these normative patterns through their own successful functioning. In a slightly different context, Gouldsblom et al. (1996) claim that democratization increases the level of mutual identification. It creates civilizing processes, in Elias’s (1938) terminology. These tip the balance from external constraints (Fremdzwange, constraints by other people) towards self-constraints (Selbstzwange). The development of markets both require and lead to changes in the nature of individuals. So, there are clearly two different and, conceptually at least, plausible views. On the one hand, economists, though perhaps personally believing that individuals are not fully autonomous, think that a reasonable approximation to the individual is to treat him or her as self-regarding, opportunistic and impervious to influence. It is still possible to generate actions which are other-regarding, and which correspond to what many have argued is an important component of social capital, trustworthiness. That is, it is possible to provide an account of social capital without necessitating a radical departure from the economist’s standard conception of the individual. But this will be done by using the notion of incentive compatibility within the context of homo economicus, as exemplified by the New Institutionalists. On the other hand, the sociological view sees the individual as constructed, and argues that this construction cannot be ignored. Although a naive argument along these lines seems to deny all human agency, this is taking it too far. The sociological view, instead, argues that there are some (perhaps lucrative) choices which an individual does not feel free to make; that these limitations are socially constructed; and that, taking Granovetter’s position, these constructions are dynamic and should be included as part of “explaining” social phenomena.16 2.3.2

The real source of dispute

The argument between these views is not over whether individuals are truly selfish and entirely impervious to social influence, that is, whether homo economicus is a good description of real people. Most neoclassical economists

14 Culture and economic development would concede that personalities are not fully exogenous, and that individuals are subject to such influence and internal constraints. Preferences are treated as primitives in economic models, but fully autonomous beings are not really supposed to exist. The argument is over whether such influences can be reasonably left in the background when providing explanations of social phenomena. Can the social wholes which economists seek to explain be understood as the outcome of the actions of individuals who are rational and not subject to internal constraint, or do the external constraints play a central role in theories of social phenomena? Thus, the debate is not over how individuals are really constituted, but instead over what elements of that constitution can be safely omitted in providing explanations. The success of the neoclassical methodology attests to the view that omitting cultural influences on the individual is an adequate abstraction in explaining many economic phenomena. Consider, for instance, an example where rationality has done poorly in providing explanation. Modeling the determination of prices on most equity exchanges has been surprisingly difficult to do with models in which all traders are rational.17 In particular, such models do poorly at predicting price volatility in the absence of information changes. However, few researchers have imagined that better explanations of stock prices would be provided by including a richer model of the individual that includes the individual’s constructed social influences; for example, to include a role for social capital, or for traders who are inherently trustworthy. This is not to debate whether equity traders exhibit these social virtues or not, but instead simply argues that, for the phenomena at hand, these elements of cultural construction are not that important. More successful models have posited traders with pressing constraints that force them to trade, or traders with only limited reasoning ability who follow simple trading strategies. But none of these theories have considered why it is that traders might be constituted like this, because such considerations do not help in explaining the events of interest. Whether the sociological view, which I am arguing represents a radical departure from the usual economist’s conception of the individual, is useful (as opposed to more realistic, which it clearly is) depends on what is being explained. The phenomenon of interest here is economic underdevelopment. In particular, why it is that the process of industrialization and the transformation of economies from the use of less productive or traditional technologies to modern ones occurs very slowly, or, in some places not at all. In deciding which view should be employed, it is natural to start with accounts of development or underdevelopment instances. However, this is complicated since, even when researchers agree over the incidents to be explained, sociological and economic interpretations can be provided for the same set of facts. An example is perhaps the most highly investigated contemporary development success story, that of Japan. The next section illustrates the difficulty in distinguishing between these two different theoretical perspectives for the case of post-World War II Japan.

Culture and economic development

2.4

15

Japan and cultural versus institutional explanations

A large amount of literature has analyzed postwar Japanese economic development. Many of the facts are indisputable: Japan has had more rapid economic development than any other country in the world over the last 125 years; it is amongst the most equitable of all advanced countries and has a high degree of social harmony; politically, a democratic system which was imposed by the United States after World War II is now strongly rooted and the Japanese are generally successful immigrants in all recipient countries. Many have documented the cultural specificities of the Japanese that could explain their rapid success in development.18 Harrison (1992) traces Japanese success to a sense of perceived backwardness at the end of the Tokugawa regime leading to an expression of national commitment to progress. Evidence of their cultural “specialness” comes from the great abundance of informal social organizations, even before the postwar growth spurt. Embree (1939) for example, documented an abundance of organizations, based on like age group, credit mobilization, women’s socializing, the practise of Buddhism, archery, flower arranging, music, horse riding and so on, at the community level. Explanations for this have been forwarded in the process of Japanese socialization which is posited to involve a style of child-rearing that de-emphasizes the individual and instead highlights the network of obligations and responsibilities as a member of family and community. This, it is argued, leads to a communitarian attitude to work and decision making.19 Further, the Japanese radius of identification and trust is argued to extend far beyond the family, and ranks very highly in most cross-cultural survey studies.20 Moreover, the Japanese attitudes to work have been argued to be driven by a future-oriented Confucian ethos, where hard work is intrinsically good and rewarded, education is the principal way of assuring progress, and moderation and frugality lead to harmony, security and progress. The economic benefits of such positive cultural dispositions in a world where relationships are difficult to fully define by contract, as for instance suggested by Sabel (1993), are obvious. He argues that good faith bargaining and commitment to common goals played a central role in the successful development of the Japanese subcontracting system. A similar argument has been made by many authors, and I will not rehearse it here. The basic point is that a general belief in the trustworthiness of others allowed Japanese to form relationships that, initially at least, required vulnerability. Such beliefs lowered transaction costs as traders did not have to ensure protection through contract or extralegal means, and allowed cooperative ventures to take root. Lewis et al. (1996), in contrast develop an economist’s more typical view that emphasizes institutional features. Though not contradicting the importance of learning and thrift, they argue that these qualities are driven by the incentives created in the Japanese system. The merit of the Japanese subcontracting system lies in the strong sense of mutual obligation it engenders in both sets of participating firms: purchasing companies expect the prompt delivery of quality produce,

16 Culture and economic development while the subcontracted party expects a committed relationship from its buyer that allows it to plan for the future with security.21 They do not dispute that this sense of commitment in Japanese firms results in efficiency gains, but they do dispute its origins in the underlying culture. They argue that Japan’s success in upgrading productivity throughout the postwar period rests on management, employment and organization practices within the average Japanese manufacturing company, and on its links with competitors, suppliers and governments. These features, they argue, are not cultural. For example, they contend that Japanese employment practices, such as the guarantee of lifetime security, were introduced to attract and keep valuable workers from a small pool of skilled labor, and were thus a competitive response to scarcity. In return, management received reciprocal compromises from labor. Such stable employment conditions in return for corporate loyalty were not an inheritance from the Tokugawa household society, but were gradually implemented in a limited number of large-scale companies (which, at its height, still only covered about a quarter of the workforce). A series of sometimes bitter and class inspired conflicts had to be resolved and this required continual adjustment and modification before the final Japanese employment system emerged. Such gradual development of the system through trial, error and adjustment contradicts the culturalist hypothesis which maintains that Japanese work harder than Westerners for inherent reasons. Though the assertion of harder work is not disputed (given the lower absentee rates, longer hours and fewer industrial disputes) they argue this is not out of a deep sense of commitment, but instead because of things like: the need for promotion; making ends meet; and altogether much more mundane, individualistic motives.22 The fact that commitment in Japanese firms is greatest in the large ones and the ones who also provide lifetime employment, argues for this commitment arising due to economic reasons. It is not due to culture but as part of an implicit contract between these firms and their workers. With respect to another feted Japanese characteristic: the system of interconnected firms densely linked by subcontracting and cross-ownership relations, they again do not dispute the basic facts. Clearly a large role was played by networks of business alliances. Before World War II, individual companies expanded to internalize missing factor inputs, they could not draw on a pool of well-trained adaptable labor and could not rely on market mechanisms for purchasing and marketing. Capital was scarce and hard to obtain, and production systems were often rudimentary, and heavily dependent on foreign technology and knowledge transfer. The zaibatsu, or business groups, were a reaction to this, supplying the financial, supply and marketing contacts essential to the development of enterprises in steel, shipbuilding and chemicals when market contacts and infrastructure were underdeveloped. Though formally disbanded after World War II, the logic of their success lead to the same groups re-forming. They implemented further managerial changes which then strengthened the industrial system of beneficial cooperative alliances, included employee support, and support of banks and business allies, and by engaging in a high degree of mutual shareholding, allowed firms to avoid interference from outsiders while at the same

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17

time allowing risk diversification. This lead to the emergence of the six major business alliances: Mitsubishi, Mitsui, Sumitomo, Daiichi Kangin, Fuji and Sanwa. Lewis et al. (1996) conclude that a cultural inclination to collective action is not needed to explain this system. It was implemented because it worked. It was mutually beneficial for the players involved, and as such it corresponds to a system of incentive compatible implicit contracts. They argue that the successful Japanese system can therefore be explained in fully rational economic and historical terms, without any need to posit an exogenously special culture to explain it. What the example of Japan shows is that macro level accounts are too vague to help in pinning down the differences in the two approaches since these will generally admit multiple interpretations. Without any dispute over the facts of Japanese development, a reading consistent with a sociological explanation emphasizing uniquely Japanese cultural elements, exists side by side with a thoroughly neoclassical explanation that makes no mention of these. This does not help in informing a decision on whether neoclassical analysis needs to include a richer view of the individual. To have any hope of distinguishing between the two approaches it is necessary to consider more narrowly defined phenomena, which is the task of the next chapter.

2.5

Conclusions

It has been argued here that social capital can be thought of as trustworthiness. Two views of this trustworthiness have been articulated. The sociologist’s or culturalist view sees it as an inherent personality type. The economist’s usual view sees it as a feature of situations in which individuals act. It has been argued here that these views are distinct and require methodological choices. In particular, there is fundamental disagreement over whether individuals can be understood as opportunistic or as whether a richer view of the individual, as someone who is limited, moral and perhaps inherently trustworthy is more appropriate. Macro level accounts of development phenomena will not help in deciding which view is most appropriate. The next chapter considers micro level studies of production in LDCs. The aim is determining whether cultural elements need to be included, or whether adequate explanations of economic interaction can be provided by a situational account which abstracts from individual level variation in inherent dispositions.

2.6

Appendix: cultural variation documented

Cross-country variations in social capital should be reflected in culture differences according to the definition of social capital used here. Anecdotal and micro level accounts are important for developing a full picture. But these will not be persuasive if there is no hope of observing culture or social capital in less impressionistic ways as well.

18 Culture and economic development The largest volume of work trying to find formal measurement has been that dealing with cross-cultural comparisons based on individual attitude surveys. This work was pioneered by Hofstede (1980) who initially compiled these cross-country comparisons from surveys administered to employees of a large multinational company.23 By using individuals with similar occupations, education and income, an attempt was made to control for as many of the noncultural differences as possible. His, and many subsequent studies, have found four consistent and coherent dimensions of cultural variation which can be used to locate differing cultures, these are: uncertainty avoidance, power distance, masculinity and individualism/collectivism. Few economists have worked with such variables, but Pi (1996) has used these cultural variables as explanatory factors in cross-country growth accounting exercises. Knack and Keefer (1997) and Temple and Johnson (1998) have performed similar growth accounting exercises for aggregate cultural variables that are also constituted from surveys.24 Relatedly, the increasingly popular social capital concept has motivated efforts at measurement. Putnam (1993) measured social capital by using information on groups and group membership as well as measures of political participation. In a development context, Narayan and Pritchett (1999) and Maluccio et al. (2000) construct indexes of group membership and numbers of organizations, and use these as explanatory variables to explain household welfare. Economists have traditionally been sceptical of opinion-based surveys, (such as the General Social Survey for the United States, or the World Values Survey), but with careful enough controls for the usual economic variables, there is no reason why surveys aiming to illicit cultural characteristics should not be admissible.25 Moreover, the large number of Hofstede type corroborating studies finding broadly similar response patterns by age group or country suggest that they are probably not just picking up noise. Even a sceptic would cautiously conclude that there are, at least, cross-country differences in patterns of answering survey questions relating to features like trust in others, or trustworthiness. On the matter of whether such differences in answers actually correlate to differences in behavior, there is much less evidence. Behavioral evidence taken from games is now being brought to bear on this question. By adopting the methodology of experimental design in psychology, economists have explored the correlation between answers to these cultural questions and behavior in games that attempt to elicit trust and trustworthiness (Glaeser et al. 2000). Encouragingly, the findings of early studies support such a correlation, though not always in the most direct manner. Additionally, improved data sources regarding observables, such as that used in Ichino and Maggi (2000), that control for much of the noncultural variation, and extensive use of measures constructed from a myriad of different sources, to corroborate survey type results, as in Putnam (2000) are helping to build a case for the remaining variable of difference, culture and its effect on outcomes. However, the attribution of causation in such studies is still far from resolved. Though interesting, cross-country accounting exercises which include right-hand side proxies for social capital and find significant effects are far from convincing

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19

sceptics that culture causes higher growth rates, and not the other way around. See, for example, Durlauf (2001) and the references therein. So, in conclusion, the whole area of measurement is largely in its infancy, there will be much more work in the near future, but, on the whole, it is at least promising in documenting differences, if not yet convincing in showing causation.

3

New Institutionalists or culturalists

As argued in the previous chapter, the New Institutionalist perspective on matters cultural is firmly neoclassical in viewing individuals as fundamentally opportunistic. The culturalist or sociological view represents a radically different conception of the individual. At the level of individuals, the culturalist view is undeniably richer. It admits concepts like trustworthiness can play a role and seems introspectively more plausible. But, the object of study in economics is not the single individual. The object is social wholes, and economics seeks to explain these in terms of their individual components, by taking an abstracted and simple view of these components. In assessing the relative merits of each perspective, the question then is not whether the culturalist view gives a better account of individuals. It does. The question is whether the culturalist view is necessary for explaining the social wholes which are the true object of inquiry. We digress briefly to consider this in the broader context of economic methodology. The power of economic methodology is that it explains social wholes by positing simple goals and behavior on the part of individuals: self-interested opportunism and rationality. Of course, by positing individuals with more complicated motivations one could “explain” more. For example, by positing that individuals, in some places seem to care greatly about their neighbors and therefore perform cooperative tasks better than in others where the care is not present, one could claim to have explained why cooperative production works where neighbors care and not where they do not. But, such explanations risk becoming tautology. Cooperation follows from posited care, but where does care come from. If care is then explained in terms of another underlying characteristic, the source of that characteristic then needs to be explained. Neoclassical explanation avoids this regress by referring all explained social phenomena to a starting point of self-interested behavior. What I have called the sociological approach is a challenge to that neoclassical starting position. It will be argued in this book that by including the richer behavior termed trustworthiness, which is tantamount to social capital, we obtain an explanation of underdevelopment. However, there are two obstacles to doing this. First, it is necessary to provide an argument for why the neoclassical explanation of a phenomenon, based purely on

New Institutionalists or culturalists

21

narrowly defined self-interest, is not adequate. This is an empirical task, depending on the phenomenon to be explained, and is the goal of the present chapter. Second, it is then necessary to be convinced that the posited explanation is not merely tautology. Since trustworthiness is the source of social capital here, and understanding development the goal, a tautological account would simply be that development occurs when people are inherently trustworthy, and does not when they are not. In order to avoid tautology it is necessary to explain where inherent trustworthiness (and its converse opportunism) come from – the goal of Chapter 4 – and to account both for why it emerges in some places and not in others and how it matters for the process of development – Chapters 5 and 6. Recapping the goal of this chapter: since this book is about economic development and underdevelopment, we ask in this chapter whether using the abstracted, opportunistic individual of neoclassical economics misses anything vital to the understanding of the development process in LDCs? Specifically, do the cultural issues discussed earlier: regard for others, altruism, honesty and in general, what we have called trustworthiness, matter for production in LDCs, or can we provide an adequate account of economic interaction using standard neoclassical theory? We attempt to answer this by reviewing the literature on production in LDCs with particular attention paid to industrial networks or clusters of producers. The studies presented here suggest trustworthiness plays a role and may even be vital. This chapter attempts to determine whether this sort of trust can be well understood situationally, as modeled by New Institutionalists economists, as the self-interested behavior of opportunists.

SUMMARY OF CHAPTER’S FINDINGS A principal difference between industrial production in LDCs and its counterpart in Western economies is producers in the former are more reluctant to risk vulnerability to opportunism. It will be seen that this constrains specialization and leads to lower efficiency levels. Industrial networks as a means to engender specialization and create the conditions under which modern technologies can be implemented in LDCs, are now receiving increasing focus in the development literature, and will also be the focus here. A neoclassical interpretation of the benefits provided by these networks is as a means of supplementing, or supplanting, poor legal enforcement of contracts with group based enforcement within the network. The analysis of network case studies here suggests that this view of networks is not complete. The very possibility of such enforcement arising in a network depends on a preexisting attitude of compliance amongst network members. Successful networks often stem from common ethnic or social bases, and do not arise spontaneously without broader social supports. But, social bonds based on shared ethnicity or familiarity cannot provide a sufficiently broad base to allow the implementation of contemporary production methods. A belief that trading partners with whom one has no direct acquaintance are essentially trustworthy is needed. This chapter,

22 New Institutionalists or culturalists thus, reiterates the posited equivalence between trustworthiness and social capital and argues it is indispensable for successful modern production.

3.1

What does production look like in LDCs?

This is not a comprehensive account of production processes in LDCs. The focus is on those situations where production requires contributions by more than a single decision making unit. This, immediately rules out a large part of production. The large majority of individuals in LDCs are in agrarian employment, usually working on own land, or that of family members, or engaged in long-term production relationships with a landowner. The advantage of the family unit is that it strongly mitigates the problem of moral hazard between members. But, it is ignored here. Though sometimes crucial, increasing productivity in family owned farms, without any change in the organization of production, nor the good produced, nor extending interaction to outside the family, does not lead to development. There has been no case of development in which the family has remained the core unit of production.26 The focus here is on modern, largely industrial or agro-industrial production. This clearly requires interaction with a group that is broader than the extended family. We wish to determine what governs the interaction between agents in this process of production. The possibilities are numerous: agents could be trading on a spot market, where an individual owning one input simply buys the services of those owning another, with all elements of this trade well defined and regulated by law. Or interaction may involve more than just buying and selling of a good; perhaps each depends on the other for timely and vital contributions that are multidimensional and complex. Are such contributions controlled by a welldefined contract and its enforcement through law or is the interaction regulated by reputational considerations or other informal means? What if, alternatively, the conditions required to sustain reputation and other informal means of disciplining are not even present, if benefits to opportunism cannot be ruled out. Does trade always break down in such situations? If it still can occur, what does it depend upon? Does it depend on a belief in one’s trading partner, or is there some other way of mitigating the risks involved? 3.1.1

Manufacturing production in Latin America

I start here with a study of manufacturing production in Latin America edited by Jorge Katz (1987). The study summarizes the evidence gained from a large-scale multi-country analysis of modern manufacturing, ending in the early 1980s in which economists and engineers explored different micro and macro aspects of technological change in various manufacturing industries. Apart from being the most comprehensive inquiry into the actual mechanics of production in a poorer region of which I am aware, it is a useful starting point as it marks out some basic stylized differences between manufacturing production in developed countries and the production of similar goods in a significant region of the developing world.

New Institutionalists or culturalists

23

Continuous production in the West A hallmark feature of modern production in Western countries, that was markedly absent from Katz’s study, was what he calls “continuity” of the production process. A continuous production process is rigid, codified and involves extremely detailed preplanning of production. It allows little room for ex post flexibility concerning product design and production processes. The activities undertaken are usually systematically organized to follow a regular, direct and predictable route. An aim in this process is to minimize the handling of stocks of worked and raw materials. Inventories are balanced and stored to meet the regular needs of the production line. Capital equipment used is extremely task specific. Its efficient use comes from its specialization, and there is typically little concern for substitutability of components. The codification of the process implies relatively little on the job decision making or discretion for workers running the line. Such a process delivers output reliably and exploits scale economies. Reliability occurs through standardization of processes, and scale economies occur because the codification and systemization of production allow large production runs. However, such a continuous process also has disadvantages that make it less attractive in LDCs, as evidenced by its infrequent use in the Latin American countries studied. The two main factors against its use are: first, these processes involve large capital outlays, so that the opportunity costs of tied-up capital are high, second, recouping large outlays requires successfully producing (and selling) high volumes. But the extreme specialization, an advantage in terms of engineering efficiency, means that each step of the production process must perform its task reliably, as it cannot be circumvented or substituted with another. In such a situation, stops occuring anywhere along the line sabotage the whole process.

Discontinuous production in LDCs The dramatically contrasting technology found to be in widespread use in the Latin American study was better described as “discontinuous.” According to Katz, a discontinuous technology has production plants organized in shops, each of which has nonunique and non-fixed outputs that allow substitutability. The capital equipment used is generally cheaper and not specialized to one or a few tasks. There is high flexibility in the way a given job is performed with similar tasks often undertaken by numerous machines or processes. This leads to high input movement back and forth between shops, and the possibility of corresponding bottlenecks, but more flexibility in coping with breakdowns. There is little product and process standardization so that ample opportunity for on the job decision making and custom ordered changes is available. Finally, there is a low degree of subcontracting compared to similar processes in the developed world.27 Almost every feature of production in their Latin American study contrasts with the continuous production process of the West. The study of production networks in developed countries gives some clues as to the reasons for this. This literature emphasizes that, for continuous processes to work, high quality

24 New Institutionalists or culturalists standards and timely input supply are needed. Katz corroborates the lack of these as important impediments.28 The two principal reasons forwarded by firms for undertaking production in-house rather than contracting out to specialists were the pervasiveness of unreliable quality standards and delivery times on the part of subcontractors. Continuous production processes require the purchase of inputs from specialized suppliers who are depended upon to contribute acceptable quality at a specified time. Though the efficiency gains from specialization are obvious, this method of production leaves one vulnerable to stops in the line through missing inputs, or delivered inputs of low quality. The widely used roundabout methods required less specialized capital and inputs, and thus had the advantage of allowing flexibility. Even when the technology requiring specialization of tasks and inputs could not be avoided, firms were reluctant to rely on contracted delivery of inputs. Instead, they vertically integrated with their suppliers, often causing large efficiency losses. Vertical integration leads firms to production of goods and services that could be highly technologically dissimilar to the company’s major activity. A striking example of these losses is provided for the case of a metalmechanic plant that, lacking a reliable supplier, was forced to produce its own rubber and plastic components. Since this required a highly differentiated set of scientific and engineering skills it was extremely inefficient. The lack of trust in suppliers was so great that the firm preferred to suffer such low efficiency rather than incur vulnerability in the production line. Thus, firms seemed to choose roundabout production methods and high degrees of vertical integration to limit exposure to unreliable trading partners. However, if the continuous production processes that require subcontractors are so much more efficient, one naturally wonders why suppliers who are able to meet these needs do not emerge. Such suppliers could presumably reap large profits by ensuring timely delivery of reliable quality goods.29 Impediments to continuous production On the supplier’s side, specializing production (often through the purchase of irreversible capital) to meet the needs of one, or a small number, of demanders, leads to the possibility of ex post expropriation. A subcontractor with such specialized products is always vulnerable to the producer renegotiating the terms of delivery ex post, as in the standard textbook “hold-up” problem.30 Walking away from the relationship is costly because the value of their customized product on the market is less than with the producer. These problems plague production in all economies, but in LDCs with less developed legal systems, the problem is worse. The purchaser is also vulnerable since, using a continuous production process, as described above, the extreme specialization of tasks and inputs implies the possibility of costly stops in the line. As we will see below, these problems are widespread, yet they are somehow resolved, at least partially in developed countries and in some successful industrial networks in LDCs, we now consider how this occurs.

New Institutionalists or culturalists

3.2

25

Industrial networks

Clearly one way to solve these problems is by contract. The buyer and seller write a binding contract that describes the amount and quality traded, a unit price, and terms of delivery and payment. Such a contract will protect both sides of the arrangement. But, even in developed countries, companies locked into such specialized production relationships rarely rely on contracts and the law to regulate trade. Humphrey and Schmitz (1998) argue that legal sanctioning is effective when business relationships are well defined and delimited, but, in reality is a costly and ineffective way of ensuring compliance. This is because contracts are costly to write, difficult to enforce and leave open the opportunity of exploitation if penalties are great and easy to misapply. An alternative means, evidenced in informally organized networks (or clusters) of producers, is receiving increasing attention. Altenburg and Mayer-Stamer define industrial clusters as: . . . a sizeable agglomeration of firms in a spatially delimited area which has a distinctive specialization profile and in which interfirm specialization and trade is substantial. (Altenburg and Mayer-Stamer 1999, p. 1694) Such networks of supply chains and interconnected firms are a common and widespread means of managing the contracting difficulties central to modern production. Weijland (1999) reports that there are 10,000 registered clusters in Java, Indonesia, alone. Following the example of late developing European regions, their model of interfirm interaction is increasingly seen as a possible lesson for firms in LDCs. As Humphrey and Schmitz note: It is widely accepted that raising competitiveness in such countries [LDCs] requires re-building inter-firm relations. Major role models are both Japanese supply chains and Italian industrial clusters. (my italics) (Humphrey and Schmitz 1998, p. 47) The study of networks grew rapidly in the 1990s – see Garofoli (1992), Pyke and Sengenberger (1992) and for LDCs Schmitz (1993) – and is now having considerable impact on policy makers. According to Altenburg and Mayer-Stamer (1999) the ILO was among the pioneers in highlighting the importance of industrial clusters in the early 1990s through their International Institute for Labour Studies. Other international organizations have followed suit: the World Bank has conducted cluster projects in Brazil, Turkey, Morocco, Egypt and India; UNIDO’s Small and Medium Enterprises Programme is increasingly based on cluster thinking; and UNCTAD is redirecting its work on enterprise, business facilitation and development towards clusters. Part of the reason for the emphasis on local networks is disappointment with the development and implementation of productivity improving technologies via

26 New Institutionalists or culturalists transnational corporations. Though initially greeted with optimism, the experience of these has been that they tend not to engender effects that are broad enough to be economy transforming. In particular, transnational corporations seem to create few domestic linkages, and do not outsource production or supply to domestic small manufacturing enterprises. They instead locate in LDCs because of fiscal incentives or cheap labor supply, not to take advantage of a cluster or local suppliers, and thus, encourage domestic industry.31 The emphasis on networks is not limited to LDCs or even late developing regions in the West. Clusters of firms and strategic alliances between firms, sometimes also called supplier networks, have come to be seen as a crucial source of competitive advantage in the management and business literatures as well. Helper (1991; 1993) describes the emphasis on such cooperative relations as a move from “exit” to “voice” in her study of the US auto industry. Exit corresponds to a market mediated view of interaction; arms length relationships between a buyer and a large number of suppliers, competition between suppliers and the threat of taking business elsewhere, the important tool in negotiating prices, quality and delivery. A voice strategy, in contrast, requires closer relations with fewer suppliers and the exchange of large amounts of information through the course of the relationship. These relations are necessarily long-term, vaguely defined and require a willingness from both sides to share ex post gains fairly. 3.2.1

The advantages of networks: the neoclassical explanation

The advantages of clusters are usually identified with one or more of the following: sharing a skilled pool of labor; attracting buyers by lowering search costs; providing forward and backward linkages between firms inside the cluster; relatedly, exploiting scale economies through specialization; allowing intensive information exchange within the cluster; and providing, in some cases, the possibility for joint action by cluster members.32 For sharing labor and attracting buyers, proximity clearly helps, but why do trade linkages and gains from specialization require firms being close to one another, or informally linked in a network? A neoclassical explanation is that informal networks can provide a form of governance in situations where a lack of formal enforcement makes members reluctant to undertake specialization and risk vulnerability to opportunism. They are a means to help maintain incentive compatibility of cooperative outcomes in a repeated interaction. Given the impossibility of circumscribing trade through formal contract, the argument is that individuals can be coerced into meeting promised obligations (implicit contracts) by other members of the group. The group does this through informal group policing and sanctioning of network members. This, in its simplest form, is the threat by a number, or all, trading partners to withdraw from all future transactions with any party that violates implicit agreements, be they over price, quality or quantity. For such networks to be feasible it is necessary that the individuals involved value the future trading opportunities afforded by the network sufficiently highly.33

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Proximity and connection thus yield two benefits. First, information sharing within a network is easier when members are close, which facilitates detection of cheating and coordination on punishment. Second, it makes the punishment, which is exclusion from trade with group members, very costly, since a punished trader will have to seek future trading partners from far afield. An interesting example of such analysis is the application to trade in pre-modern economies by Greif (1994). Greif (1994), studied enforcement of contract amongst two groups of Mediterranean merchant traders in the eleventh century: the Maghribi, based in North Africa and the Genoese. Both groups of merchants faced the same vulnerability to opportunism on the part of agents. They commissioned traders to vend their goods through the region. The traders as agents, were thus trusted with valuable cargo which they could abscond with outright, or, less dramatically, fail to remit the full selling price for upon return. The Genoese relied on individually administered punishments. That is, lacking coordinated information sharing, merchants relied largely on their own experience of a trader to determine reliability. If cheated, they alone would not deal with the trader again. The Maghribi, in contrast, utilized the informal network of spoken communication and letter writing within the group of well-connected merchants to share information regarding the performance of traders. If a trader performed poorly, the trader’s reputation was undermined by these means and, since future employment as a trader was likely to come from the same or another connected merchant, the costs of cheating were high. Thus, the group was largely an information sharing network whose function was to ensure incentive compatibility of action. The outcome, according to Greif (1994), was greater efficiency amongst the Maghribi. The larger punishment meted out to Maghribi traders meant they could be trusted to remit at lower cost than the Genoese.34 This neoclassical account of networks is plausible and straightforward. Networks are a means to regulate interaction when contract law, and/or formal enforcement of it, are insufficiently well developed to mitigate opportunism. It will be argued that, though this is clearly part of the role played by such groups, this interpretation of the role of networks is limiting. We first point out a number of complications in this simple story of networks. The subsequent section then considers the empirical performance of actual networks in the light of these.

3.3

Neoclassical networks reconsidered

Three complications to the simple account of networks are discussed here: the first relates to the emergence of profitable interaction itself, the second to the possibility of maintaining interaction in a changing environment and the third to the enforcement of punishment. 3.3.1

The start-up problem

The threat of ending a relationship as an informal means to support risk taking, when there is vulnerability to opportunism begs the question of how a good

28 New Institutionalists or culturalists relationship emerges in the first place. For the threat to have power, a profitable interaction must already exist, or be expected to come about. But, in situations where the possibility of opportunism is regulated by such threats, there are typically also outcomes in which opportunism is unchecked, and the threats have no meaning. Individuals may always believe the possibility for future cooperation is bleak, and thus decide to cheat whenever they have the chance. In that case, since everyone believes that no one else is committed to sustaining relationships by foregoing opportunism, everyone rationally chooses to do the same.35 Such problems would seem to be particularly apposite at the start of a relationship. At this point, without a mutual past from which to infer the likely equilibrium play of one’s partner, an agent’s prior beliefs determine his or her optimal behavior. Without at least some sort of proclivity towards trusting, or inclination to believe others will do the same, there is no reason to expect the trusting, or cooperative equilibrium to emerge. As Gambetta (1988) and Platteau (2000) have both argued, without such tendencies, the chances of ending up in the trust outcome are low. 3.3.2

Instability of interaction

A belief that one’s trading partner, or partners, values future interaction is central to the possibility of sustaining incentive compatible interaction. The threat of ending a trading relationship as a way to ensure compliance only has power if, when agreements are met, the relationship is expected to continue with a good chance into the future. Thus, the more settled the definition of products and processes the easier it is to implicitly contract. But, the changes accompanying development disrupt this reliability. Humphrey and Schmitz (1998), argue that undermining stability is inherent to the development process, and that this impedes the formation of business relationships: Economic volatility means that transactions are frequently not repeated. Even when they might be, the possibility of large one off gains makes the behavior of partners unpredictable. (Humphrey and Schmitz 1998, p. 44) This is also an argument made by Webster (1995) in the case of transition economies: Given the degree of uncertainty in the economy, it is rational for most entrepreneurs to focus on quick profits, which obviates the need to develop a reputation. A pervasive lack of trust impedes the development of sophisticated business relationships and narrows the scope of private activity. (Webster 1995, p. 211) Sabel (1993), argues a similar tension is endemic to the development process. On the one hand, development is about change and upheaval, as it requires learning about and implementing new (more productive) modes of production. On

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the other hand such changes increase the difficulty in monitoring and sustaining productive relationships since they undermine repetition, continuity and incentive compatibility. The dilemma of development is that learning undermines the stability of relations normally required for monitoring. (Sabel 1993, p. 137) 3.3.3

The second order public goods problem

In networks, traders are protected from cheats by the guarantee that others will punish cheats in future by foregoing mutually beneficial trades. These threats of future punishment by revoking trade must be credible. However, both parties to a trading agreement typically benefit from it, so that enforcing such punishment is frequently costly to the punisher as well as to the punished. One solution is to posit a norm of behavior insisting on punishing cheats. But, since the aim of an incentive compatible approach to contracting is to show that chosen actions maximize each party’s payoffs, appealing to a contrivance such as a social norm, or taboo against trading with cheaters, also requires showing that it is in the punisher’s interest to follow that social norm. There are a number of solutions to this problem. In Greif’s (1994) framework, the loss of reputation involved when an individual cheats makes further cheating in their own self-interest. Even if they do manage to meet a network member who is willing to overlook their past they will cheat again. Knowing this, future traders rationally choose to avoid trade with such individuals, so that punishment is rational. More generally, by specifying traders’ strategies carefully enough, one can ensure that, when the punishment phase is entered, each individual’s actions are payoff maximizing given the actions of their counterparts. These strategies can be complex when the history of the game is long and when possibilities for renegotiation are allowed. However, it is theoretically at least, generally possible to specify such strategies as an incentive compatible whole.36 Alternatively, a meta-norm which punishes individuals who trade with cheaters, even if they themselves have not cheated, can make punishing payoff enhancing. In that case, punishers find it in their interests to punish for fear of the losses to their own reputations that non-punishment necessarily involves.37 Though possible, these solutions to the second order public goods problem are complicated. They typically imply both information and reasoning which exceeds the simple act of self-interested avoidance of those with a bad reputation. This complication, and the other two above, do not invalidate a neoclassical account of networks. What they suggest, however, is that the neoclassical account of networks may be convoluted. It is important to know whether these complications actually thwart the functioning of networks in reality. In turning to the empirical work on networks, the aim here is to see whether the neoclassical account, that has a goal of providing an explanation for their functioning based wholly on self-interested incentive compatible behavior, achieves

30 New Institutionalists or culturalists that goal.38 It will do this if, in order to explain the functioning of networks in reality, one needs only to appeal to the self-interested behavior of its members. However, if, as will be seen, the very functioning of networks seems to imply a prior circumscribing of such behavior, then we will have to conclude that the neoclassical account does not achieve that goal. This motivates using a richer view of the individual, and I will outline a sociological one towards the end of this chapter.

3.4

Case studies of networks

A number of factors play a role in the development of successful networks. Here, studies are organized around two key features.39 3.4.1

Common ethnic or social ties

A network’s early success seems to be linked to the broader ethnic and sociological context of the members’ interaction. An example of a successful industrial cluster in an LDC where common ethnicity played an important role is the shoe exporting cluster in the Sinos valley of southern Brazil. Members of this cluster shared a common German heritage which helped them trust each other in the 1930s when the industry was in its fledgling form and occasions for opportunistic gain were frequent. The 1970s saw an export boom in the region and the increased industry size made it infeasible for all steps in the process to be conducted by locals. Key roles (such as exporting agents) had to be played by outsiders so that sociocultural ties as a means to ensure trustworthiness, were weakened. Schmitz (1999), argues that, by the 1990s, cooperation had come to have an entirely different basis, and, though not legalistic, the trust had come to be more process than individual based. That is, it grew to depend on the reputational considerations that are central to neoclassical accounts of clusters.40 A similar evolution of trust from a heavy reliance on personal elements in the early stages to the situational in the latter is documented for a successful industrial cluster by Nadvi (1999). The surgical instrument producing cluster near the town of Sialkot in Pakistan grew out of Punjabi caste-based (iron-smith) connections between the participants. The effects of reputation and concern for future profits were both present in moderating moral hazard in the cluster, but traditional forms of maintenance (friendship and local knowledge), played a critical role initially. These became progressively weaker with the entry of outsiders, particularly the international buyers who came to play essential roles as the cluster grew. Once again, when the growth in complexity of the product required the cluster to incorporate actors from outside, the reputational considerations became paramount. Schmitz (1999), argues this pattern is generally found with clusters. He contends that, like the Italian studies on which initial work on clusters was based, sociocultural ties matter at the start, but come to be replaced by earned trust (i.e. reputations) as clusters grow.

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Powell and Smith-Doerr (1993), also survey networks in North-central Italy and Baden Wurtemberg in Southwest Germany. They find socially integrated, smallscale, decentralized production units that are grouped in specific zones according to product: knitwear (Modena); bicycles, motorcycles and shoes (Bologna); food processing and machinery (Parma); wood-working and machine tools (Capri). When there was no past to base the relationship upon, the initial risk taking required the expectation that leaps of trust would not be abused and depended on governance structures limiting exposure if that happened. Social ties between the members allowed production to occur despite this vulnerability because they suggested abuse was unlikely. Thus, even though there was no possibility of legal recourse and, at least early on, the disciplining that would arise through reputational considerations was low, the networks were able to get off the ground.41 An example where cultural differentiation created insurmountable problems for the functioning of a cluster is provided by Knorringa (1999). He analyzes footwear production in Agra. This is a large hub of the Indian footwear industry which is differentiated by caste between artisans (lower caste Jatavs) and sellers. For most standardized footwear, almost all of the transactions between the parties are in the form of direct sales. These occur without sample making. Manufacturers simply show up with the produced final product appropriate for the regional specialization (there are many sellers and relatively few buyers since each regional style is represented by about 30 buyers). In such transactions, the full risk is borne by the artisan producer. A large part, if not all, of his working capital is tied up in one production run (between 24–48 pairs), so he is not able to postpone selling for long. Moreover, the lack of credit implies he cannot start producing the next load before selling the last, so working capital must rotate quickly. The interaction between traders and artisans is highly antagonistic and generally characterized by mutual distrust. Buyers have more bargaining power since, knowing that traders must sell and that they are numerous, they bargain down individual sellers to opportunity levels. The author argues that there exists a mutually beneficial form of trading arrangement that should supplant the spot transacting process. This is for artisans to work to order for traders who have already secured commitments to buy from retailers in their speciality region. This would benefit traders as they could take orders, based on prespecified designs, to deliver set (larger) amounts to retailers in their region at more favorable terms than if they come with already produced final products. The extra surplus arising from production to order can then benefit artisans through higher margins. However, there would be risks to such relationships borne by both parties. Traders would be entering into commitments to sell quality under a time constraint without controlling the production process. Artisans would have to undertake larger runs to meet these orders so they would face more income irregularity, and may have to employ nonfamily labor at higher cost. They would also receive payment ex post and would have to trust in the trader providing timely payment to finance their next run. In conclusion, both sides in a made to order relationship are vulnerable to poor performance or opportunism by the other. There is, however, a price benefit to working to order which could improve returns for

32 New Institutionalists or culturalists both. This is evidenced by the small group of artisans able to work to order with traders who were visibly less poor than the rest. The author finds that very few of the artisans managed to sustain such relationships with traders. Interestingly, though most artisans are Jatavs, a small group of non-Jatav artisans (most of these from a trader background often Sikh or Muslim) were the ones able to enter into longer term relationships. This was not due to better informal monitoring within the traders’ network, but rather because of castebased antagonism between the groups. Based on interviews, he concludes that the minority of artisans from a non-Jatav background simply had more inherent trustworthiness, in the eyes of the traders. That trust was based on their ethnic background and was not an inference about improved enforcement amongst them, nor an inference based on their past actions, since trust played its most important role early in the relationship. He argues that for these non-Jatavs a sufficient basis exists to permit earned trust, based on past performance, to emerge. Eventually, the earned trust became more important than the inherent trust, but the initial trustworthiness was necessary to make the relationship viable. The fact that very few Jatav traders graduated up to this level of interaction was not because of inherent incapacity, but rather because the caste-based antagonism disallowed the first steps required in building the relationship into its more lucrative form. 3.4.2

A sense that others can be trusted

Successful clusters seem to be pervaded by a sense that other members of the cluster are basically good and can be trusted. As networks of interconnected buyers and sellers, LDC clusters have a similar structure to well-studied buyer–seller relationships in developed countries. The marketing literature on buyer–seller relationships in modern economies has been centrally concerned with what makes them succeed. Doney and Cannon (1997) summarize the outcome of this marketing view: It is now well established that trust supports exchange and helps partners project their exchange relationships into the future. (Doney and Cannon 1997, p. 36) They explicitly distinguish between the calculating view of trust, and others which are based on inferences about a trading partner’s intentions and predictability – or type considerations in the terminology here. Relationships which are built on calculating trust are at the lowest and most fragile level. The highest level of trust builds on experience with a partner which allows one to attribute to them benevolence and the belief that they are willing to internalize, at least partly, one’s own intentions and desires. It is this sort of trust that is likely to be robust and flexible to changing conditions. Their’s is an empirical study of purchasing managers and suppliers which concludes that though a purchasing manager’s choice of supplier was based on formalized criteria – price and delivery capability – to be even considered from the group of possible suppliers they had to be believed trustworthy.

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McCormick (1999) reiterates the view that clusters can play an important role in development as a means to create the increased specialization involved with greater complexity of modern production. The possibility of this occuring, in the case studies she surveys, depends critically on social features of the communities supporting the clusters: the ways in which people socialize within and beyond their own ethnic group; the relative rewards assigned to academic and technical expertize; the ways in which different communities provide for the needs of their members; the rules surrounding trust. (McCormick 1999, p. 1547) A similar argument for the necessity of trust is made by Weijland (1999) in the context of Indonesian industrial clusters. She argues these rural clusters are stimulated by social networks, low transaction costs and community wide reach. The successful ones had, as a basis, earlier connections that preceded the network formation: . . . rural industries could develop even in small and distant villages if they were aided by local traditions of trust and mutual dependence of traders and artisans. (Weijland 1999, p. 1517) Clusters lacking trust seemed to be limited in the degree to which gains could be exploited. A lack of trust plagued the “micro” or “survival” clusters studied by Altenburg and Mayer-Stamer (1999). These, the most frequently found cluster in their study, are typified by production of low quality consumer goods for local markets, a small degree of interfirm specialization and low cooperation. Complementary forward and backward linkages leading to specialization require investments in skills and/or high initial investments in capital, which were not forthcoming in these clusters due to this lack of trust. Apart from stimying any attempts at specialization, this lack of trust also implied a low willingness to cooperate. Evidence came from firms’ purchasing arrangements which were limited to spot transactions and individual purchasing of inputs even though unit prices could be significantly lowered if bought collectively. The lack of cooperation in these clusters was argued by them to reflect the “fragile social fabric.” (Altenburg and Mayer-Stamer 1999, p. 1695). Successful clusters seem to also devise means whereby members can learn about the characteristics of their trading partners. This process is exemplified in case studies cited by Humphrey and Schmitz (1998). For example, Menkhoff’s (1992) analysis of Chinese traders in Singapore. The uselessness of contractual sanctions and the uncertainty regarding many dimensions of the relationship implied first ascertaining the extent a trading partner could be trusted before leaving oneself vulnerable. Relationships started out small, with wholesalers taking only limited

34 New Institutionalists or culturalists risks with traders at first. When sufficient occasions for observation had occurred, wholesalers were willing to take larger risks. An alternative way of interpreting such gradual increases in the amount risked, is as inferring the competencies of trading partners, or as part of building an incentive compatible mechanism (see, e.g. Rauch and Watson 1999). Of course, the relationship becomes more valuable the greater the amount of potential trade, and, in a valuable relationship the threat of termination has a greater disciplining effect. But, though this was also undoubtedly present, traders were clearly trying to determine what “type” of person they were transacting with. In particular, the authors note that the threat of terminating a relationship, though part of the disciplining procedure, as the incentive compatible approach suggests, was not sufficient: The loss of future business cannot be seen as a deterrent until the trading strategy of the client is understood. (Humphrey and Schmitz 1998, p. 40) This method of building trust through repeated interaction through time has been highlighted in the marketing literature (Swan and Nolan 1985; Doyle and Roth 1992). Unlike the calculative view which sees repetition as a means of sustaining incentive compatibility, repeated interaction here enables the trading partner to learn more about the other party, and thus predict their likely behavior in future contingencies. In Doney and Cannon’s (1997) terms, traders were trying to infer the benevolence of their partner’s intentions, that is, their goals and objectives. The thing being learned about is the other person’s type. The only way to infer type, however, was to experience trade, and hence taking risks (albeit limited) was unavoidable. 3.4.3

Implications for the neoclassical view

The neoclassical view of networks is as a group based means of ensuring incentive compatibility in repeated interaction. This suggests the critical ingredients necessary for a successful cluster are the existence of sufficiently valuable interaction, and agents with high enough valuations of the future so that the threat of terminating the interaction is meaningful. According to the neoclassical approach, trustworthiness has to overcome a number of hurdles to develop – the start-up problem, possibilities of disruption and a second order public goods problem related to punishment. What characterized successful clusters in practice was that they either emerged from shared ethnicity, or an environment with strong social bonds. Also, individuals within clusters had time to develop relationships and learn about each other. So, though the impediments to network development could be solved, the case studies showed that their capacity to function seems to depend critically on elements of the members’ surrounding social milieu; though functioning networks also have elements matching the neoclassical account. Networks seem to work

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only when there is a sense that others can be trusted. This sense might come from shared ethnicity, it might be because people believe others are trustworthy, or alternatively when they have had enough time to find it out. The studies suggest that, in reality, some sort of preexisting trust is required to overcome both the startup problem inherent to the neoclassical account, and the fact that actors are often located in rapidly changing environments where interaction is not repeated enough to ensure incentive compatibility of cooperative behavior. Thus, the neoclassical or calculative account of trust is incomplete because it appears that the very thing needed for trust to emerge is preexisting trust.42 A number of the studies showed that localized bonds or ethnicity could provide a basis for trust to emerge. It will be seen now that there are, however, limits to the effectiveness of ethnic links and social bonds in engaging modern production.

3.5

Shared ethnicity and social bonds limit trade

Numerous doubts have been raised about the possibility of modern production growing out of localized interaction. Barrett (1997) similarly claims hold-up type vulnerabilities to opportunistic traders are pervasive with the expansion of trade to larger markets. Moreover, these risks cannot be attenuated by ethnic and social bonds because they necessarily require trade with individuals beyond the known social network. The desire to take these risks is much greater when there exists a level of inherent trustworthiness in the population. Moderating the risks by informal reputational mechanisms, like those based on ethnicity, is not seriously entertained: As one’s trading network expands beyond family, friends, neigbours, the quantity and quality of information about one’s commercial counterparts, the likelihood of repeated interaction with them, and the availability of cost effective extralegal monitoring and contract enforcement mechanisms all tend to decline. (Barrett 1997, p. 561) This, according to him, is a way to make sense of empirical findings that social capital plays an explanatory role in the development process which requires spheres of exchange to be expanded.43 Lacking these informal control mechanisms and repetition, interpersonal trust, or what I have called a belief in the trustworthiness of others, is required:44 Trust obviates the problems of degraded information, enforcement and monitoring, and a lower probability of repeated interaction with one’s customers or suppliers. (Barrett 1997, p. 562) Industrial networks growing out of shared ethnicity are more likely to work because they allow individuals to ascribe characteristics of trustworthiness to their

36 New Institutionalists or culturalists trading partners and not because of advantages in monitoring and punishment. However, these networks are not likely to be sufficient in what he calls “spatially and intertemporally” expansive markets, Barrett (1997, p. 554). This need for trustworthy individuals is also emphasized for similar reasons by Gambetta (1988, p. 219). Again this is because modern production, in contrast with traditional production which largely occurs within the family or kin unit, increases the set of actions required and allowed, and the larger the set of feasible actions, the more trust that is needed.45 A similar argument against the situational account, also arising from the view of development’s disruptiveness, is given by Platteau (1994, pp. 552–3). He argues that trust based on mechanisms of reputation based considerations are only likely to work in small communities. This limits market size and leads to disconnected markets, since the informational requirements for such situational trust in large markets are prohibitive. New trading opportunities give rise to more risk, more population movement, population growth, different choices from different types of production, and the integration of smaller trading groups into larger ones. All of these should tend to undermine the situational trust embedded in stable repeated social interaction. A way around the problem suggested by Platteau is the establishment of a generalized morality in which abstract principles or rules of conduct are considered equally applicable to a vast range of social relations beyond the narrow range of personal acquaintances. (Platteau 1994b, p. 802) Platteau (2000, p. 331), argues that post-Soviet Russia is an example where relatively good networks of personalized relationships are unable to support broader-based economic ties. These informal networks have persisted, but have been used to subvert the proper operation of markets, and lead to extortion and the growth of criminal activities. None of these are conducive to the development of healthy modern production and have not evolved into a more generalized morality. A generalized morality would reduce the personal gain, from cheating, or the personal cost of cooperating, depending on the nature of the moral code, and may support inherent trustworthiness. Barrett (1997), also reasons for a similar view, arguing that belief systems which heap opprobrium on exploiters, or those who abuse trust, are vital to keep exploitiveness in check. Seligman (1997, p. 42) also emphasizes the disruptive elements of modern production. He insists that the complexity of production in modern societies requires individuals to undertake numerous roles; a process he calls “role segmentation.” Role segmentation increases the risk associated with modern interaction because individuals are no longer defined fully by their positions in a social hierarchy. According to Seligman, the emergence of modern societies replaces a situation where moral agency resides in the group and where individuals can be expected to fulfill their group role, with one in which such agency resides in the individual. In the latter, contracts or agreements are made between individual selves and

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group identity or position is no longer a guarantee of behavior. For him, trustworthiness thus emerges simultaneously with the notion of individual agency and can only occur when there is increased role differentiation, and hence increased role conflict.46 Seligman thus argues that modern societies, with their increased divisions of labor, require trust in other’s agency, since the breakdown of traditional roles means behavior cannot be fully anticipated in terms of another’s position. This is also a view of the development process shared by McCormick. Industrialization, like the broader process of development of which it is a part, generally involves increasing complexity of production which, in turn, demands greater reliance on others for certain activities. (McCormick 1999, p. 1532) Similarly, Clarke and Short (1993) and Sztompka (1999) argue that the extreme form that the division of labor takes with modernity and the great differentiation of roles, makes the conduct of individuals more ambiguous. In pre-modern societies, the familiarity of interaction based on kinship, shared religious beliefs or the density of social interactions, maintained order. In modern society, lacking such stability, and where interaction with unfamiliar people is needed, one has to believe in the integrity of the individual actor. Seligman thus distinguishes between reciprocity based on direct, immediate and balanced exchange, against reciprocity that is generalized, and not based on immediate expectation of return. An older literature on peasant societies has also emphasized the need for immediate reciprocation and the opportunism that marks transactions occurring beyond the kin group: If I am buying from or selling to a relative, I neither seek profit nor concern myself with money. The same can happen in a transaction with a friend. But if I am dealing with a stranger, then there are no rules, other than the one of exploiting him to the utmost. (Da Matta 1985, p. 40).47 On the question of how trust emerges Seligman like most others, sees it as a cultural heritage.48 Some countries have a smaller, family-oriented radius of trust, as in Banfield’s study of the peasant community “Montegrano,” and others are broader.

3.6

A sociological account

According to the neoclassical view, networks are self-regulating because they make it incentive compatible, even for wholly opportunistic individuals to act in cooperative ways. But, as Granovetter (1993) has asked, to what extent do the operations of such business groups depend upon a preexisting moral community in which trustworthy behavior can be expected, normative standards understood

38 New Institutionalists or culturalists and opportunism foregone. As we have seen, in practice, such preexisting social capital seems to be essential. But, where then does this come from? A sociological account of trust allows that not all individuals are totally opportunistic. Granovetter’s (1985) embeddedness argument stresses the role of concrete personal relations in solving the hold-up problems which are central to business interactions. In the examples of contractor/subcontractor ongoing relationships, he emphasizes the importance of stability through time. In a sense, this appears similar to the economists’ notion of situational trust, since it requires repeated transaction with individuals that are known through past trade. But, there is a difference. In the embeddedness account the past does not matter for reputational reasons, but because it allows inference of type. Stability is valuable not because it supports incentive compatibility, it is instead based on the individual’s desire to derive pleasure from the social interaction that accompanies their daily work, a pleasure that would be considerably blunted by spot market procedures requiring entirely new and strange work partners each day. (Granovetter 1985, p. 68) A stable and embedded relationship is infused with features that make individuals enjoy the interaction for reasons that are additional to the pure pecuniary benefit. Such interpersonal enjoyment can make trading partners inherently trustworthy, even when pecuniary considerations dictate acting otherwise.49 Granovetter (1993), describes these features in terms of intrinsic pleasure derived from the interaction. But it does not matter whether it is a pleasure derived from the interaction, or a belief in a general code of behavior, or a personality type that stops the individual from cheating. A critical difference from the neoclassical approach is that reliability is inferred from the agents own preferences and not the situation. This emphasis on the personality of a trading partner is a recurring theme in the management literature on successful business relationships. In an early study, Macaulay (1963) argued that few business supplier contracts specified contingencies clearly in writing, and that this was often a deliberate choice. Businesses operated with the feeling that personal relationships would enable them to solve problems that arose down the track. A similar conclusion was found in Beale and Dugdale’s (1975) study of UK engineering firms and has been argued for by Tomkins (2001) as a necessary inclusion in the accounting approach to information flows. Tomkins cites Vincent-Jones (1985) who similarly concludes that . . . whilst the legal institution of contract undoubtedly plays a central role in certain circumstances, it is clear that the “extra-contractual” constraints of convention, custom and expedience are of far greater and more direct importance in the vast majority of transactions. (Tomkins 2001, p. 177) Humphrey and Schmitz (1998) also argue that though formal sanctions can contain the amount of damage incurred when relationships break down, and thus limit

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39

the extent of exposure, firms must still remain vulnerable to ill-will, and individuals will let themselves be vulnerable only if they believe they have a trustworthy partner.50 One could attempt to understand these relational contracts as a situational form of trustworthiness but, once again this interpretation cannot account for the preexisting trustworthiness underlying the relationship: If the incidence of such arrangements simply reflected the density of social networks and the capacity of firms to monitor one another’s behavior, then we would not need to invoke culture to explain them. But frequently business networks entail ties between actors who have had little previous contact. To some extent, the rate at which such relationships form depends on the degree of . . . social capital in a given market or society. Such social capital involves not simply enduring structures, but also the availability and understanding of cultural signals and norms that engender trust . . . . (Granovetter 1993, p. 39) Again, his emphasis is on a cultural interpretation of trustworthiness: Without adding a cultural element to structural accounts of embeddedness it is difficult to understand the negotiated emergent quality of trust in many concrete settings, and the ability of entrepreneurs to construct networks out of diverse regions of their social worlds. (Granovetter 1993, p. 39) Granovetter, thus reiterates the view that the very emergence of such business networks depends on trusting behavior. Though incentive compatible situational accounts do highlight important forces in practice, they do not explain how the underlying trust that supports the network comes about.51 Sztompka (1999, p. 13) suggests what I would term a sociological resolution to this problem. The problem is solved where there is a large pool of inherently trustworthy individuals. The need for such individuals who are just the right type seems unavoidable. But to avoid a tautological account, it remains to specify where they come from.

3.7

Summary

Case studies suggest that trust plays a central role in enabling modern production to occur. High productivity requires specialization, which in turn implies vulnerability to opportunistic trading partners. But, vulnerability will not be tolerated without trust. This central role of trust in modern production cannot be replaced by rule of law, nor can its existence be ensured solely by reputational considerations and informal enforcement. These clearly help, but require a form of trust to themselves function, and are not a substitute for it.

40 New Institutionalists or culturalists Trust seems to be present in abundance in close knit communities, when they share common ethnicity or other social bonds. But, it is doubtful as to whether these can provide sufficient width to enable the economic interaction involved in modern production to take hold. Modern production requires risks to be taken with previously unfamiliar trading partners. These risks will be taken when individuals are, on the whole, believed to be inherently trustworthy. A society with many such individuals is high in social capital. Where trustworthiness comes from is much less clear. History and common background are cited, but for the purposes of economic analysis, it is usually treated as exogenous. Even the common reference to it as an “endowment” suggests it as arising from an external source. Consider Platteau (1994b) on a “generalized morality,” something that covers what I have called trustworthiness: one critical factor behind the “rise of the West” in the modern era has lain in the extraordinary conjunction of two phenomena: the emancipation of the individual from old ties of social and political allegiance with the space of newly emerging nation states on the one hand, and the development of generalized morality in which abstract principles or rules of conduct are considered equally applicable to a vast range of social relations beyond the narrow circle of personal acquaintances, on the other hand. (Platteau 1994b, p. 802) The view that a social factor like this generalized morality facilitates economic progress is widespread. However, previous analyses have not clearly spelled out how economic factors in turn affect these social elements.52 The focus on continuous production processes and industrial districts in this chapter does not mean to suggest these as a blueprint for development. They are interesting as a relatively pure example of the cooperation that makes enterprises function.53 Such cooperation is evident everywhere, though it may be obscured in developed economies by appending formal and legal structures elsewhere. It is also clearly supported by informal enforcement mechanisms based on reputation and implicit contracts. However, the very growth of these external controls depends on the existence of a functioning network, it cannot be set up in anticipation of the network. The growth of the network itself depends on initial risks being taken, but risks will only be taken if there is a general notion of likely success. Constant growth and the perturbing of stable social relations that the process of development entails, requires reaching out to new individuals and taking risks with unknowns. This is only possible when there is an expectation that such risks will be met with cooperation and not with opportunism. Previous studies have treated this trustworthiness as vital but exogenous. My reading of this literature similarly points to the conclusion that inherent trustworthiness is vital both for modern production and for the emergence of networks that allow modern production to occur. However, this seems to lead to a tautology or what Granovetter has called an oversocialized position.

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Since production has been argued here to critically depend on this sense of the inherent trustworthiness of individuals, it is necessary to explain where these trustworthy individuals comes from. Developing a methodology to do this is the goal of the next chapter. The final goal is to return back to the issue of development; to understand why there are some individuals who are trustworthy, and in some places a seeming predominance of them, which makes modern production feasible, whereas in other regions that lack them, modern production fails. This is the focus of Chapters 5 and 6.

4

Accounting for characteristics

The previous chapter’s conclusion that inherently trustworthy types are essential for modern production leads to the question of how such types arise. Without an answer to this, “explanations” that stop at development succeeding due to trustworthy individuals, or failing due to their absence are tautological. What is needed is a way of accounting for the construction of individuals. Economists usually start by assuming identically self-interested individuals. This assumption’s inability to explain how firms operate in practice, drives our desire to modify it, not its lack of realism. It may seem that our model should then come from sociology, where the central focus has been the orientation of individuals and how this is affected by their environments. But there is no straightforward model of the individual’s construction that can be directly imported in from sociology. This is not a shortcoming but merely reflects a difference in focus. Their aim is to provide a realistic and thorough account of how that construction is achieved. Realism is important, so this informs our modeling here, and subsequently we consider their views further. But since our focus is not the individual per se, but the social wholes that interacting individuals create, we need an account which is both plausible and allows the construction of individuals to be handled simply. Simplicity is essential because our individuals will then be embedded in a broader framework of multiple interacting individuals to explain social phenomena. As argued in Chapter 2, the most realistic account would admit the immense heterogeneity that occurs in the real world, but this would be too messy to help here. Evolutionary models, which have previously been applied in biology, are simple enough to provide a possible tool.

4.1

Evolutionary models

Evolutionary models applied to economic problems bear close relation to evolutionary models used in biology. Two basic elements of such models are mutation and selection. The mutation mechanism generates perturbations, or the introduction of change, to the stock of types in the population. The different criteria of evolutionary stability are concerned with the robustness of evolutionary equilibria to these mutations.54 In simple terms, if a particular evolutionary equilibrium

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contains, for instance, a population composed completely of trustworthy individuals, that will be a stable equilibrium if the introduction of a small subset of individuals who are not trustworthy leads to that introduced subset dying out. If, in contrast, their numbers tend to increase, it is unstable. It is hard to avoid using terms like “die out” when speaking of such models even though such terms have a clear biological connotation. In application to cultural or social characteristics, however, biological analogies seem forced unless one assumes that genetic transmission is the means by which cultural traits are propogated. A more natural mechanism of transmission for cultural variation would seem instead to be imitation or learning. Until recently, most evolutionary interpretations of these mechanisms have also led to transmission processes that are analogous to the biological one. For example, one may think the way that traits are transmitted is for successful types to be copied by the young, thereby causing similar types in subsequent groups. This interpretation also implies that success leads to a higher frequency of types with similar characteristics, precisely as in a biological model. Though this occurs through copying and not genetic transferral, is irrelevant to the outcome. This equivalence between the means of transmission in cultural and biological models has been the norm.55 The second basic element of such models, selection, determines which varieties of competing types are favored over others, and what the criteria that determine this are. In biological models, this is “fitness.” Fitter types are generally those that can command the greatest resources. In a biological context, the reasoning for this is clear. Fitness implies the ability to nurture more offspring to maturity. Since offspring are genetically linked, successful types’ genes are increasingly represented in the population, thus leading to their increased predominance. In a cultural context, selection based on fitness, in the sense of commanding more resources, is much more controversial. I will argue against it here.

4.2

The problem with biological analogies for culture

Biological models are clearly useful for modeling social characteristics if these are proclivities hard-wired into human brains. However, it is now almost universally accepted that cultural variables, such as trustworthiness, are not genetically transmitted, and sociobiological approaches to explain cultural variation of this sort are not promising. The human capacity to experience and enact culture is clearly physical, and generally accepted to be the outcome of a biological process of selection. However, few would argue that manifestations of culture, for example, documented cross-country differences in answers to the World Values Survey, have a biological basis.56 I similarly rule out the possibility of a genetic basis for societal differences in trustworthiness and consider another means of transmission here. However, before proceeding to outline the evolutionary model that will be used, I first outline the limitations of traditional economic evolutionary models in the present context.

44 Accounting for characteristics 4.2.1

Fitness-based replicators yield homo economicus

Arguments against the use of a purely fitness-based selection mechanism, as in biology, come from the findings of the recent theoretical literature examining evolutionary processes and types. This recent work has been concerned with the evolution of preferences, and contrasts with most previous evolutionary work in economics which has been concerned with selection of strategies. In standard evolutionary models, individuals use strategies (e.g. “cooperate” or “cheat”) that they do not choose. They play these strategies because the strategy is inherent to their character. The evolution of the strategies themselves is dictated by payoff considerations (and only payoff considerations). Through this process of evolution, strategies that do not maximize payoffs are slowly weeded out of the population, eventually leading to the survival of only those that perform well under the fitness-based replicator. Thus, the strategies that end up being selected by the replicator dynamic are those maximizing payoffs in any case, and thus correspond to those that would be chosen by the agent if they made rational choices. So, though not rational, a replicator based on fitness (i.e. purely pecuniary economic returns) ends up choosing agents who act as if they were rational. It has recently been demonstrated that this is a very general finding in evolutionary models based on fitness replicators. Ely and Yilankaya (2001)57 show that if a person’s type cannot be directly observed by others, the only type that emerges in a population is the one that maximizes fitness. There are models in economics which use evolutionary reasoning to give rise to types that are not payoff maximizing, but many start from the position that types can be directly revealed, at least with some positive probability.58 However, the logic of evolutionary selection itself would argue against assuming that types can be directly revealed.

Types should not be directly revealed To see this, we must first understand why direct revelation of types is important. Let us consider it in the context of trustworthiness. As the work surveyed in Chapter 3 suggests, finding trustworthy individuals with whom to interact is valuable for entrepreneurs who cannot specify fully all the particulars of trade. If able to directly reveal themselves, such trustworthy individuals would be highly sought after. This is because, as the previous chapters suggested, the trading opportunities for which they are required cannot threaten sufficient punishments to coerce them into taking the correct actions. If the individual in question supplies a firm basing production on their input, nothing contractually stops them from threatening to lower quality, and thus lower own costs. Such threats are costly to the producer and can be used by the supplier to negotiate more favorable terms. If producers could directly observe who the opportunists were, they would simply avoid trade with them. The trustworthy, in contrast, given their type, would be expected not to exploit such opportunities for gain at the expense of their partners and be sought out in trade. Observability would thus guarantee a cost to being an opportunist and rewards for the trustworthy. The observable trait of trustworthiness, by being a credible

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commitment to one’s not acting opportunistically, would imply that trustworthy individuals are better financially rewarded than opportunists, whose only goal is to seek financial rewards. With such direct revelation of types, it is thus possible for a purely fitness-based replicator to select types who are concerned with more than just maximizing their own fitness. But, consider the consequences if types cannot be directly revealed. Now entrepreneurs do not know who the trustworthy individuals are before entering into trade. However, since the hold-up problem occurs precisely because there are financial gains to being an opportunist, opportunists will be happy to trade with such entrepreneurs. They will do so, and cheat them, thereby obtaining higher financial rewards than the trustworthy, who, though also willing to trade, eschew opportunities for personal gain at the entrepreneur’s expense. Since the opportunists obtain higher financial rewards, they will always be “fitter” than the trustworthy and the population should come to consist of these almost exclusively. Consider then a type who manages to look like a trustworthy individual, but is really an opportunist. A person who looked trustworthy would be favored by all entrepreneurs and would thus not suffer the opportunists’ losses of exclusion. However, this type would then act to exploit entrepreneurs by taking advantage of any opportunistic gains that became available. They would thus do better, financially, than the trustworthy who would not exploit these gains. But, since this type does better than both opportunists and trustworthy types it should, by evolutionary reasoning, come to dominate this population. This is only not true if it is assumed that such mimicking types cannot arise. But, it is hard to imagine why this would be the case. The upshot then is that assuming individuals should be able to directly observe others is necessary, to maintain the possibility of non-payoff maximizers being selected by a fitness-based replicator. However, this assumption is untenable if we allow for the possibility of mimicry. There are other means by which a fitnessbased replicator can give rise to individuals that are not payoff maximizers, but these also suffer from drawbacks. Non-observability and payoff maximization Another way to generate rewards to types who are not fitness maximizers, while assuming non-observability of type, is to use group selection. That is, for the unit of selection to be the group instead of the individual. In this form, the returns to a number of individuals are aggregated and the fitness-based replicator applied across groups. In cases like the trustworthiness example above, groups with predominately trustworthy individuals perform better than groups dominated by opportunists, since they can successfully undertake mutually beneficial trade, and are thus selected by such a replicator. However, selection at the group level has not found favor amongst evolutionary theorists. The principal reason is that it leads to outcomes that are vulnerable to mutation at the individual level. In particular, accept for now the conclusion that group selection leads to the survival of predominately trustworthy groups. Then

46 Accounting for characteristics consider returns to individuals within that group. A random mutant opportunist entering the group would do better than a trustworthy individual for precisely the reasons that trustworthiness matter, that is, because there are pecuniary gains to acting opportunistically. Any such group which is thus successful in the group selection stakes would tend to be vulnerable to opportunists. Such a group is not stable once individual selection is allowed and it is not clear why individual selection should be ruled out. An alternative means of generating non-payoff maximizing behavior is to have a form of segregation amongst agents based on their types. In such a situation, as modeled in, for example, Bowles and Gintis (1998), individuals of like types tend to interact with each other and thus can benefit indirectly from having a non-payoff maximizing nature because they can realize mutually beneficial outcomes. This type of interaction is also subject to invasion by players with payoff maximizing tendencies, as long as they cannot be directly observed, since these will do better still playing in a community with others who think they are trustworthy. Once again, this will not occur if types can be observed, or even if there is selection on the group rather than the individual, but these seem hard to support. Another way of establishing non-payoff maximizing behavior which is more in line with traditional approaches based on selection over strategies, is to posit evolutionary costs to complexity. Such an approach supposes that the ability to reason, or perhaps behave strategically, is computationally costly. It is therefore costly in a resource sense and can be a drag on fitness. Of course, complexity allows a broader range of choices, which creates fitness advantages, but now there is a tradeoff. A less costly type is limited to actions like, for instance, always cooperating, or always cheating. It is then possible for evolution to select a simple and honest type over more costly strategic or opportunistic types if the costs of foregone opportunities are not too large. However, though conceivable for such a framework to yield richer behavior than payoff maximizing and thus account for more types, it will not be used here. Such a framework does not adequately capture the sociological view surveyed in Chapter 2. No part of that literature argues that inherently trustworthy types are individuals lacking the capacity to calculate alternative more lucrative strategies. The trustworthy are not less sophisticated, but instead simply “choose” not to partake in such calculation. They voluntarily exclude actions from their choice set while remaining aware of the possibility of the actions and their consequences. It is not a limit in rationality that makes them choose non-payoff maximizing behavior. In general, these considerations apply to the selection of any type whose nature is payoff limiting, in the sense of encumbered with a trait like trustworthiness, or regard for others, or a generalized morality or any of the other examples that were brought up in Chapter 2. Standard models of selection are adequate to explain payoff maximizing behavior.59 The evolutionary paradigm selects selfish behavior because, not surprisingly it does best in maximizing a selfish (fitness-based) replicator. But then the mechanism of evolutionary selection has little value. Why not just posit selfish and rational behavior from the outset? Since the discussion in Chapters 2 and 3

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argued that inherently trustworthy types were essential, this finding suggests that fitness-based evolutionary models will not be useful. The challenge then is to formulate a selection process that can create fully rational individuals who choose not to exploit all opportunities for personal gain, and which also provides a plausible account of socialization processes. The model of cultural transmission in the next section does both.

4.3

A cultural model of preference transmission

I propose here an evolutionary model that is both more suited to cultural transmission and leads to the possibility of non-payoff maximizing types emerging. The mechanism is in the spirit of Boyd and Richerson (1985, p. 11) in allowing that successful enculturation need not be equivalent with payoff maximization. The framework is drawn almost directly from Bisin and Verdier (2001) and allows selection to be based on parents’ preferences as well as fitness.60 The next section discusses this mechanism conceptually and contrasts it with the usual fitness-based replicators. An analytical treatment, which forms the basis for the model used in the next two chapters is then developed. 4.3.1

Conceptual discussion

A plausible avenue of cultural transmission is parental socialization. Parents attempt to inculcate values into their children. Such values will alter their children’s preferences. It seems plausible that fitness considerations would enter into a parent’s evaluation of the preferences that their children will obtain, but it also seems unlikely that fitness considerations would be the sole criterion. For instance, in deciding whether a child should be taught to follow the maxim “honesty is the best policy,” parents would likely take into account the pecuniary consequences of them doing so. If honesty pays, the maxim passes the fitness criterion. But, in a world of scoundrels where, for example, honesty is extremely costly, fitness considerations alone would dictate teaching a child to perhaps be strategic. But, even where fitness considerations dictate otherwise, parents who themselves value honesty might choose to raise an honest child. This is more likely, the lower the costs of honesty, but the point remains that fitness need not be the unique determining criterion that parents use. As Boyd and Richerson (1985), in one of the earliest attempts to model cultural transmission have argued, behavior that maximizes the chances to enculturate may be very different than behavior that maximizes transmission of genes. Dawkins argues:61 . . . for an understanding of the evolution of modern man, we must begin by throwing out the gene as the sole basis of our ideas on evolution. (Dawkins 1989, p. 191) A recent formalization of this, provided by Bisin and Verdier (2001), will form the basis of the modeling used here. The difference between their approach and the

48 Accounting for characteristics standard evolutionary approaches used by economists based on fitness, is precisely the possibility of extra choice dimensions. With a standard fitness-based replicator, the selection of types is based entirely on rewards, and in the economic contexts we consider, these are pecuniary rewards. Bisin and Verdier’s (2001) replicator is based on the process by which parents evaluate their children’s outcomes. Fitness considerations clearly also enter into this process as parents estimate the financial rewards and costs to having certain characteristics. But, parents also estimate the likely actions their child will take with the inculcated preferences and evaluate these with their own preferences. Their framework allows, for example, that even if a parent estimated that their child could reap high financial rewards to being a thief, they may still attempt to inculcate the belief that thieving is wrong if they themselves think it. 4.3.2

Analytical treatment

There is asexual one for one reproduction with the possibility of only two types in the population; the trustworthy and the opportunists. An individual’s type is not directly observed by anyone else. Unlike the restriction against evolution of mimicry in standard models of evolution, the restriction to there only being two types does not play a central role in generating a possibility for the trustworthy to exist in the framework here. This is because one of the types allowed here, opportunists, as will be seen, is always concerned with maximizing material rewards and thus represents a payoff maximizing strategy. Both types are also fully rational and aware of all opportunities. Each type differs in preferences as represented by different utility functions. The trustworthy’s preferences are represented by the utility function uT , and the opportunists are represented by the utility function uO . We leave until the next chapter formal details of how these preferences differ, but intuitively, the two types are as follows: Opportunists, type O, are simply homo economicus. These are individuals who are entirely instrumental in their outlook. They care only about outcomes and feel no remorse nor benefit from how those outcomes are achieved. They do not mind cheating, will not feel slighted if cheated, and will not benefit by selecting certain actions over others, per se. In contrast, the T type are trustworthy, these people are also concerned with monetary rewards, but suffer disutility when acting in ways that violate the trust of others. If they promise to undertake certain actions, they will suffer if these actions are not performed.62 In addition they gain a benefit when acting morally by voluntarily fulfilling commitments that they have promised to meet. These benefits and costs of respectively fulfilling commitments and cheating, are non-pecuniary and intrinsic to the individual. They capture the idea embodied in what was defined in the cultural or sociological view of the individual in Chapter 2. Recall Charles Taylor on the essentially moral individual who possessed a “. . . collective good that was posited as of equal or sometimes greater worth than the individual’s own interest . . . .” This modeling also captures Granovetter’s (1985) emphasized nonpecuniary components of individual satisfaction. The framework is not, however, limited to these interpretations, we could alternately think of these benefits as

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raising the individual’s self-esteem, creating a warm glow of happiness, creating psychological resonance or many others. Platteau (2000, pp. 298–9) provides a comprehensive survey of the sociopsychological literature on such inherent sources of satisfaction. This will be elaborated in the next chapter where the precise form of utility functions is stated. 4.3.3

The socialization process

The first step in socialization is the efforts of parents. Parents cannot actively socialize a child to be someone different than their own type. However, by neglect, they can ensure that the child’s socialization will be determined from outside the family. The parent thus decides how much effort to expend in socializing the child like itself. In general, the process is probabilistic. The greater is parental effort committed to socialization, the higher the chance that the child will be like the parent. But parents can never be sure that their efforts will create the same preferences in their child. There is also a probability that, no matter how great parental effort, the child’s characteristics will be determined by imitation outside the family. Let the fraction of individuals who are trustworthy or T type be denoted β and those not, the O type, are therefore fraction 1 − β. Let the probability that a trustworthy parent directly socializes their child into being trustworthy be denoted d T (β), correspondingly the probability that an opportunist directly socializes their child into being an opportunist is d O (1 − β). Both of these probabilities are, potentially at least, functions of the proportions of each type in the population. This is to allow for parents’ choices to depend on type frequencies. For example, in a population where everyone is trustworthy a parent may be more willing to inculcate trustworthiness than in one where no one is. For now, these functions are left unspecified, as these will depend critically on the actions of others in the full model to come, but we will return to these in the next chapter. If a child from a family with trait i = T or O is not directly socialized by their parent, then he or she is inculcated with a trait by imitating a randomly chosen other member of the population. This person may be a teacher, more distant family member, friend or anyone else with influence. For modeling simplicity, the probability of socialization along these alternative lines is assumed to simply reflect the frequency of each type in the population. That is, for a family of type T , with probability 1 − d T (β) the child is not socialized by her parent. In that case, with probability β she becomes trustworthy anyway. This is because, since the trustworthy occur with frequency β in the larger population, this is also the probability that one of these larger population members will become the critical socializing influence. With probability 1 − β she will be an opportunist, since this is the probability of an opportunist being the socializing influence. For the child of an opportunistic parent, with probability 1−d O (1−β) the child is not socialized by the parent, and then with probability 1 − β, she is the same type as her parent anyway, and with probability β she will be trustworthy. If we let P ij denote the probability that a child from a family with type i is socialized

50 Accounting for characteristics to trait j , then, by the law of large numbers, P ij will also denote the fraction of children with a type i parent who have preferences of type j .63 We then have the following elements describing the transition matrix for each type: P T T = d T (β) + (1 − d T (β))β P T O = (1 − d T (β))(1 − β) P OO = d O (1 − β) + (1 − d O (1 − β))(1 − β)

(1)

P OT = (1 − d O (1 − β))β. Its implications for the evolution of β are demonstrated for the discrete time case, even though the model can be developed as the continuous time limit of this. The change in the variable β between any two periods of time, denoted t and t + 1, is computed as: βt+1 = βt P T T + (1 − βt )P OT .

(2)

This equation simply says that if currently there are proportion βt of type T in the population, the proportion of individuals of type T in the next period, βt+1 , comprises those who have been directly socialized to be type T by their type T parents, the term βt P T T , and those with type O parents who were not socialized by them, but who were then socialized by chance, outside the family, to be T type anyway; the term (1 − βt )P T T . Substituting from the relevant terms in equation (1) into (2) we obtain:

 βt+1 = βt d T (βt ) + (1 − d T (βt ))βt + (1 − βt ) (1 − d O (1 − βt ))β which, after rearranging yields:
 βt+1 − βt = βt (1 − βt ) d T (βt ) − d O (1 − βt ) .

(3)

This difference equation describes how β will change as a function of parents’ socialization efforts. It very intuitively, states that if the probability of direct socialization by a parent of type T exceeds that of a parent of type O, d T (βt ) > d O (1 − βt ), then evolutionary pressures will lead to an increase in type T , provided one type is not already eradicated; βt = 0 or 1.64 Up until now, we have not made any assumptions on these socialization probabilities d i , but this is where the substantive assumptions about our cultural evolution process now enter. Parental socialization is increasing in returns to own type Parents evaluate how a person of their own type performs, on average, when determining whether to socialize their own children after themselves. They do not have to be able to evaluate how an individual with preferences other than

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their own would act or feel. They only have to make evaluations using their own preferences. The only reasonable assumption here is that the better a person of their own type does when evaluated from the perspective of their own preferences, the more effort they put into socializing their child, and the more likely their child will become like them. Thus, the selection process for preferences is dictated by parents’ evaluations of their own lives and the likely lives that their children will lead if inculcated to be like them. This includes, but is not restricted to, the resources their children will command if behaving in accord with those preferences. Thus, in terms of the notation, if the average utility of a person of type T in a population comprising proportion β is high, then d T (β) should also be high, and this is similarly true for type O. That is d T (β) is higher the higher is A[uT ], and d O (1 − β) is higher the higher is A[uO ], where A denotes average.65 It is clear from equation (3) that the direction of change depends critically on the relative probabilities d T (βt ) − d O (1 − βt ), we thus need to describe how these relative probabilities vary with differences in average utility. Again, what seems reasonable is that if the average utility of a type T rises and the average utility of a type O falls then the difference in socialization probabilities, d T −d O , should also rise. However, this is not sufficient to ensure that both types have the possibility of existing. And if the framework can only ever allow the possibility of one type existing, it reduces to being tautological.66 To see why there is a possibility of tautology here, consider what happens if we assume, for example, that one type is always inherently less likely to socialize their children than the other. Suppose, for example, that it is always true that d O < d T . Then evolutionary dynamics necessarily drive β → 1. To see this, note that from equation (3), starting at any value of β > 0, only at β = 1 will it be possible for βt+1 − βt = 0. Conversely, if it is always the case that d O > d T the evolutionary dynamics will drive β → 0. Either such assumption then effectively rules out an analysis of socialization and types in the population because either one simply implies that one type is so much more concerned with the socialization of their offspring, it comes to dominate the population. 4.3.4

A replicator allowing both types

For such a model to provide an account of different types, it must allow for socialization efforts to vary with utility realizations in a way that permits both types the possibility of being represented in the outcomes. That is, the replicator process must at least allow for the possibility that the ordering of the d i can change with utility realizations. Since we are using utility realizations to map into the respective d i , this requires a cardinal restriction on the utility functions. A very simple form of mapping will be used here. The function  maps from the difference in average utility realizations A[uT ] − A[uO ] which is defined anywhere along the real line, into the domain of probability difference d T (βt ) − d O (1 − βt ) which is within [−1, 1].67 More formally, define the

52 Accounting for characteristics continuous mapping  :  → [−1, 1] to be such that: (0) = 0;

 > 0.

The second quality is non-controversial. It simply states what was argued earlier; the higher the average utility of the trustworthy relative to opportunists, the higher the relative socialization efforts of trustworthy parents. However, the combination of the two conditions together is not innocuous. It says that if, and only if, average utility realized by either type is equivalent, there is no evolutionary pressure for change. Checking whether this specification allows the possibility for both types, requires considering the form of utility specification used. This will be ensured as a parametric restriction in the next chapter. The goal of this chapter is now complete, the replicator dynamic that will be used to describe preferences evolution is:   βt+1 − βt = βt (1 − βt ) A[uTt ] − A[uO t ] .

(4)

This replicator allows fitness to enter, but only through its effect on utility, it also allows whatever else we put in the utility function to affect selection. As I have argued above, this seems a desirable feature for a cultural replicator. A couple of its features are worth reiterating explicitly. First, it allows that next period’s β is affected by the predominance of β types in the population today. This works through two avenues: for given efforts at socialization by trustworthy parents, (d T fixed) the higher is β the higher will be β in the next period in simple reflection of their greater starting numbers. Also, as β is larger, even if not socialized to be like one’s parent, there is a higher chance that someone outside the family will socialize in the same way. A second feature is that relative benefits matter, since utility realizations determine socialization effort levels. This allows for change in the system to be driven by type rewards and avoids a tautological account. The precise way relative benefits matter will be specified in the next chapter where we spell out the utility functions used.

4.4

Summary

Following Chapter 3 which argued that trustworthy individuals were essential for firms to be able to exploit the scale economies, complementarities and specialization of modern production, this chapter’s aim was to develop a framework which could be used to analyze the emergence of differing types. It has been argued that cultural evolution could not be adequately treated by evolutionary models that use a replicator model of selection based entirely on fitness or payoffs only. If parents are the primary agents of socialization, though payoff considerations are important, non-pecuniary motivations should also enter into the selection mechanism. The greatest drawback of a purely fitness-based selection mechanism is that it generally requires awkward accompanying assumptions to yield types that are anything other than pure payoff maximizers.

Accounting for characteristics

53

The chapter has instead adopted a model of cultural selection pioneered by Bisin and Verdier (2001). The process corresponds to parents choosing the preferences of their children (probabilistically) by deciding how much effort to expend on socialization. This decision is informed by payoff considerations, but not uniquely so. Parental effort at socialization rises if being the parent’s type tends to yield higher payoffs. Higher parental socialization effort then implies a higher chance of the child being like the parent. If not socialized by a parent’s direct efforts, children develop according to external societal influences in a manner that reflects the frequency of the differing types in the population. The main substantive assumption about this process is that the relative probabilities of type socialization depend on the average utility realizations of those types in the population. But, the framework is still incomplete since the factors leading to utility outcomes have not yet been specified. Since these will depend on the outcomes in the broader economy, this requires specifying a model of the broader economy.

5

A model of trustworthiness in production

Chapter 3 argued that, to understand why modern production methods that require vulnerability may be limited in developing countries, it is necessary to incorporate a broader view of individuals than the merely self-interested and opportunistic one usually used in economics. Chapter 4 outlined an evolutionary framework that could be used to provide an endogenous treatment of individuals, and which would allow for a broader type than purely self-interested opportunists to emerge. This chapter develops a model that embeds that view of the individual in an economic context. Its aim is to analyze the endogenous determination of the population’s degree of trustworthiness and to explore how this trustworthiness interacts with the productive side of the economy. Another aim here is to provide an endogenous determination of social capital. Here, the level of trustworthiness in the economy, can be interpreted as the economy’s social capital. By exploring the dynamic and mutually causative interaction between factors that are traditionally considered economic (those relating to pecuniary incentives), and those that are considered cultural (those relating to non-pecuniary motivations and dispositions like trustworthiness) the framework provides a theory of social capital formation. The next section sets out the formal structure of the model and its underlying assumptions and the chapter proceeds to characterize the equilibria that arise in this framework. The final part of the chapter provides interpretation of the models results and relates these to the findings of studies in developing economies. A nontechnical summary of the model is also provided.

5.1

The basic model

The model developed here is “simple” rather than comprehensive. There is no attempt at generality, and the presentation is littered with statements like – “this can be simplified without affecting the results.” The aim is to use this model to learn something about policy. Thus, mathematical simplicity is useful here as it allows perturbing and extending the model to answer policy questions – the goal of the next chapter. The danger of simplicity is that it is possible to confuse innocuous assumptions (which make life easier, but could be relaxed without much effect) with critical ones (that might look the same, but are central to the model’s results).

A model of trustworthiness in production

55

I attempt to avoid this by drawing attention to the critical assumptions as they are made, and discussing simplifying assumptions at the end of the chapter.68 We first start in a situation that will be characterized as the pre-modern, LDC economy. We are, as in the previous chapters, concerned with production that occurs outside the family unit and in which the possibility of formal contracting is not present. The discussions in Chapter 3 emphasized complementarities and jointness in production, and these will be present here. In some cases there was mutual vulnerability of trading partners on all sides of the relationship. But, in the modeling here we allow the vulnerability to fall on only one side of the interaction. Though, in reality, the inception of valuable trading relationships may be risky for both partners, it is far easier to model if we separate analysis of the decision making regarding trustworthiness of the other party, that is, the risk taking behavior, and the trustworthiness itself. 5.1.1

Agent types and returns to production

There are two separate agent types in this model. On the one side are the potential risk takers, who are called “entrepreneurs.” These are the firms who must take the first step in starting the relationship. This first step involves vulnerability to the risk of exploitation. Without their initial risk taking there is not even a chance of developing a beneficial interaction. They need, but cannot depend upon, the trustworthiness of their trading partner, termed the “contractor.” Contractors do not bear risk in the project, but their contributions are essential to entrepreneurship being successful. Knorringa (1999), in his study of Agra footwear producers from Chapter 3, provides a stylized description of the ever-present risks that businesses face. His account corresponds closely with the way we shall model entrepreneurial risk here. What he calls “A” below are the entrepreneurs and “B” the contractors: . . . B has the opportunity to choose whether he will cooperate with, or behave opportunistically towards, A. Moreover as A must choose his action before he knows which choice B will make, A takes calculated but uninsured risk. Although rational businessmen do not take risks lightly they also cannot afford not to take chances . . . In short, the degree to which A trusts B, is the extent to which A assumes he can predict B’s behavior to be collaborative. (Knorringa 1999, p. 70) There is a unit measure of potential entrepreneurs. Each period they can either enter into what we shall term “modern” production, which leaves them vulnerable to opportunism on the part of contractors, or stay in “traditional” production, where there is no such vulnerability. We can think of traditional production as that occurring using labor from within the family unit, or engaged in simpler tasks where the possibilities of opportunistic gain are not present. Normalize returns to traditional production at 0 each period. If the contractor undertakes the actions required, and modern production is successful, total gross returns from the project

56 A model of trustworthiness in production are an amount π(pt ). The value π is strictly positive, and pt ∈ [0, 1] denotes the measure (or proportion) of the unit interval of entrepreneurs who enter into modern production in period t.69 The values of π are bounded between a lower bound, π l , and upper bound π u . There are diminishing returns to such production so that π  (pt ) < 0, which implies that the lower bound occurs when all entrepreneurs are in modern production, π(1) = π l , and is most productive when the fewest producers undertake it, π(0) = π h . We also assume that π  = 0. The diminishing returns could be either because entrepreneurs that enter undertake the better projects first, or, abandoning the assumption of homogeneity, if entrepreneurs on the interval vary in their inherent capacities, with the more able entering first.70 Risks are modeled as a sunk cost, k > 0, borne by the entrepreneurs, which cannot be recouped. If the contractor fails to contribute correctly, the entrepreneur earns an amount −k. The formalization here then reflects the concerns for losses on fixed, sunk investments, as described at length in Barrett (1997, pp. 560–4) and the references therein. There is no formal contracting in this environment. That is, as emphasized almost universally in the literature on business networks, the law cannot regulate the relationship between the entrepreneur and contractor sufficiently to control the interaction between them. This lack of contracting is pervasive. Not only is it impossible to hold the contractor liable if the correct effort is not contributed, but there is also no possibility of writing an ex ante contract between the parties that will divide the spoils, π(pt ), in case of success. Ex post, returns are “owned” by both participants, and we do not have much to say about the way a division occurs. Instead, we simply model it as a split that is determined by an exogenous bargaining process. The entrepreneur receives proportion απ(pt ) and the remainder (1 − α)π(pt ) goes to the contractor.71 The division of these returns is immaterial, provided it is the case that there is no way for the risk taking partner to receive the full amount, π(pt ). Once again we return to why this matters later, and why any divisions other than this one will lead to qualitatively similar results. We model the contractors according to the considerations in Chapter 4. There is also a unit measure of these individuals who must take actions that are critical to the success of the project.72 For now we leave out discussion of how individual pairings come about, and simply consider what happens between a matched pair consisting of a risk taking entrepreneur and the contractor with whom they interact. At the project’s start, the contractor promises to provide the correct action to the entrepreneur. To make things concrete, the examples of the previous chapter – providing reliable quality inputs, at a reliable time – can be kept in mind. If the correct action is taken, the project is successful with certainty. If not, it fails with certainty. The moral hazard problem arises because the contractor gains a financial benefit of amount b > 0 if NOT performing the action required correctly. Though there is no formal contracting here, introducing the possibility of formal contracting over some elements of the relationship would only change interpretation, provided there remained components that could not be so controlled. For example, allowing formal contracting over the timeliness of delivery, which could lead to substantial

A model of trustworthiness in production

57

punishment of the contractor for lateness, the amount b then corresponds to reducing quality in a way which could not be described by the contract. It is then the benefit from not having to exert the effort required to produce high quality, or the savings that come from substituting cheaper inputs, or the cost saving from not engaging in proper quality control, or it could, alternatively, denote the monetary benefit the contractor can expropriate from the project. By enriching the framework to allow contracting over some elements of the interaction, the amount b then corresponds to whatever is left over after all the things that can be contracted over have been. We model this amount as independent of the entrepreneur’s fixed cost, k, though they could alternatively be linked. This is again without loss of generality. 5.1.2

Preferences

Contractors are either inherently trustworthy or opportunistic. Once having promised to undertake the correct actions, trustworthy individuals would never choose to do otherwise. Violating their undertaking would make them so much more worse off that they do not even consider it. Here we follow Platteau closely: The fact of the matter is that often operating in individuals are internal rewards and sanctions which are manifested in the form of self-satisfaction feelings aroused by abidance of the honesty code and in the form of guilt feelings . . . conformity becomes a motive of its own because it is intrinsically rewarding or because deviation is intrinsically costly. (Platteau 2000, p. 298) Such individuals receive internal rewards from fulfilling their commitments, and this is what gives rise to the possibility of the trustworthy type emerging in the population. That is, when making good on their promises they receive a psychological, non-pecuniary benefit, which we model here as an amount γ . Platteau (2000, p. 299) provides a comprehensive review of the sociopsychological literature investigating this.73 The term γ is measured in the utility metric. For simplicity, utility is also assumed to be linear in income and the γ term. Thus, the utility of a trustworthy person, uT , can simply be expressed as the addition of these two components: uTt = yt + dt γ , where dt = 1 if the individual has met promised commitments, and dt = 0 if no such commitments were made in the period. We do not explicitly use notation for the utility realized when breaking promised commitments as we assume this is low enough to never be chosen. Once again, it is as if trustworthy individuals simply cannot choose to do otherwise. Opportunists differ in that they always maintain the possibility of violating their commitments without personal loss. They neither feel a sense of remorse when

58 A model of trustworthiness in production violating promises, nor feel good when delivering on their promises. They are thus exactly like the individuals at the heart of neoclassical models, and used by New Institutional economics.74 As in these standard models, such features do not rule out their keeping commitments, but simply link commitments to the situational logic of the case at hand. For these opportunists the amount γ = 0 always. They have a utility function, uO , that only depends on the amount of income they earn in a period, linearly, that is: uO t = yt . Modeling two starkly different types is a convenience, but not essential. In reality individuals differ in a more continuous fashion. Allowing for this here would complicate matters, but not change qualitative results. 5.1.3

Evolutionary selection of preferences

The determination of individual type, that is, inherently trustworthy or opportunistic, is determined by the evolutionary process that was set up in Chapter 4. Recall that the proportion of the population that is trustworthy in any period t is denoted by βt . Individuals who are trustworthy suffer a fixed lifetime loss of F . This is because they have a smaller choice set than opportunists. This reduced choice set is generally detrimental throughout life, which is captured in the term −F . On the other hand, such an individual benefits intrinsically in situations where he or she is able to act in a trustworthy manner, the term γ above, so this has the potential to offset the costs of F . From Chapter 4, we saw that a process of socialization involving choice by parents and then random socialization failing that, leads to a cultural replicator as: βt = βt+1 − βt = βt (1 − βt )(A[uTt ] − A[uO t ]),

(5)

where A denotes the average of economy wide returns to a type and  is an increasing function with (0) = 0.75 Notice that the replicator used here is backward looking since it is average returns for a type, calculated in the current period. If we instead take a forward looking replicator, which uses the expected value to estimate returns to a type in the next period, results are unchanged.76 Note the “slow” adjustment implied by such an evolutionary specification. If average returns to being trustworthy are lower than to being an opportunist, that is, A[uTt ] − A[uO t ] < 0, then there will be fewer trustworthy individuals next period, but they will not go to zero immediately, or need not fall by so much that the differential A[uTt ] − A[uO t ] goes to zero. Returns can only be computed on average because contractors are unsure that they will be able to trade with an entrepreneur. By design, we are interested in situations where the pecuniary logic of the contractor’s decision favors not fulfilling their obligations, as in Chapter 3. In that

A model of trustworthiness in production

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case, only contractors who are trustworthy will perform as required. Opportunists will not. A simple restriction that ensures this is: (1 − α)π h < b.

(6)

Given equation (6), opportunists will never meet promises of reliable delivery when contracting with entrepreneurs, so the utility obtained by an opportunist when trading with an entrepreneur is b, that is, uO = b. A trustworthy individual, however, because of the immense disutility to deceiving their trading partner, delivers the good or service as promised and realizes their share of a successful project; (1 − α)π(pt ). In addition, they receive the non-pecuniary benefit, γ , but, they have also suffered a lifetime loss from their reduced choice set of F , so that their lifetime utility is uT = (1 − α)π(pt ) + γ − F .77 If an individual of either type does not have the opportunity to trade with an entrepreneur, we simply assume that they achieve pecuniary rewards normalized to 0. In that event, the lifetime utility of a trustworthy individual is simply uT = −F , and the opportunist obtains uO = 0. 5.1.4

Utility realizations and entrepreneurship

In general, pt , which denotes the proportion of potential entrepreneurs, need not coincide with the probability of a contractor trading with an entrepreneur. The probability of meeting an entrepreneur naturally rises with more of such individuals in production, but it also depends upon: the number of each type of entrepreneur relative to the contractors, the number of contractors that each entrepreneur trades with, and the number of meetings they typically have. Given their opportunity costs of trade, any contractor, both opportunistic and trustworthy, is better off trading with an entrepreneur than pursuing their alternative, yielding utility, 0. Opportunists would cheat and obtain b > 0, trustworthy would trade honestly and receive (1 − α)π(pt ) > 0. Since there is a stable measure 1 of contractors in the population in each period, the number of contractors who are willing to trade strictly exceeds the number of entrepreneurs. For simplicity, we assume that each entrepreneur in modern production matches with one, and only one, contractor once in their life. If one side of the market is in excess supply, the rationing is done randomly. The assumption conveniently allows that pt , which is endogenous, denotes both the proportion of entrepreneurs and the probability of a contractor meeting an entrepreneur. In a well functioning market, where the good or service provided could be contracted upon, competition on the side of the market in excess supply, the contractors, would drive prices down to cost levels. But in this market, entrepreneurs have no way of identifying the reliable contractors. Moreover, there is no way to contractually specify the ex post division of the trading surplus, so the effective price of working with a contractor is fixed at (1 − α)π(pt ) in the case when a successful product is realized, or 0 when nothing is produced, since there is no profit to share. Recall that since type is not observable, the entrepreneur cannot know, before trade, which outcome will ensue.

60 A model of trustworthiness in production For given pt we can obtain the average lifetime utility of a contractor of either type. It is: A[uT (pt )] = pt [(1 − α)π(pt ) + γ ] − F and A[uO (pt )] = pt b, recalling that the notation A[uJ (pt )] denotes the lifetime average utility of a type J = O or T , with proportion pt entrepreneurs in modern production. Substituting these values into the replicator function yields an expression describing the evolution of β, the proportion of trustworthy agents in the population, as a function of the proportion of entrepreneurs entering modern production, pt , that is:   (7) βt = βt (1 − βt ) pt [(1 − α)π(pt ) + γ − b] − F . Note again the “slow” adjustment implied by such a specification. Even if average returns to being trustworthy are lower than to being an opportunist, that is, A[uTt ]− A[uO t ] < 0, not all individuals immediately become opportunists. Instead, since the term in large parenthesis is negative, there is negative pressure on β, but adjustment is gradual. If β is either 0 or 1, then there is no adjustment. These points are thus always points of rest in this framework, but it will be seen that they share very different stability properties, which we will consider further subsequently. 5.1.5

Dynamic adjustment of entrepreneurs

The equation of motion for pt is more straightforward. This describes the risktaking behavior of entrepreneurs. The critical assumption here is that entrepreneurs can enter and exit quickly relative to the speed at which individuals’ characteristics change. A simple way to model this is to assume that, if there are profitable opportunities for risk taking, entrepreneurs enter to exploit them until either all potential entrepreneurs have entered, or until the profitable opportunities are dissipated. If, however, entrepreneurs are expected to make losses, then some entrepreneurs will leave, until either all entrepreneurship ceases, or expected returns have risen so that those remaining find it worthwhile. Since these changes can occur quickly, we assume that they all occur within a period.78 The expected value of undertaking entrepreneurship depends on the proportion of trustworthy individuals in the population: E[απ(pt )] = αβt π(pt ) − k,

(8)

since a project is only successful when the entrepreneur trades with a trustworthy type; occurring with frequency βt . Thus, motion in this dimension is described by

A model of trustworthiness in production

61

the following equations: if αβt π(pt ) − k < 0

then pt = 0,

(9)

if αβt π(pt ) − k > 0

then pt = 1,

(10)

if pt ∈ (0, 1)

then αβt π(pt ) − k = 0.

(11)

These equations of motion imply immediate, that is, within period, adjustment on the part of the entrepreneurs.79 Equation (9) states that if expected returns to risk taking are below zero, the alternative riskless return, then potential entrepreneurs choose not to take risks, pt = 0. Equation (10) says that if, however, these returns were to exceed zero, then all potential entrepreneurs would take risks. The final line (11) says that if some, but not all, potential entrepreneurs are taking risks, then expected returns to risk taking just equal expected returns to the alternative activity. The variable p is thus a jump variable which implies that entrepreneurs are always in equilibrium, entering or exiting risk-taking behavior depending on expected returns. This is not meant to be a literal description of reality. Instead, it is the speed with which entrepreneurs adjust relative to “types” that matters for the results that will be developed here. The critical difference between these and the equation of motion for trustworthiness, equation (5), is the speed of adjustment. 5.1.6

Parameter restrictions

Consistent with the studies in Chapter 3 we are interested in modeling the interaction between profitable risk taking and inherently trustworthy types. We thus assume that, trustworthiness is essential for positive returns to risk taking. That is: Assumption 1 If everyone is trustworthy, then production is always profitable: απ(1) = απ l > k. Assumption 2 If no one is trustworthy, then production can never be profitable: π(0) = π u
∞. Assumption 2 simply puts a finite bound on profits. It seems a natural assumption to make, but is noted here explicitly since it is inconsistent with the often used Inada conditions. Assumption 1 is less innocuous. Trustworthiness has substantial “bite” in the model simply because it is so important in production. Assumption 1 ensures that ALL potential entrepreneurs would be able to take risks and produce profitably if only there were enough trustworthy individuals around. In order to give rise to the possibility of interior solutions from the perspective of individuals we have to also assume that

62 A model of trustworthiness in production

(1–
)(pt )

0

pt

Figure 5.1 Effect of p on entrepreneur’s profits

Assumption 3 (1 − α)π h + γ − b > 0. If this did not hold, evolutionary forces could never favor the selection of the trustworthy type. That is, the net pecuniary benefit to being trustworthy in the best possible case, that is, when it yields highest possible returns relative to an opportunist, (1 − α)π h − b, plus the utility benefit to such action, γ , has to be positive.80 It must also be assumed that returns to trustworthiness are not so high that it would always be chosen irrespective of the economic environment in order to avoid a tautological account of trustworthiness. That is: Assumption 4 (1 − α)π l + γ − b < 0. These assumptions thus allow the possibility, discussed at the end of the last chapter, of giving both types the chance to emerge endogenously. Recall that we have assumed that π  (pt ) < 0, which makes the relationship downward sloping as shown in Figure 5.1. The linearity follows from our restriction that π  = 0, but this is not necessary. All that is required is the slope. However, from an entrepreneur’s perspectives it is not just απ(pt ), returns when production is successful, that matter, but also the probability of such returns being realized. Recall that this depends on the proportion of trustworthy contractors, βt , as follows: E[απ(pt )] = βt απ(pt ) − k.

5.2

(12)

Steady state

The interaction between equation (7) and equations (9)–(11) determines the model’s steady states. A steady state occurs both when entrepreneurs are in

A model of trustworthiness in production

63

equilibrium, and when evolutionary forces do not favor a change in types. In order to understand where this happens it is first necessary to more carefully analyze how contractor “type” returns change with a change in entrepreneurship. 5.2.1

Analysis of type returns

Consider again the term (7) and, in particular, the term in large parenthesis which describes the average returns to trustworthiness relative to opportunism, A[uT ] − A[uO ]: pt [(1 − α)π(pt ) + γ − b] − F.

(13)

Note first that the sign of equation (13) determines the direction of evolutionary change. If positive, evolutionary forces increase trustworthiness in the population. If negative, opportunism increases. It is immediate, by inspection, that it does not directly depend on β. Since this term plays a central role in determining the equilibrium (or steady state) configurations, we first need to evaluate how it is affected by pt . The expression depends in a non-linear way on the proportion of entrepreneurs, pt . This enters in two ways. First, the probability of interacting with an entrepreneur depends on their frequency, represented by the term pt outside the square brackets. For both types in the population, trading with an entrepreneur is good: for the trustworthy it implies a net return of (1 − α)π(pt ) + γ , for the opportunists it is a chance to cheat and obtain b. The relative benefit for each type determines whether increases in the probability of trading enhance or diminish trustworthiness. But, these relative benefits themselves depend on pt . Since the function π is decreasing in pt , the term (1 − α)π(pt ) + γ − b is monotonically decreasing in p. This is simply because, as the proportion of successful trades increases, the marginal one creates less surplus. As already argued, this could arise for any of the usual reasons that lead to diminishing marginal returns. Computing the derivative of expression (13) with respect to pt yields: (1 − α)π(pt ) + γ − b + pt (1 − α)π  (pt ).

(14)

This may be negative or positive depending on the relative sizes of exogenous parameters and the value pt . However, the second derivative of the expression (13) simply reduces to: 2(1 − α)π  (pt ) < 0.

(15)

(Note that the linearity of the function π(p) plays a simplifying role in removing any π  terms.81 ) Since the second derivative of the whole expression is negative and the term (1 − α)π(0) + γ − b = (1 − α)π h + γ − b > 0, we know that the function initially slopes upwards, at p = 0 and then reaches a unique turning point at which it changes slope. Thus, the function is of the form as shown in Figure 5.2. Values on the vertical axis are not labeled since we do not, as yet, know the value these returns take over the relevant range of p.

64 A model of trustworthiness in production

pt [(1–
)(p t ) +  –b ] –F

pt

Figure 5.2 Effect of p on relative returns to trustworthiness

5.2.2

Existence

In this section we establish the model’s main existence proposition. As will be seen, this proposition has two components, one relating to the existence of the interior points of rest, and the other to their stability properties. We proceed here by stating the proposition and then proving the various components of it over the next two sections. Proposition 1 Under Assumptions 1–4, if and only if there exists at least one value of p ∈ (0, 1) such that p[(1 − α)π(p) + γ − b] − F > 0. Then there is a unique stable interior equilibrium, (pA , β A ) in which: β A (1 − β A )(p A [(1 − α)π(p A ) + γ − b] − F ) = 0 and β A απ(p A ) − k = 0. We will proceed by first proving the sufficiency part of the proposition. In the next section we look at the dynamics of this model economy which will allow us to corroborate the “stability” assertion in the statement of the proposition. The necessity part of the proposition is shown in the appendix of this chapter, since it is not that interesting in itself. Suppose that there exists at least one value of p denoted p  , such that p  [(1 − α)π(p ) + γ − b] − F > 0. Then, there exists another value of p denoted pA with 1 > pA > p  , such that pA [(1 − α)π(p A ) + γ − b] − F = 0. This follows immediately from the continuity of π in p and Assumption 4 which states that (1 − α)π l + γ − b < 0. The continuity and boundedness of π (Assumption 2)

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65

pt [(1–

)(p t ) +  – b ]

F

pB

pA

Figure 5.3 Evolutionary forces for different values of pt

also ensure that there exists a lower level of p, that is, 0 < p B < p  such that pB [(1 − α)π B + γ − b] − F = 0. Note that, for p < pB and p > pA returns to trustworthiness are below those to opportunism (i.e. p[(1−α)π(p)+γ −b]−F < 0 in these ranges) however, for p ∈ (p B , pA ) returns to trustworthiness exceed those from opportunism. This is depicted in Figure 5.3. Between the two points pB and pA evolutionary forces lead to upward pressure on the proportion of trustworthy individuals in the population, however, outside this range, evolutionary forces imply a decrease in trustworthiness. Intuitively, this is because at the bottom end, when p is low, though returns to interacting are high for the trustworthy, they are unlikely to obtain such interaction because there are few entrepreneurs around. Then, as p increases to within the range (pB , pA ) the increased likelihood of trading with an entrepreneur increases expected returns to trustworthiness. However, at very high levels of p, though there is a good chance of trading with an entrepreneur, returns are relatively low, and, in particular, not high enough to generate sufficient rewards to justify the other costs, F . The necessary and sufficient condition of the proposition merely assumes that there are at least some values of p for which the curved line crosses the flat line in the figure. We can depict the evolutionary implications of these p ranges for changes in β, that is β, in a simple phase diagram in (β, p) space. A phase diagram shows how the dynamic forces affecting variables change for different values of those variables. Since the motion of β is only affected by the values that p takes, the dynamic forces in β will be uniform for given values of p as depicted in Figure 5.4.

66 A model of trustworthiness in production ∆ = 0

∆ = 0

t

pA

pB pt

Figure 5.4 Phase diagram for β

For low values of p < p B there is downward pressure on β, hence the downward pointing arrow in the figure in the first panel. The same is true for the last panel representing high values of p > pA . In the middle, where diminishing returns have not set in greatly and the probability of trading with an entrepreneur is high enough, there is positive evolutionary pressure on β; hence the upward pointing arrow there. The only values at which there are no evolutionary incentives for a change in β are the values pA and p B . We now turn to construction of the phase diagram for p which depicts how the actions of entrepreneurs are affected by “types” in the population. The critical relationship is the one equating returns in modern production with their outside option, that is, the relationship determining points at which entrepreneurial incentives are balanced between entry into modern production and remaining in traditional production to receive returns of 0. This relationship is given by setting equation (12) to 0: βαπ(p) = k.

(16)

This can also be represented in (β, p) space. It solves for points where p = 0. First, note that, since π  < 0, this function is upward sloping in (β, p) space because higher values of p imply a lower value of π(p), thus requiring a higher value of β to generate equality with k. Note also that, for values of parameters above the function, entrepreneurs have incentive to enter production since expected returns exceed fixed costs, and the converse is true for points below the function. When β = 0, we know from Assumption 2 that equation (16) can never hold, even for p = 0, thus when p = 0, equation (16) only holds when β > 0. Thus, the point at which this function cuts the β (vertical axis) in (β, p) space must be positive. Now consider what happens when p = 1. From Assumption 1, we know that if β = 1, then απ(1) = απ l > k so that equation (16) will not hold. It can thus only

A model of trustworthiness in production

67

1

t

∆p = 0

0

1 pt

Figure 5.5 Phase diagram for pt

hold at p = 1, if β < 1. Note here the crucial importance of these assumptions for guaranteeing existence of the interior steady states: by ensuring that the p = 0 function cuts the vertical axis above zero and is less than 1 at p = 1, it guarantees that p = 0 is interior valued for the whole range of p. This will ensure it always has a crossing point with the β = 0 correspondence of Figure 5.4. We are now ready to draw the phase space for entrepreneurs in (β, p) space (Figure 5.5). Once again the arrows describe the direction of change in the variable p depending on the location in (β, p) variable space. In the bottom portion of the diagram to the right the combination of relatively low levels of trustworthiness, low β and relatively high amounts of entrepreneurial entry, high p, together imply expected returns for entrepreneurs in modern production are lower than those in traditional production, so that p falls – the left pointing arrow. Conversely, in the upper lefthand range, the relatively high number of trustworthy types and low numbers of entrepreneurs ensure returns are profitable, so that there is entrepreneurial entry into modern production – the right pointing arrow. Combining the two phase diagrams, Figures 5.4 and 5.5 yields the phase space for both endogenous variables. The points of intersection then correspond with points of stability of the system. Note also that since p is always in the interior of the space, these points of intersection always exist. At these points, labeled (β A , pA ) and (β B , pB ) in Figure 5.6, evolutionary forces do not cause a change in the proportion of trustworthy types in the population, β = 0, as their returns just equal those of the opportunists. Also at these points, the proportion of entrepreneurs is stationary, p = 0, since there are no extra returns to be gained by either entering or leaving risk-taking behavior. The arrows in the regions describe the dynamics of the system outside of the steady state (Figure 5.6). These are derived by combining the arrows in Figures 5.4 and 5.5 for each of the six regions.

68 A model of trustworthiness in production 1

t ( A, p A)

( B, p B)

0

pA

pB

1

pt

Figure 5.6 Steady states

The directions of change for any one point in the space can then be traced by following the indications given in the arrows. Only the points (β A , pA ) and (β B , pB ) are stationary. By analyzing these dynamic forces we are able to determine the motion of the system starting from anywhere in the phase space. This is important for determining the likely resting point given an initial starting value, which we do now. 5.2.3

Stability and dynamics

Analysis of the stability of a steady state in an evolutionary system described by difference equations is an indirect method of establishing the robustness of such a state against mutations. By definition, in a steady state, the system is at rest and there are no endogenous forces leading to change in the model’s variables. Stability analysis asks what happens if, instead of being exactly at the steady state, variables are slightly perturbed from their steady-state values. One way of interpreting such slight perturbations of the system is as representing the entrance of differing types, or in the case of interior equilibria where both types are already represented, as the existence of slightly too many (or too few) of one type relative to the steady-state configuration. Stability exists, simply, when such a slight perturbation sets off endogenous changes in variables that tend to drive the system to adjust in the direction of the steady state. In the present context, if there are slightly more opportunists than the steady-state proportion, a stable steady state is one in which changes in relative returns (perhaps induced by accompanying changes in entrepreneurship) lower evolutionary pressures for opportunism. Conversely, an unstable steady state would see an increase in evolutionary pressures for opportunism when there are slightly too many opportunists.

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Recall that in equations (9)–(11), we assumed that entrepreneurs respond relatively quickly to changes in their opportunities, but individual types change in a more gradual way. This corresponded to the notion that individual characteristics, though variable and thus not determined by exogenous considerations, are relatively slow to change in comparison with the actions of entrepreneurs who size up likely returns to risky and non-risky production and act so as to maximize returns quickly. This difference is central to the model’s results. The change in individual types is not viewed as a decision, but something intrinsic to the individual. Though influenced by economic factors, these change in a gradual manner. Firms’ adjusting, however, is a change in the actions of rational, profit seeking agents. This, we conjecture, is subject to much more rapid adjustment. The net effect of these assumptions is that, from any point in the phase diagram, adjustment will be rapid in the horizontal (p) direction, while being gradual in the (β) direction. For simplicity, our equations (9)–(11) starkly assumed that adjustment in the p direction is immediate, entrepreneurs simply do not persist in production when making losses, and enter immediately to exploit chances for gain. Thus, in terms of our phase diagram, this implies that if starting from a point out of either steady state, the next period there is adjustment, horizontally, so that a within period equilibrium (which may not be a steady state of the whole system) must nonetheless be an equilibrium for entrepreneurs, and is thus always on the upward sloping line, p = 0. Note that this is in sharp contrast with evolutionary incentives for individual types. Within period returns for one type will strictly exceed the other whenever the system is not in steady state and this can persist for a number of periods. Thus, the dynamics of the system from points that are out of steady state are extremely easy to analyze. They are simply immediate horizontal movement to the upward sloping p = 0 line, which are the points of equilibrium for entrepreneurs. It remains now to consider where the system moves from points on this line. Here I provide an informal but intuitive analysis of dynamics in the vicinity of the steady states. A more formal examination is provided in the appendix. First, both pairs (β A , pA ) and (β B , pB ) are steady states and therefore points of rest for the system. If starting there, the system will remain as is. However, both of these points are not equally likely to occur. Consider first the lower pair (β B , pB ). Suppose that the system is slightly perturbed so that, instead of being precisely at the point (β B , pB ) it is slightly away from this point, even by an arbitrarily small amount. Consider for instance a point such as the point labeled m in Figure 5.7. At this point, returns to risk taking, for entrepreneurs, strictly exceed returns to staying out. This is because the point m is above the p = 0 line, implying that, at this value of β, the level of entrepreneurial entry is too low to have fully exhausted all of the potential for profit. So the immediate movement in the system is horizontally in the eastward direction as depicted by the dashed arrow, towards the line p = 0. That is, entrepreneurs know that there are positive expected returns to be had in risky modern production and they enter. At this point, however, evolutionary forces favor an increase in the trustworthy types because there are higher returns to trustworthiness than opportunism between the points p B and p A . Recall the reason for this is that, at these points, there are sufficiently many entrepreneurs

70 A model of trustworthiness in production

1

∆p = 0

t m ( B, p B)

0

pB

pA

1

pt

Figure 5.7 Divergence when starting in vicinity of (β B , pB ) 1

∆p = 0

n

t

( A, p A)

0

pB

pt

pA

1

Figure 5.8 Convergence when starting in vicinity of (β A , pA )

for the chances of profitable interaction to be high, but not so many that marginal projects are of low value. This tends to further increase β and entrepreneurs respond by increasingly entering production, that is, p continues to rise. This process of mutually increasing β and p continues, pushing the economy away from the point (β B , pB ), as depicted by the dashed arrow pointing in the northeast direction. It can be verified that a similar process of divergence from this point occurs if we start slightly below the point (β B , pB ). In summary, when the system is not already at the point (β B , pB ) there is no way that it can be reached, moreover even slight changes from (β B , pB ) lead the system away from that steady state. We thus conclude that, though the point (β B , pB ) is a steady state, it is unstable, thus extremely unlikely to occur and not worth analyzing. Consider the other steady state (β A , pA ) and suppose that the system is slightly away from that point, say at the point n depicted in Figure 5.8.

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1

t ( A, p A)

( B, p B)

0

pA

pB

1

pt

Figure 5.9 Convergence paths in interior

Then, by the same reasoning as above, horizontal adjustment leads to a point on the upward sloping line slightly above the steady state, that is, entry of entrepreneurs. Here, however, returns to projects are relatively low and trustworthiness, rewarded with (1 − α)π , is too low relative to b. Thus, at this point, evolutionary forces favor a decline in β, as they did in Figure 5.4. This downward adjustment will occur along the line p = 0, and continue until the steady state (β A , pA ) is reached. It can be verified, by taking points anywhere in the vicinity of (β A , pA ), that such a process of immediate horizontal adjustment, and approaching the steady state along the p = 0 locus, always leads to (β A , pA ). Since the same convergence is true for all points in the local vicinity, we conclude that this is a stable steady state. Figure 5.9 depicts all paths of convergence and divergence in the interior. Since p is a jump variable, convergence, or divergence, is always along the arms of the p locus. In the stable steady state (β A , pA ) the economy’s level of trustworthiness, β A , makes it worthwhile for some measure of entrepreneurs to engage in risky production. At the measure p A , entrepreneurs are just indifferent to entering risky production given β A . In turn, the existence of a proportion pA entrepreneurs implies that trustworthiness has a good chance of being rewarded and therefore maintains evolutionary pressure on sustaining the level β A . At points below p B the system diverges towards p = 0. This is because when the proportion of entrepreneurs in modern production is too low, evolutionary incentives for trustworthiness are declining. As the proportion of trustworthy decline, incentives for entrepreneurs to enter modern production fall further still. This starts off a downward spiral of declining trustworthiness and declining modern production.

72 A model of trustworthiness in production 5.2.4

Interpretation

In the stable interior steady state we have a number of trustworthy individuals whose continued existence is important for production, reflecting the considerations central to Chapter 3. The model provides an account of where this trustworthiness comes from. The main feature giving rise to trustworthiness is economic rewards, and the assumption underlying the replicator used here is simply that the higher the level of these rewards to being trustworthy, the greater the amount of trustworthiness in the population. In reality, these rewards correspond to the share of profits that both parties would receive when having created a successful productive arrangement. The model also makes clear, however, that these financial rewards depend critically on the willingness of entrepreneurs to take risks. The financial rewards are also not enough in themselves. To see this, simply set γ = 0 and note that the condition required for existence then implies p[(1 − α)π(p) − b] − F > 0. But from equation (6) this condition can never hold. It is thus, also important that there are non-pecuniary rewards to sustain the trustworthy equilibrium. As I have argued above, these are the intrinsic motivations that individuals obtain from interacting with each other and fulfilling their obligations. The existence of these motivations is introspectively plausible and is widely argued for. The assumption that opportunism is always better financially rewarded than trustworthiness, condition (6), implies these are essential. A further implication of this is that admitting the non-pecuniary component of preferences into the replicator dynamic, which comes from the cultural selection model adapted from Bisin and Verdier (2001), is critical in supporting trustworthiness. Without it, that is, using a more standard fitness-based replicator that does not allow a role for non-pecuniary components, the model can never generate a steady state with positive proportion of trustworthy types and provides no insight into the process of social capital formation. One way to see the model’s interaction between production risk and trustworthiness is as a formal demonstration of the point about trustworthiness that has been made by Seligman (1997) and earlier before him by Luhmann (1979). According to them, inherent trustworthiness is only needed when there is both the possibility and the pecuniary benefit for individuals to act in ways that are not prescribed by duty. However, the very existence of that possibility itself gives rise to these trustworthy individuals. Trust then is a recognition of alter’s (that is, the other’s) agency, an agency which, we recall, only appears when the “fit” between the person and the role is loose, when the role does not – indeed cannot – circumscribe all of alter’s possible behavior. This is the meaning of that freedom of the other that Luhmann refers to in explaining the emergence of trust. The freedom involved is not an ontological condition of existence but a socially determined and structured aspect of personality which – for reasons worked out above – developed most saliently (if not uniquely) in modern social formations with their increased division of labor and system differentiation. (my italics) (Seligman 1997, pp. 62–3)

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This is slightly beyond the model’s context, but seems a close analogy. Entrepreneurs, by choosing modern production that depends on inherent trustworthiness, allow for the possibility that individuals are no longer predictable in their actions based on their traditional or within group roles. This “freedom” to choose actions that will be damaging to the other, brings with it the need for trust, and, as the model makes clear, by providing some pecuniary benefit to the trustworthy, as well as the intrinsic benefit, this generates the conditions under which trustworthiness can thrive. In turn, trustworthy individuals, by making production viable, allow the entrepreneurs to enter and to profit. This beneficial interdependence between risk takers and the trustworthy captures an optimistic development scenario. One interpretation of this outcome is as similar to that which has been suggested to have occurred in early postwar Japan. Economic development in Japan depended not only on individuals ready to take chances but also on the cooperative, concerted efforts of many persons imbued with a relatively high sense of mutual trust and social responsibility. (DeVos 1973, p. 182). Note that, in this steady state, there are still a proportion (perhaps large) of contractors who are opportunists. Williamson (1985) has argued that, in a world where even though there are some types who are trustworthy, there exists opportunists, there will be a kind of Gresham’s law of trust: I do not insist that every individual is continuously or even largely given to opportunism. To the contrary, I merely assume that some individuals are opportunistic some of the time and that differential trustworthiness is rarely transparent ex ante. (Williamson 1985, p. 64) In Williamson’s view this leads to the conclusion that, in their own defence, individuals must always assume they are interacting with someone who is not trustworthy, and thus protect themselves. This, however, does not happen in the interior steady state (p A , β A ). Our analysis, in fact, argues that this very lack of protection – or vulnerability to opportunism – actually plays a central role in allowing the inherently trustworthy types to develop. Entrepreneurs know that they are vulnerable to such opportunists, that these opportunists are out there trying to exploit, and that they cannot be identified. However, they still persist in risky entrepreneurship because they believe there are enough trustworthy individuals present to make the risks worthwhile. Note finally, the proposition’s “only if” component allows us to rule out the cases when values of F do not permit two crossing points. The formal proof of this is not so interesting here, but the necessity of the assumed parameter configuration is dealt with in the appendix.

74 A model of trustworthiness in production (1, 1)

1

t ( A, p A)

( B, p B)

(0, 0)

pA

pB

1

pt

Figure 5.10 Convergence paths to all steady states

5.2.5

Corner steady states

In addition to the interior steady states analyzed above, there also exist steady states at the two extreme values of p. If p = 0, evolutionary forces clearly favor a reduction in β since there are simply no profitable opportunities for trade and no chance of realizing either γ or (1 − α)π . So from the point at which p = 0 meets the vertical axis in Figure 5.9, there is downward pressure on β. There is also downward pressure on p at this point, but since there are no entrepreneurs anyway, p cannot fall any further. Figure 5.10 shows the direction of movement at the lower extreme of the diagram. The proportion β will continue to fall until the origin is reached. At the origin with β = 0 and p = 0, the system is again at rest in steady state. It should be clear that this steady state is stable; starting at points within its vicinity. Convergence will occur along the path depicted by the arrows in Figure 5.10. Strictly speaking, given the replicator used in equation (7), (β = 1, p = 1) is also a steady state, but this can also be verified to be unstable by again taking a point in the vicinity and using the same reasoning as in the previous section. The appendix also provides a formal proof that this steady state is not stable. 5.2.6

Interpretation

The corner equilibrium, at (β = 0, p = 0), has a meaningful interpretation which helps to shed light on situations like that of “amoral familism” depicted by Banfield’s (1958), study of a South Italian village Chiaromonte (which he fictitiously called “Montegrano”). There, he described a dramatically zero-sum view of the world: “. . . any advantage given to another is necessarily at the expense of one’s family” (p. 114). In this steady state there are none, or almost none, of the

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ascriptively trustworthy type in the population. The cardinal rule of behavior is: maximize the material short-run advantage of the nuclear family, assume that all others will do likewise. (Banfield 1958, p. 85) It is similar to the situation vividly described by DaMatta (1985) quoted in Harrison (1992) and repeated from Chapter 4: If I am buying from or selling to a relative, I neither seek profit nor concern myself with money. The same can happen in a transaction with a friend. But, if I am dealing with a stranger, then there are no rules, other than the one of exploiting him to the utmost. (DaMatta 1985, p. 40) Since everyone behaves opportunistically, entrepreneurs know that if they take risks, they will be cheated, and they wisely desist from trading. However, given there are no entrepreneurs in the market place, evolutionary forces favor opportunism because the trustworthy never get the chance to obtain pecuniary and non-pecuniary gains. This steady state corresponds to a very bad outcome in the LDC context. It is a complete breakdown of trust (i.e. risk taking) and trustworthiness. Transactions are limited to ones like those described below by Fafchamps: When firms feel uncertain about the reliability of a client or supplier they fall back on a “flea market” mode of transacting: inspect the goods on the spot, pay cash and walk away with it. (Fafchamps 1996, p. 444) Platteau (2000, pp. 313–14) has also highlighted the problem of trust’s undermining trade in Sub-Saharan Africa. Not surprisingly, such a situation is not conducive to the emergence of complex modern production.

5.3

Non-technical summary

Here we provide a non-technical summary of the preceding model and its equilibria. As we saw in Chapter 3, the ability to trust one’s trading partners is a necessary pre-condition to allowing oneself vulnerability to them in trade. It was argued that lacking this, development of modern production requiring specialization that allowed firms to exploit scale economies and complementarities in complex production would not be possible. We saw there also that the usually posited solutions to the problem – formal contracting and informal contracting based on repetition and reputation were not sufficient, in reality, to mitigate the risks involved.

76 A model of trustworthiness in production What was needed were trustworthy individuals. And, as numerous authors have agreed, this is an inference about the inherent type of individuals with whom one will trade. Chapter 4 then provided a framework through which the determination of type could be analyzed, by modeling the socialization process using an evolutionary framework. In it, parents are the first step in socialization, and evaluate the actions and outcomes of their offspring using their own preferences. If they estimate that a child with preferences like their own will do well, then they place more effort into socialization. The goal of the model in this chapter is to embed the process of individual preference formation into a broader model of the economy’s productive process. 5.3.1

Risks and production

The economic actors in this model who undertake production are called entrepreneurs. Central to Chapter 3 was the notion that risk under modern production arose due to the inability to fully control all components of the process. Also, these risks could not be mitigated by contract, and were costly to the entrepreneurs. These entrepreneurs thus face an entry decision. They choose whether to risk losses by attempting modern production, or whether they stay in traditional production, which, though of lower productivity, has guaranteed safe returns. For simplicity, assume that they know nothing about the nature of the people they will trade with, when undertaking modern production. This is not always the case in reality, and the more they know, the lower the risks involved. They will avoid the opportunists in favor of the trustworthy using that knowledge. But, recall Chapter 3 argued that even though people organized in groups sharing strong social bonds or common ethnicity had good knowledge of each other’s characters, and could be well disposed towards each other in a way that mitigates risks, the breadth of interactions required to successfully undertake modern production meant that vulnerability to unknown agents was inevitable. The limitations imposed by kin groups meant these could also not engender modern production. So a critical decision process here concerns the willingness of entrepreneurs to engage in trade with people about whom they know nothing. If, by chance, they meet an opportunist, they will make losses, and if they trade with a trustworthy agent, they will gain. Since they do not know details of particular individuals, their decisions are dictated by their expectation of the underlying proportions of individuals in the population. If they expect most people are trustworthy they will enter modern production. If not, the potential losses involved are high enough to keep them out. 5.3.2

Determination of types

Using the socialization process developed in the previous chapter we now relate the evolution of types to the decisions of firms. The trustworthy are individuals who value keeping their word. Once they have promised to do something, they will try their best to follow through on that promise. This may not always be possible,

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but it will not be because they have been tempted away by financial gain. Even if, once having promised, it turns out that they can reap substantial financial gain, they will not do so. For these people the very act of keeping a promise is valuable, and is a source of utility. Opportunists do not care for promises they have made. They only calculate the net financial gains to following a course of action, and this dictates their decisions. Entrepreneurs undertaking modern production are prey. They would happily trade with them because such trade yields the chance to cheat the entrepreneur for financial reward. The trustworthy would also be happy to trade with entrepreneurs. This trade, when successful, creates mutual financial benefits, and both parties share in these. The trustworthy also benefit from delivering on their promised course of action. They could, of course, also do what opportunists do – cheat and reap higher financial gain – but, this would not make them better off, since they value keeping their promises. From the previous chapter, evolutionary processes dictate that the frequency of either type in the population is a function of their average, or expected returns. Entrepreneurs are complementary with the trustworthy. When they come together in modern production mutual benefits are created. Opportunists benefit too from there being many entrepreneurs, since this increases the chance that they will meet someone to cheat. But, they are a drain on the entrepreneurs. 5.3.3

Speeds of adjustment

The socialization process giving rise to types is akin to the formation of individual personalities. Though it may be possible for an individual’s personality to change through their life, it is likely that this will take a long time. A population of potential trading partners is not stationary, however, new people are born into it and older ones die out. However, even such change in the identity of the agents is gradual. The speed at which the level of trustworthiness in a population changes is thus best considered as gradual. In contrast, the speed by which entrepreneurs can adjust their decisions about whether to enter into modern production, is something that changes quickly. If the returns to modern production dramatically fall, then entrepreneurs contemplating setting it up will not do so. Moreover, those already in production will leave. Unlike the formation of a personality, business decisions can be changed rapidly in response to profit and loss opportunities. 5.3.4

Equilibrium

Now consider the interaction between the types in the population and the business decisions of the entrepreneurs. An equilibrium is a situation in which the entrepreneur’s decisions on whether to enter or exit modern production are in balance with the evolutionary forces dictating the proportions of trustworthy individuals in the population. If, for example, entrepreneurs entered modern production en masse because they all expected that there were a large proportion of trustworthy

78 A model of trustworthiness in production individuals in the population, but the evolutionary incentives favored the selection of opportunistic preferences in that case, then the system would be out of balance. There would either be evolutionary incentives for a decline in the proportion of trustworthy individuals (with so many entrepreneurs in modern production) and/or, there would be incentives for entrepreneurs to leave modern production if there were few trustworthy individuals. When there are incentives for one or both sides of the interaction to be altered, then the system can never be in equilibrium. If, however, given the number of entrepreneurs in modern production, evolutionary incentives dictate that there be no change in the proportion of trustworthy types, and in turn, given that proportion of trustworthy types in the population, entrepreneurs just find it worthwhile to enter modern production in the initial numbers, then the system is in equilibrium. There are two points of balance, and hence two equilibria, in this system of interaction between entrepreneurs and trustworthy types. 5.3.5

No entrepreneurship – no trust

Suppose that entrepreneurs believe that all individuals in their population are opportunists. Under this belief, all expect that upon taking risks in modern production they will trade with an opportunist, be cheated and make a loss. They, thus, prefer to remain in traditional production. But, if all entrepreneurs remain in traditional production, any trustworthy individuals in the population never get the opportunity to trade. The trading partners with whom they are complementary, the entrepreneurs in modern production, do not exist. In contrast, opportunists are individuals who do not benefit from interaction per se, and who only care about the financial benefits of action. Consequently, given the possibility of intrinsic rewards is not present, evolutionary forces favor selection of the opportunists. With a population that is full of opportunists, the decision of entrepreneurs to not enter into modern production is a sensible one, so the system is in equilibrium. 5.3.6

A trustworthy equilibrium

Suppose, instead, that entrepreneurs believe that, though not always the case, people are generally trustworthy. If the chance of meeting an opportunist is low enough, entrepreneurs will then think it is worthwhile to undertake modern production. Consider the impact on evolutionary forces of entrepreneurs entering into modern production. Opportunists do well, because they now have the chance of meeting and stealing from entrepreneurs. But, the trustworthy do better. The trustworthy, when trading with entrepreneurs reap lower financial benefits than the opportunists, but they gain from their intrinsic enjoyment. Parents will thus choose to inculcate trustworthiness into their children because they know that, though yielding less financial gain, trustworthiness has a good chance of yielding its own intrinsic benefits.

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An equilibrium ensues then, when for a given number of entrepreneurs, evolutionary incentives to be opportunistic just equal incentives to be trustworthy. If this is the case, the current proportion of trustworthy individuals will repeat itself through time and thus be in a position of balance. The entrepreneurs then, expecting a given proportion of trustworthy individuals, enter into modern production upto the point where the expected gains from it equal those to staying in traditional production. At this point, there are neither incentives for entry nor exit of entrepreneurs from modern production so that the system is stable.

5.4

Conclusions

The chapter has shown the co-existence, for identical underlying parameters configurations, as stated in Assumptions 1–4, of two different, though equally stable, steady states.82 One of these sees the emergence and sustaining of trustworthiness as a population trait. Never, as is seen from the instability of the β = 1 steady state, for every single member of the population, but for a substantial enough number to allow risky projects to be attempted. In such an economy, risk taking is not always rewarded, and there are always going to be instances of opportunism and of failed initiatives. But the presumption on the part of entrepreneurs is that people are generally trustworthy enough to instigate risky projects with. They are thus willing to trust, as in Baier’s definition, this is to experience: accepted vulnerability to another’s possible, but not expected, ill will (or lack of good will) toward one. (Baier 1986, p. 235) Social capital, as represented by the population’s degree of trustworthiness, plays a critical role in allowing this, but is neither the sole, nor an exogenous, driving force. It is affected by the actions of rational profit seeking economic agents. The actions of entrepreneurs – their taking of risks – allows the critical trait of trustworthiness to be rewarded, so the social capital is endogenous to this system as reflected by the determination of β. At the same time, however, the existence of economic rewards to these entrepreneurs is also not exogenous as their profits from, and hence willingness to, take risks depends on the amount of inherent trustworthiness they can attribute to their contractors. Their actions are represented through the endogenous term p. Both β and p are simultaneously determining and determined factors, locked together, in an interior steady state, in a mutually beneficial supportive relationship: entrepreneurs rationally decide, given the prevalence of trustworthy individuals in the population, to start up risky undertakings; evolutionary forces then support the existence of trustworthy individuals since they benefit more from the undertakings, which, in turn, reinforces the decisions of the entrepreneurs. The existence of an equally stable “no trust” situation at the (β = 0, p = 0) equilibrium, that is, no entrepreneurs and no trustworthiness, makes it clear that this story is not culturally deterministic. There is nothing at all intrinsic to this

80 A model of trustworthiness in production population that makes it able to be in the trustworthy as opposed to the no-trust equilibrium. The mutually reinforcing nature of both equilibria lead to the conclusion that the very same people who are capable of the trusting equilibrium are also capable of the complete breakdown of trust. In some ways then, though we have developed a framework able to account for social capital, endogenously, and able to provide some account for a diversity of real-world experiences, we are still left short of “explanation.” That is, in our framework nothing tells us whether we will be in one of these steady states or the other. Though we can rule out the unstable steady states, what can we say about which one of the stable ones the economy will be in? Everything here depends on initial conditions, and at this point, it would be tempting to follow the time-honored tradition of pointing back to history, and “special” country specific considerations that would explain why countries fell into one steady state and not the other. Though I believe this is both useful and essential for understanding the particular trajectories followed by particular countries, this is not the task for which I have constructed this model. I instead want to use this model to gain insight into the PROCESS of development. That is, taking history (which I can say little about here) as given, I ask what are the changes in the system that tend to succeed, that is, tend to promote the things like trustworthiness and risk taking, that are the hallmarks of progress and economic growth. Conversely, what are the changes that tend to make development fail, that undermine risk taking, trustworthiness and lead to stagnation. This is the goal of the next chapter.

5.5 5.5.1

Appendix: some proofs Necessity part of existence proposition

Suppose that for all p ∈ (0, 1), p[(1 − α)π(p) + γ − b] − F ≤ 0. Necessarily, then either p[(1 − α)π(p) + γ − b] − F < 0 for all p in the range or for some p, p[(1 − α)π(p) + γ − b] − F = 0. Suppose the first situation holds so that p[(1 − α)π(p) + γ − b] − F < 0, if this is the case then for all p, β/t = 0. Thus, the only point of stability for the system is β = 0. However, if β = 0, then necessarily from Assumption 2, p = 0. Thus, it is not possible to sustain an interior equilibrium. Now suppose the second situation holds, so that, for some p at least p[(1 − α)π(p) + γ − b] − F = 0. First, note that from the fact that π  < 0 it can only be the case that this holds at a single point. Let that point be denoted p. ˆ At p, ˆ and only at p, ˆ do evolutionary incentives allow the development of some trustworthy types in the population. This implies that there could not possibly be an interior steady state at any point other than p, ˆ and if we can rule out stability at such a point then we will have proved the proposition. The instability of such a stationary point is similar to the instability of the lower internal steady state (β B , pB ), so we do not analyze it separately.

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Dynamics

We show here that for the two interior steady states (β A , pA ) and (β B , pB ) the latter of these is necessarily unstable, whereas the former is locally stable. First note that from equations (9)–(11) in the interior, necessarily, p = 0 always. Thus, αβπ(p) = k always, which implies that, p/β > 0 in the interior. Since p adjustment is immediate to ensure this equality, the stability of the system is determined by analysis of the β equation. For simplicity, let period length be small here and compute this as time derivaties instead of discretely, so that we have:   dβ = β(1 − β) p[(1 − α)π(p) + γ − b] − F . The change in this with respect to β is: d2 β =

d(·) d [β(1 − β)] · (·) + β(1 − β) . dβ dβ

At either interior steady state (·) = 0, so that the first term cancels. The sign then depends on the second term and can be reexpressed as follows: d2 β = β(1 − β)

d(·) d(·) dp . = β(1 − β) dβ dp dβ

From above dp/dβ > 0, and d(·)/dp =  (·)[p(1−α)π  +(1−α)π(p)+γ −b]. Since  (·) > 0, the sign of the expression depends on the previous expression in square brackets. Consider first the steady state (p B , β B ), the square bracketed expression there is (1 − α)π(pB ) + γ − b + pB (1 − α)π  (p B ) > 0, where the sign follows from this point being on the upward sloping part of the schedule p[(1 − α)π(p) + γ − b]. Thus, since this implies d2 β > 0, the steady state is unstable. Consider next the steady state (p A , β A ). The bracketed expression is (1 − α)π(pA ) + γ − b + pA (1 − α)π  (p A ) < 0, where the sign follows from this being on the downward part of the schedule p[(1 − α)π(p) + γ − b]. Thus, since this implies d2 β < 0, the steady state is stable. Thus, interior steady state (pA , β A ) is the unique stable one. 5.5.3

Proof that corner steady state (β = 1, p = 1) is unstable

If β = 1, dβ = 0 from equation (7), also from Assumption 1, βαπ(p) > k for all p, thus, from equation (10) dp = 1. Thus, (1, 1) is a steady state. To consider stability, again reconsider the expression d2 β: d2 β =

d(·) dp d [β(1 − β)] · (·) + β(1 − β) . dβ dp dβ

At (1, 1) dp/dβ = 0 since we are not on the dp = 0 locus, but at a corner value for p = 1, so substituting in for β = 1, p = 1 into the  expression and noting

82 A model of trustworthiness in production that (d/dβ)[β(1 − β)] = 1 − 2β we obtain: d2 β = (1 − 2β) · ((1 − α)π(1) + γ − b + (1 − α)π  (1)) = (1 − 2β) · ((1 − α)π l + γ − b + (1 − α)π  (1)) = −((1 − α)π l + γ − b + (1 − α)π  (1)). Note that from Assumption 4, (1 − α)π l + γ − b < 0 and since π  < 0 always we have d2 β > 0. Thus, the (1, 1) steady state is unstable.

6

The anatomy of development success and failure

This chapter uses the model developed previously to determine the type of changes that are likely to be successful in nurturing development and those that are likely to fail. Once the model’s results have been developed, we then discuss which of the many simplifying assumptions are critical for those results and which are merely convenient. The first task of the chapter is, however, to define what development means in the model, and to establish a means by which to evaluate successful change.

6.1

Development and welfare

The definition of development that I use here is consistent with that followed by Ray (1998). It is sustained increases in GDP per capita. Though controversial to some, as Ray (1998, ch. 2) has pointed out, this measure is generally well correlated with the things that do correspond more highly with human welfare – child mortality, literacy, education, health, etc., so it is not a bad short cut measure to take. In our present context, the engine of development will be the implementation of more productive technologies in the modern entrepreneurial sector. As we saw in Chapter 3, in addition to the strong emphasis on inherent trust required for modern production, the other major differences between LDC and modern production were increased specialization and the scope from exploiting of scale economies in the latter.83 An obstacle to the exploitation of these scale economies is the small size of domestic markets in LDCs, in comparison with domestic markets in developed economies, and in comparison with the world market. But, a small domestic market need not impede use of more productive technologies if firms can sell on world markets. The idea is that their cost advantages due to cheap labor should allow less developed economies to find their activities of comparative advantage and trade successfully abroad. The previous chapter should already cast suspicion on the simplicity of such a prescription. In particular, as the (β = 0, p = 0) no-trust equilibrium suggests, it is possible for an economy to be mired in a situation without the very ingredients necessary to produce and trade modern production on world markets. In that event, even free and open access will not enable firms to exploit the potential economies of scale presented by modern technologies, since they will be impeded by the

84 Anatomy of development success and failure lack of trustworthy trading partners. Where there is a complete breakdown of trust, even if trade offers substantial profit opportunities (in terms of the model, provided (1 − α)π remains less than b), the economy will not be able to instigate modern production. However, this assumes that all trade is in goods that constitute modern production. An alternative avenue to sustained increases in GDP per capita is to trade in goods and/or services where the difficulty in contracting over the particulars of the relationship are not present. A possible area may be primary good production, where extraction or reaping can presumably occur much more completely within a company or unit than in modern manufacturing production where we have already seen that business networks and extensive use of subcontractors play an important role. But even here, in the transporting, marketing and trading of the output to world markets, the cooperation of diverse actors would seem necessary. Though not impossible as a path to development, such a primary production lead push was not followed by the successful late developers. Moreover, even if it could be for the newly developing countries, it is not clear that successful modern primary production for world markets, as opposed to small-scale subsistence production, is devoid of the concerns regarding trustworthiness and lack of contractibility that we have seen play an important role in modern industrial production. The possibility of modernizing technologies and exploiting scale economies was part of the reasoning, motivating the shift in focus away from import substituting industrialization towards export led industrialization in the early 1980s. Up until the 1960s and, in most countries until the end of the 1970s, LDCs followed policies that largely dissuaded trade. These included, overvaluation of the currency, quotas on imports, tariffs, directed subsidies, low interest rates with credit rationing and directed financing to favored sectors (usually heavy industry). Debt servicing problems that occurred through the 1980s led to the partial abandonment of most of these measures at the behest of both the World Bank and IMF. Also, even where aggregate financial problems were not the direct precipitating factor, the demonstration effect of the successful late industrializers of East Asia (Taiwan, South Korea, Hong Kong and Singapore) which, though also having a heavy role for government, focused on export markets, lead to a wave of change in policy to redress biases against trade. These effects were manifest to greater or lesser degree in most developing regions of the world: in Sub-Saharan Africa and Latin America, largely through structural adjustment programs and even in South Asia, where levels of indebtedness did not mandate change externally.84 The expression of this in policy occurred throughout the 1980s and into the 1990s. It has been argued that industrial clusters or supply networks occurring in cottage industries and small manufacturing enterprises were the areas most challenged by the shift to openness over the period, see, for example, Altenburg and Mayer-Stamer (1999, p. 1700). This will be the focus of the policy analysis undertaken here. We shall abstract from the details of these policy changes and model the main impact of openness in a two-fold manner. An opening to trade implies, on the one hand, the possibility to import cheaper mass produced goods

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from abroad, which is a potential threat to producers who are selling to a local market. This was the case of clusters considered by McCormick (1999) in Africa and for those clusters of producers analyzed in Latin America by Altenburg and Mayer-Stamer (1999) where the largest threats were cheap imports from East Asia. On the other hand, the potential to access world markets and the considerable advantages in marketing and exploiting scale economies that this affords, provides an opportunity for enhanced productivity and profit if standards can be raised sufficiently to compete on an international scale. Before modeling these changes we first develop criteria by which outcomes in the model can be evaluated. This involves specifying how welfare is measured in the model. 6.1.1

Welfare in the model

Recall that there are two types of agents in the model, entrepreneurs, who simply enter and exit modern production depending upon profit opportunities, and contractors who can be socialized to either opportunism or trustworthiness. Different types have different utility functions, and moreover, the frequency of each type in the population is endogenous and thus varies with the equilibrium outcome. This complicates statements about welfare, as making unambiguous welfare rankings across steady states may involve trading off increases in the welfare of one type with a decrease in its population frequency. We will avoid the need for such comparisons here by defining a welfare measure that only involves partial orderings. Consider then two different Situations A and B, each of which allows potentially different expected outcomes for entrepreneurs and contractors in the model. We use the following notion of welfare improvement: Definition Situation A is an unambiguous welfare improvement over Situation B if, and only if, in Situation A the average utility of each agent type – entrepreneur, trustworthy and opportunist – is at least as great as it is in Situation B, and, moreover, at least one of the agent types has strictly higher utility, on average, in A than in B. Reciprocally, Situation A is an unambiguous worsening of welfare in comparison with Situation B if and only if in Situation A no agent type has higher average utility, and at least one type has strictly lower average utility in A compared with B. The ordering implied by such a definition is only partial because it does not compare welfare across situations where some types are made strictly better off and others strictly worse off. It is a natural and intuitive analog of the Pareto criterion for improvement in our environment where the frequency of types can differ. We will use this definition of welfare in order to judge the impact of policy changes in our environment. We first compare the stable interior steady state (β A , pA ) with the stable corner steady state (β = 0, p = 0).

86 Anatomy of development success and failure Proposition 2 Welfare in the stable interior steady state (β A , pA ), exceeds that in the stable corner steady state (β = 0, p = 0). The welfare criterion simply compares welfare for each type of agent in steady state. Consider the agent types in turn. In steady state (β A , pA ) the expected utility of an opportunist equals p A b, which clearly exceeds the expected utility of zero in the corner steady state. Now consider the trustworthy. In any interior steady state, the expected utility of a trustworthy type must be equal to that of an opportunist. If not, evolutionary incentives would favor one type over another, violating the steady-state conditions. Thus, the expected utility of a trustworthy type at (β A , pA ) which equals p A [(1 − α)π(p A ) + γ ] − F = p A b > 0. Since this also exceeds zero, the trustworthy are also better off in the interior steady state than in the corner steady state. Finally, in both steady states, entrepreneurs earn zero expected profit so they are indifferent across situations. Thus, since two of the agent types are strictly better off and the other is no worse off, the interior steady state is a welfare improvement.

6.2

Modeling development

An economy in the no-trust (β = 0, p = 0) equilibrium, will not benefit from access to improved modern production and possible economies of scale in world markets except trivially, where (1 − α)π in this case can exceed b. If that happens, the concerns of contracting incompleteness, opportunism and the hold-up problem which were the focus of the cases examined in Chapter 3, are no longer relevant, since, even lacking contractibility and a means of ensuring division of gains ex post, trading opportunities are so lucrative that cooperation will be ensured. The tone of the studies in Chapters 2 and 3 is that the opposite in fact happens with development, so I will not model such a case. It suffices also to simply note that in an economy starting in the complete no-trust equilibrium, the changes I will look at here will not affect that. Of more interest are the possible development paths of an economy which starts in a situation that at least has the underpinnings for modern production to occur – where the problems that arise due to a complete lack of social capital are not present. Thus, I will examine a possible development path for an economy with a relatively good historical endowment of social capital; one already in an equilibrium like the A equilibrium of the previous chapter. Recall that such an equilibrium contains a significant proportion of trustworthy agents already present, β A . Also, as a consequence of their presence, there are a significant number of entrepreneurs, p A , who are able to undertake production that is risky. It allows for the chance of loss (amount k), and exploitation by those they trust (amount b), but nonetheless, when successful, yields profits that are lucrative enough (amount απ) to warrant the risks. I ask here, does opening up to trade on world markets, which both allows and necessitates investments in increasing the scale of modern production, lead to an increase in the amount of modern production and consequent increase in trustworthiness, entrepreneurship and welfare, or a reduction?

Anatomy of development success and failure 6.2.1

87

Opening to world markets

In order to focus on the features of interest here – trustworthiness and entrepreneurship – the general equilibrium consequences of accessing world markets and implementing a new technology, will not be modeled. A standard trade model would require endogenously computing the prices of traded goods and services, both traditional and modern, and thereby endogenously determining whether producers in the home country would specialize in either type of good, or produce a mixture of both when trading. Embedding the model of production and trustworthiness developed in the previous chapter into such a properly formulated trade setting would be complicated, and I will not attempt it here, primarily because this complexity would add very little. Instead, I introduce some short-cuts in the treatment of the trade side of the model, in order to focus on its implications for development. In particular, I model the opening up to trade as consisting of two implications for exogenous parameters which are spelled out in the next section. The advantage of treating it this way is that it allows us to explore the implications for the variables of interest without adding additional structure. A disadvantage is that these “reduced form” implications are exogenous, I leave further discussion of this to the subsequent section which examines the implications of relaxing simplifying assumptions. 6.2.2

Implications of openness

Trade allows a larger scale of production which, although involving higher set up costs, raises profitability of the undertaking. The parametric implications of this are: (i) The variable k increases, reflecting the higher fixed cost involved in production at the larger scale. Denote the new variable k W > k, where W mnemonically denotes “world” markets. (ii) The value π increases, reflecting that, if successful, a larger market will generate higher unit sales and higher gross profits. Since π(·) is a function, we define a new function π W (·) which corresponds to an upward proportionate shift in the function π(·). This is depicted in Figure 6.1.

(1–

)(pt )

0 pt

Figure 6.1 Effect of trade on profits

88 Anatomy of development success and failure

6.3

The effect of openness on steady states and welfare

We establish the implications of openness to world markets for the steady-state configurations established in the previous chapter. It is first demonstrated that openness gives rise to an interior steady state with higher welfare, more risk-taking behavior and higher trustworthiness than (β A , pA ). Recall the two difference equations that govern the dynamics of this system. The evolutionary condition governing change in the proportion of trustworthy individuals is: βt (1 − βt )(pt [(1 − α)π(pt ) + γ − b] − F ) > 0, <

(17)

and the condition determining whether entrepreneurs enter into risky production is: βt απ(pt ) − k > 0. <

(18)

First consider the effect of openness on equation (17). For given p and β, substituting π W (pt ) for π(pt ) implies the term within the large parenthesis becomes pt [(1 − α)π W (pt ) + γ − b] − F , this corresponds to an upward shift of the curved graph in Figure 5.3, as depicted by the dotted line in Figure 6.2. Note, however that the flat line, F , is unchanged. As the figure shows, the net evolutionary effect is that the steady-state level of p required for there to be no evolutionary pressure for change is lower at the unstable steady state p BW < p B , and higher at the stable one; p AW > p A . In (β, p) space this implies a rightward shift in the locus β = 0 at the stable steady state and a leftward shift at the unstable one, which is depicted by the dotted lines in Figure 6.3.

pt [(1–
)W(pt ) +  – b] p t [(1–
)(pt ) +  – b]

F

pB p BW

pA p AW

Figure 6.2 Effect of openness on returns to trustworthiness

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1

t

0

p BW p B

p A p AW

1

pt

Figure 6.3 Effect of openness on p

The reasons for this are that openness generates greater returns for the trustworthy types, ceteris parabus, since they receive (1 − α)π which tends to rise, whereas the opportunists receive b, which is a constant. Thus, the range of p values for which evolutionary forces favor increased trustworthiness (i.e. between the vertical lines) should increase. We can now show that this effect in itself is sufficient to guarantee that any new interior steady state will have higher welfare. Proposition 3 Welfare across interior steady states is increasing in p. Consider two interior steady states, with p levels denoted p AW and p A < p AW , respectively. The expected utility of an opportunist, A[uO ] is pAW b and p A b in each one, respectively. Since pAW > p A opportunists have higher utility in the steady state with higher p. In steady state A[uO ] = A[uT ], so the trustworthy are also better off in the steady state with higher p. In interior steady states, entrepreneurs have expected profit equal to zero, so they are indifferent. Thus, openness ensures welfare rises since, as can be seen from Figure 6.3, if an interior steady state exists, it must occur at a higher value of p denoted p AW . The effect of openness on equation (18) is more complex. Figure 6.1 demonstrates the upward shift in the π component. But, offsetting this is the rise in fixed > costs with scale, k W . The net expression becomes βt απ W (pt ) − k W < 0. Whether this is greater or less than zero depends on the relative size of changes in π and k. To calculate the direction of change in the locus, hold p fixed and compare the value of β generated under the two cases. For a given p denoted p  , β in the pre-trade case is given by setting equation (18) equal to zero: β = k/π(p  )α. In the openness case it is β W = k W /π W (p  )α. When β > β W the locus shifts down to the right, and it shifts up to the left when β < β W . Thus, the condition determining the direction of shift in the locus, p = 0 is: k > kW . π(p) < π W (p)

90 Anatomy of development success and failure 1

t

0

pt

1

Figure 6.4 Downward shift in the p = 0 locus 1

t

0

pt

1

Figure 6.5 An upward shift to the left in the p = 0 locus

If k/π(p) > k W /π W (p), then there is a downward shift in the locus to the right as depicted in Figure 6.4. This condition is easier to interpret if rearranged to π W (p)/k W > π(p)/k. It implies that, though facing higher fixed costs to starting up production, entrepreneurs stand to earn proportionately higher returns under openness. Thus, for a given level of entry, p, the level of trustworthiness, β, required to ensure indifference to entry is lower. This corresponds to the case in which entrepreneurship depends LESS on trustworthiness when competing on world markets with higher scale. Conversely, if π W (p)/k W < π(p)/k, then the p = 0 locus shifts upwards and to the left as depicted in Figure 6.5. This direction of shift happens when the higher fixed costs rise more than proportionately with the increase in profits. The net effect then is that, to support a given level of entrepreneurship, p, it is necessary to have a higher level of trustworthiness, that is, β must rise. This is a case when entrepreneurship depends MORE on trustworthiness when trading on world markets.

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Since these two cases yield markedly different results, and since we cannot theoretically rule out either case, we analyze them both separately. 6.3.1

When openness decreases reliance on social capital

Consider first the case: π W (p)/k W > π(p)/k. In this case, the change in steady state configurations is as depicted in Figure 6.6 (with only the stable interior steady state depicted, in each case). The dynamics of convergence to the new interior steady state (β AW , pAW ) are depicted by the arrows in the diagram. As in the previous chapter, the dynamics involve a horizontal jump in the p direction until on the new p = 0 locus, and then convergence along there to the new steady state. The arrows depict an initial increase in entrepreneurship reflecting the increased rewards, but then, with lower evolutionary pressure for trustworthiness and its constant decline, subsequent falls in entrepreneurship until the new steady state is reached. Though depicted as lower in the figure, the change in level of β from the old to the new steady state is ambiguous since it depends on the relative size of the shifts in either locus. However, the level of p is unambiguously higher. Ambiguity in the direction of β change is caused by increase in profitability being so much higher than the increase in fixed costs, implying that openness may require less reliance on trustworthiness. The new steady state is a welfare improvement as stated in Proposition 3. It has higher risk taking, that is, more modern production, the same profits for entrepreneurs, since these are driven to zero by entry, but higher welfare for both types. The welfare increase is immediate for the opportunists, since, with more production, they have a greater chance of expropriating b, however, since average utility of the trustworthy has to be the same as the opportunists in steady states, the trustworthy individuals will also be better off.

1

( A, p A) t

(0, 0)

( AW, p AW)

p A p AW

p BW p B

1

pt

Figure 6.6 New and old steady-state configurations when downward shift in p = 0 locus

92 Anatomy of development success and failure This change paints an optimistic picture of openness as a path to development. It suggests that, when such openness involves a process that is LESS reliant on the trustworthiness of individuals (as evidenced by the fact that the same net level of returns can be obtained with a lower level of β) then it is bound to succeed. It leads to more production, higher p, and higher welfare. However, even though the current case cannot be strictly ruled out, there are serious reasons to doubt that investing in scale in order to access world markets requires less social capital, as here. In fact, the readings in Chapter 3 suggests the opposite. Increasing scale seems to imply more vulnerability to opportunism. Recalling Katz (1987), this vulnerability was a principle reason for using production methods requiring lower fixed capital and smaller scale. More reasonably, openness that forces the development of larger scale modern production should raise reliance on trustworthiness. We consider that case now. 6.3.2

When openness increases reliance on social capital

Now consider the case: π W (p)/k W < π(p)/k. For a given chance of success, that is, β fixed, the expected returns to risky projects fall, as evidenced by the upward shift in the p = 0 locus. The increase in risk-takers’ profits in case of success do not justify the higher risks imposed through greater fixed costs. This implies the viability of risky projects is MORE dependent on the proportion of inherently trustworthy individuals. The phase diagram now sees an upward shift in the p = 0 locus, as shown in Figure 6.7. In the figure, the new steady state is to the northeast of the old one. As in all internal steady states, expected profits of entrepreneurs are zero in equilibrium since they are dissipated by entry. But, now there is more entrepreneurship and more modern production. A second feature of the change is that trustworthiness levels end up unambiguously higher. This again seems to portray a case of success through openness. Even though the entrepreneurs do not obtain a sufficient amount of the returns to benefit from 1 ( AW, p AW) t ( A, p A)

(0,0) p BW p B

p A p AW

1

pt

Figure 6.7 New and old steady state with upward shift in p = 0 locus

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openness at a given level of β, and they are more reliant on trustworthiness, there is still more entrepreneurship in the new steady state. This is because evolutionary forces increase β in the new steady state. This rise in β in turn reinforces the entry of more risk-takers and the net effect is a mutually supportive higher level of both modern production and trustworthiness. Once again, welfare rises from Proposition 3. Entrepreneurs again enter to dissipate excess profits, so they are indifferent in the new steady state. The trustworthy have returns that are equivalent to the opportunists – the terms in parenthesis in equation (17) must equal 0 for a steady state. But the chances of an opportunist trading with an entrepreneur are higher, since pAW > pA , yielding higher average utility for an opportunist: pAW b > pA b. But then average utility for the trustworthy must also be higher. Though the move to open markets and the use of technologies that advantage scale gives rise to the possibility of a new, better, steady state, the path by which the economy approaches it is not as straightforward. Consider first this path in the case of Figure 6.7 where it is depicted by the arrows. As the economy opens up to trade there is an immediate and sharp decline in the amount of entrepreneurship, in contrast with the increase in Figure 6.6, and, hence a decline in modern production. The increased riskiness of the larger scale technology required to access world markets arises from the higher sunk costs. Since, initially at least, the trustworthiness level is unchanged, not all of the entrepreneurs who were previously willing to take a risk on modern production in a closed economy, are willing to do so in an open economy where larger investments are required. Thus, the initial effect of the change is a decline in modern production.85 The decline simply reflects the earlier assumption of fast reacting entrepreneurs relative to the slow adjustment in population’s type from the dynamics. With different dynamics in which the population type could immediately jump to its new steady state level, β AW , there would be no such decline. In any case, since the evolutionary forces created by openness lead to increased evolutionary pressure favoring the trustworthy type, in the next period, with more trustworthy trading partners, more entrepreneurs are willing to enter into modern production. This, in turn, increases evolutionary incentives for the trustworthy types and generates motion towards the new better steady state. The end result is convergence on the new better steady state where the initial decline in trustworthiness and risky production have been more than offset by their subsequent growth. Again this path sketches an optimistic scenario of development through opening to trade. The initial effect is immediately negative; a decline in entrepreneurship reflecting the greater risks involved with higher fixed costs. But, since social capital adjusts, the economy is able to successfully use the larger scale technology.

6.4

A failure of development

This optimistic conclusion changes dramatically once we consider a slightly different version of essentially the same change. This is where the model’s main policy

94 Anatomy of development success and failure implications are to be found. Consider the same directional shift as in Figure 6.7, but now suppose that the p = 0 locus shifts by slightly more. We can express this more formally as follows: Proposition 4 Suppose π W (p)/k W < π(p)/k and consider an economy starting in the (β A , pA ) steady state. Let p : αβ A π W (p) = k W be denoted p  . If p  < pBW then the economy uniquely converges to the welfare dominated stable steady state (β = 0, p = 0). This situation is depicted in Figure 6.8. Note now the direction the economy takes after the initial opening to trade. The horizontal jump to the left in p is the same direction as previously, now slightly larger, reflecting the fact that there has been slightly more exit of entrepreneurs, since expected returns are lower still. The value denoted p in the proposition simply solves for the value of entrepreneurship, p, that would ensue under the new parametric conditions (π W , k W ) with the old steady state level of β, β A . It can be seen that this slight decrease in entrepreneurship relative to the previous case has a devastating effect on the economy. As the convergence arrows show, now the final outcome of this process is unilateral convergence on the (β = 0, p = 0) steady state where there ends up being a complete breakdown of trust in the population and no modern production. As previously, the better steady state continues to exist. There is still the possibility of a good outcome with even higher levels of trust than in the pre-openness equilibrium available, but it cannot be reached. This depicts the pessimistic scenario for development through openness – a complete breakdown in fledgling modern production, rampant opportunism and complete dismantling of social capital. The measured welfare implication confirms this as a bad outcome. Both the trustworthy types and opportunists obtain their

1

( AW, p AW) t ( A, p A)

(0, 0) p BW p B

p A p AW

1

pt

Figure 6.8 A complete dismantling of social capital due to openness

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alternative utility, 0, (even though the trustworthy are a vanishingly small proportion in this steady state) and are strictly worse off on average. Entrepreneurs stay at zero expected profit. Moreover, this disastrous scenario occurs in an economy which is also perfectly capable of supporting both high entrepreneurship and high trust as evidenced by the existence of the (p AW , β W ) steady state, but which, nonetheless, sees production totally de-modernized by the opening to world markets. It should be emphasized that this is the UNIQUE path of adjustment to the change depicted in Figure 6.8. There are no alternative optimistic beliefs that could change this. 6.4.1

Interpretation

What is the difference between these two cases that leads to such dramatically different results? Recall that a central feature of this model, reflecting the discussions in Chapter 3, is the complementarity in production between risk-taking entrepreneurs and trustworthy types. The risk-taking entrepreneurs who stand to lose from opportunistic behavior depend on the trustworthy, but the trustworthy also depend on the entrepreneurs to provide the opportunities from which they will benefit the most. The critical difference between the scenario depicted in Figure 6.8 and the case of successful development in Figure 6.7 is that, in the case of Figure 6.8, the slightly larger decline in entrepreneurship implies p falls to the left of the pBW point. This means that because so many entrepreneurs have left, there are relatively few opportunities for the trustworthy to find beneficial trading partners. Even though the trustworthy who could find trade would be extremely productive, the scarcity of trading partners implies that evolutionary incentives switch to favoring opportunism. This sets in motion negative forces which tend to be reinforcing. In subsequent periods, further increases in opportunism encourage even less entrepreneurship, which, in turn, encourages even more opportunism and so on. In short, the opening to world markets and the opportunity to use a more productive technology sets the economy into a nasty downward spiral, the end result of which is a complete erosion of the initially good social capital prevailing in the population. This is truly a case of a development failure – there is an increase in opportunistic and selfish behavior, a complete dismantling of trust and any social capital that was there is gone. There is no possibility of modern production at all, even though the technology allowing it is freely available. 6.4.2

Application to Russia

The model’s main result cautions against rapid change when production depends upon social capital. The performance of post-Soviet Russia may be a case in point. Reforms that were introduced to make possible an outcome like (β AW , pAW ), appear to be driving the economy towards a steady state like (β = 0, p = 0). The socioeconomic position of many has deteriorated. There has been a worsening in the position of young people in the labor market, a growth in unemployment,

96 Anatomy of development success and failure including long-term unemployment (more than six months), and the emergence of poverty, which is exacerbated by relatively few of the unemployed receiving benefits. The early transition saw a remarkably rapid divergence in the income distribution, with an increase in the proportion of the population at the bottom of the scale and a thinning in the middle. By the end of 1992 the average per capita income of the top 10 percent of the population was almost five times higher than that of the bottom 10 percent, and by the spring it was more than eleven times higher, a sharp contrast with the compression of the Soviet era, see Tchernina (1994). Criticism of Russia’s reform process has emphasized the problems arising because individuals’ attitudes have been ignored. Tidmarsh (1993) argues that for three generations communism systematically weeded out workers with the greatest drive, leaving a demoralized and dissatisfied work force. This dates back to the earliest initiatives under Lenin where workers became clearly aware of a ratchet effect in performance assessment and solidified under Stalin where an implicit contract was formed between workers and the state; a low standard of living was balanced by the right to meet low quality standards. He suggests the situation could be described as “they pretend to pay us, we pretend to work,” see also Giordano (1995). Pejovich (1997) argues that neoclassical economics is ill-suited to understanding East European and Russian reform because it ignores the learned informal rules of behavior governing actions, and their effects on incentives and transaction costs. In an analysis based on North (1990), he argues that transplanting the formal rules of capitalist economies will fail without the informal rules, or norms of behavior, which also govern action. As the model here suggests, the needed higher levels of social capital may organically grow in response to the productivity improvements of the change. This is the case depicted in Figure 6.7. Alternatively, they could fall as in Figure 6.8. In the Russian case, many have suggested that the bedlam of the transition has worsened social capital in the younger generation. Tchernina (1994) argues that the lack of employment prospects implies it is mainly people over age 50 who have the values associated with work. Having been employed for longer, they are less alienated from the work process and more enthusiastic. She also notes survey data showing the young lack an appreciation of the social value of work. Szymanderski (1995) argues there is a view that the gains from market activity are a redistribution of wealth and not as the rewards individuals receive for creating value. Numerous others have emphasized a crisis of values in contemporary Russia. There also seems to be a pervasive lack of trust. It was estimated in 1998 that over 70 percent of all business activity in the Russian Federation was carried out through barter, Kingston-Mann (1999). If reforms are on a successful path, the model here suggests that there should be an upward trajectory in their development. The documented increase in the criminal class and their corresponding illegal activity, suggest that the norms or values needed to support modern production are not emerging, see Platteau (2000, pp. 330–4) for further evidence of this decline.

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Though an opening to world markets was part of the post-Soviet changes in Russia, the consequences of this are minor relative to the institutional and political changes experienced. Still, it is possible to interpret the changes as a shift in the production possibilities available. The model’s interpretation of this process is that the initially low social capital levels inherited from the Soviet era implied a mismatch between the level required to ensure successful production and that initially in place. Consequently, there is a lack of entering entrepreneurs willing to chance vulnerability in production, and little opportunity for the development of beneficial social capital. This corresponds to the reduced work opportunities experienced. Could the good outcome, as in Figure 6.7, have alternatively been engineered? The next section considers the model’s policy implications.

6.5

Policy

Development failure is by no means a necessary consequence of an opening to world markets. It instead corresponds to a number of special features of the changes. Since these changes also give rise to the possibility of a better outcome with the new interior steady state, it is possible that, if managed correctly, the destructive outcome could be avoided. The following are suggestions as to how this might be done. 6.5.1

Improved protection

If b can be lowered enough so that (1 − α)π W > b, then both types in the population have strict pecuniary incentives to deliver on obligations. This is much like the standard economic prescriptions which call for an improvement in property rights. Simply put, if contracting and enforcement can be improved sufficiently, the sociological or culturalist considerations pertaining to individual types become largely irrelevant. Entrepreneurs will trade without having to even believe anything about trading partners simply because the trading partner’s nature or type does not matter. This would be the case if the law, or an informal counterpart, provide sufficient enforcement. As the examples from developed economies in Chapter 3 suggested, there are reasons to doubt that contracting, either formal or informal, can ever be strengthened sufficiently to render type considerations irrelevant. Platteau similarly shares a pessimism about ever making formal enforcement sufficient. As he notes, in economies with bad civic records, advocating improved contract enforcement mechanisms, or credit rating, or enabling banks or financial institutions to better assess lenders, or promoting specialized commercial courts or improving auditing are all interesting possibilities, but, What is not said, however, is how judges will be made impartial and noncorrupt . . . , or how falsification of credit rating records will be prevented

98 Anatomy of development success and failure when powerful business people are designated as loan delinquents, or how the auditing of accounts will be made sufficiently independent to be reliable. So far at least, economists have had little to say on these vexed questions which are all the more difficult to solve as they tend to arise simultaneously. (Platteau 2000, p. 335) Such vexed questions relate to the economy’s social capital, which are precisely the policy conclusions we turn to now. 6.5.2

Encouragement of trustworthiness

Trustworthiness clearly provides an externality here, since the trustworthy make production viable and hence raise expected returns of entrepreneurs. By undertaking risky production and only receiving fraction α of the returns, entrepreneurs also provide externalities for the trustworthy. Optimal policy then should encourage activities generating positive externalities. There are numerous examples of government policies in LDCs aiming to do just this in the context of emerging industrial clusters. Altenburg and Mayer-Stamer (1999) provide a review of these policy initiatives, many of which are geared towards maintaining trustworthiness and enhancing cooperation in business networks. Some examples are: the Proyectos de Fomento in Chile and the Empresas Integrados in Mexico. These are government financed initiatives which promote the association of small enterprises. Their main objectives are to consolidate the building of trust amongst group members. These policies work through provision of subsidies, or tax advantages to joining members, who are then encouraged, along with other members, to explore areas of mutual gain and improvement. Another example are policies that indirectly reward cooperative behavior, for example, providing financial services for micro enterprises that build on group guarantees, as in Rhyne and Otero (1992). These also encourage and reward firms for building trust-based bonds. By providing direct financial rewards for increased trusting and facilitating that behavior, the model interprets government policy as improving the rewards of the trustworthy type and thus, improving evolutionary incentives for its maintenance. 6.5.3

Gradual change

The large size of the change in Figure 6.8 compared with Figure 6.7 is critical. If the change could be broken into smaller components, which are introduced sequentially and gradually, then the disastrous outcome, depicted in Figure 6.8, could be avoided. To see this, consider a convexification of the changes such that, instead of implementing the whole difference (k W − k) and [π W (p) − π(p)], only a fraction of the changes, say proportion φ < 1 are implemented in 1/φ steps. Thus, the initial change sees k increase to k + φ(k W − k) and π increase to π + φ[π W (p) − π(p)]. Then the magnitude of leftward shift in the locus p = 0, is smaller, as depicted by the first outward shift in Figure 6.9.

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1 ( AW, p AW)

t ( A, p A)

(0, 0)

p BW p B

pA

p AW

1

pt

Figure 6.9 Sequential shifts in p = 0

Such a gradualization of the change could correspond to a number of policies. It may mean allowing openness in only a subset of sectors, or, if there are tariffs or quotas present, it would imply reducing these partially, in a staggered manner, rather than all at once. Whatever the interpretation, if φ can be made small enough, the leftward jump in p can be reduced so that sufficient entrepreneurship exists to sustain positive evolutionary forces favoring increased trustworthiness. Note that the leftward jump in Figure 6.9 to the first dotted line is sufficiently small to maintain evolutionary incentives for trustworthiness. If the change had been implemented all at once, it would involve implementation of the final dotted line, then as the dashed arrow in the figure shows, entrepreneurship would have fallen by so much that, a point to the left of p BW would have been reached. Thereafter, convergence on the bad (β = 0, p = 0) steady state would be assured. There would have immediately been such a dramatic decline in modern production in response to the dramatic increase in vulnerability, that evolutionary forces would continue to favor opportunism over trustworthiness. In the contrasting sequenced change, the system’s gradual movement keeps it heading in a northeast direction. Once β, and consequently p, have increased sufficiently, then the next step in the process can be implemented increasing to k + 2φ(k W − k) and π + 2φ[π W (p) − π(p)], which is depicted as the second parallel dotted line, and the process repeated. By gradualizing the changes in this way, the economy can be forced to converge on the good equilibrium and avoid the bad one. Gradualism is beneficial here because, by limiting the immediate decline in entrepreneurship, the slow moving social capital (trustworthiness) is given a chance to catch up with changes in the fast moving variable. When the social capital increases there are increased incentives for entrepreneurship and the mutually reinforcing complementary benefits can start to take place. Eventually, when the

100 Anatomy of development success and failure level of trustworthiness has increased by enough, the economy is ready to start on the next step of the process, and the next sequence in the changes can be introduced. The view that rapid change may undermine the basis for trust, or more generally, social capital is often stated in the development literature. Platteau (2000) contends: True, societies may undergo profound changes and depart from previous trajectories under the influence of new economic opportunities and the presence of new constraints imposed by economic and political forces operating on the national, regional or international level. The question nevertheless remains as to whether endogenous changes in societal fabrics are rapid enough to meet present-day challenges effectively. (Platteau 2000, p. 336) This is also argued for the case of transition economies. In economies going through such change, the old structures of stability are no longer in place, the new ones do not have time to develop, and evolutionary forces favor opportunism. Maluccio et al. (1999) states: economies in transition, or those with high levels of inequality, may be especially prone to the “dark side of social capital” and may be trapped in a syndrome of distrust. (Maluccio et al. 1999, p. 58) The general point made here is thus extremely simple. If successful modern production requires complementary components, one of which is slow to adjust, and the other fast, then large changes are a cause for concern. This is especially true when these changes imply a decline in the fast moving feature, which, though in the best of worlds should only be temporary, instead sets in motion declines in the slow moving variable which will never be arrested. In the context of developing economies, these slow and fast moving variables have ready and natural interpretations. Entrepreneurship and the set up of modern production is fast to respond to incentives. Changes that undermine it may also undermine the very social capital (the slow variable) that it depends upon. The bigger and more dramatic the change, the more likely this is to be true, so gradualizing change can be helpful. The policy implication here for gradualism is reminiscent of older arguments in the development literature which pointed towards a “dynamic externality” arising from small and medium scale manufacturing activity. Such externalities were argued to imply that it takes time for firms to become competitive, see, for example, Krueger (1992, p. 7) for a critical view of this. The very slowness of type adjustment in the model here shows a new, and perhaps more plausible, rationale for these older arguments.

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Disadvantage of being a follower

The dynamics of adjustment outlined above provide a possible explanation for why it is that the early industrializing countries of Western Europe that developed the technology which gave rise to sustained productivity growth may have been able to coordinate on the good steady state, whereas the countries that were late to industrialize, and who have the opportunity to do so by importing that technology dramatically, may not be successful. In particular, early industrializers had to implement productivity improvements gradually, simply because technology improvements had to be discovered, and such discovery was, by its very nature a drawn out process. Thus, the process of development in the West was one of gradual increases in productivity, similar in nature to the sequential outward shifts in the p = 0 locus sketched in Figure 6.9. These gradual changes preserve evolutionary incentives for trustworthiness and allow convergence on the good state. The supposed advantage of being a follower country is that technology does not have to be invented it can be taken “off the shelf” and implemented in production directly. However, as Figure 6.9 shows, such dramatic changes can have a disastrous effect on any existing social capital, and not only fail to be utilized in production, but push the economy to a worse steady state than where it started. The model thus yields a possible explanation for the large cross-country differences in productivity persisting today. That GDP per capita differences across countries are heavily dependent on differences in productivity is well known; see Hall and Jones (1999), King and Levine (1994) and Klenow and Rodriguez-Clare (1997). As argued by Prescott (1998) this is something which is difficult to explain using existing theory because the differences in observable inputs are insufficiently large to account for it. The usual explanation is the positing of barriers to technology adoption. The model here suggests that these barriers may be due to an underlying culture of mistrust in business relations. However, it also suggests that the reason this cultural barrier occurred in follower countries was not due to their inheriting a smaller exogenous endowment of trustworthiness, that is, to low social capital levels. It may thus not be helpful to blame a long history of low social capital. Instead, the reason may be the supposedly advantageous opportunity that these countries had of being able to adopt technologies relatively quickly. Quick adoption and the rapid change it implied could have worked to erode any existing social capital already in place.

6.5.5

Short-term protection of entrepreneurs

The new interior steady state has sufficient entrepreneurship to support trustworthiness. The problem with the transition path sketched in Figure 6.8 is that the immediate decline in entrepreneurship accompanying openness is so great that evolutionary incentives for trustworthiness decline. A remedy can be to subsidize entrepreneurship for a limited time and thus keep it above the critical level

102 Anatomy of development success and failure required to sustain positive evolutionary incentives for trustworthiness. Such a subsidy could be direct, as in an infant industry argument, or it could be a tariff to provide short-term protection while the slow moving cultural variable adjusts. Any temporary subsidy, say an amount, S, given indiscriminately to entrepreneurs entering modern production makes expected returns equal to αβπ W (p) − k W + S. If large enough so that p solving: αβπ W (p) − k W + S = 0,

(19)

exceeds pBW , then evolutionary incentives for the maintenance of trustworthiness persist. The economy can again be forced to converge upon the better interior equilibrium. Equation (19) simply solves for the p values on the p = 0 locus with the subsidy that is to the right of p BW . This interpretation is a new rationale for infant industry type temporary protection in light of opening to foreign trade. Temporary protection for fledgling modern production can be useful if it induces complementary changes in “type” that support this production. As the discussion in Chapter 3 suggests, the critical type are the trustworthy. More directly, this implication is reminiscent of successful kick-start initiatives for entrepreneurship, and business networks, that Humphrey and Schmitz (1998, pp. 54–6) describe in Germany, Denmark and Chile. This is also similar to the policy view expressed by Sabel: Unless the state reduces the risks of breaking with subsistence strategies or outdated practices, by, say, sheltering domestic markets from foreign competition, facilitating the acquisition of new technology, or subsidizing exports, the routines are the routine. (Sabel 1993, p. 137) But he also notes that helping can be subverted by firms into protection of stagnated production. An important feature of this subsidy here though is that it need only be temporary; persisting only until the cultural variable has increased sufficiently to make entrepreneurship at sufficiently high levels self-sustaining. If the government is unable to commit to temporary subsidies only, then the usual political economy arguments relating to capture apply. If the entrepreneurs can form a lobby, they will have incentive to protect their subsidy even after it has served its usefulness. Even more worrying, is that if the lobby group can limit entry or access to the subsidy – if it can ensure that only existing entrepreneurs receive the amount S – then it will receive strictly positive rents from its maintenance. Though the huge rent-seeking literature addresses exactly this possibility, the point still remains that there is a role for enlightened and beneficial short-term subsidies. Some have argued, Amsden (1989), Wade (1990) and many of the proceedings in Aoki et al. (1996), that this is precisely the role that was played by governments in the late developing Asian Tigers. A critical feature was the avowed temporariness of the help, which was revoked for industries that could not meet standards of foreign competition.86

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Discussion of simplifying assumptions

Having established the model’s results, we now consider the essential features of the model in generating these. Which of the model’s many simplifying assumptions are essential for the results to persist, and which are merely convenient? If an assumption is merely convenient, then it can be relaxed, perhaps at the cost of much complexity, and the ensuing model would still generate similar results. If it is essential, then the assumption has to be defensible in terms of realism. The most important result is that described in the movements sketched in Figure 6.8, thus the discussion of generalizability mainly refers to this.

6.6.1

Sluggishness in type adjustment

Relative adjustment speed are critical for the model’s results. Consider what would happen if individual types adjusted instantaneously, as do entrepreneurs and suppose the openness to world trade occurs, as in Figure 6.8. As we saw there, the new steady state (β AW , pAW ) is better than the old, but it cannot be reached, instead the economy’s unique path is to the (β = 0, p = 0) steady state. However, if we allow for types to also adjust immediately, then the proportion β also becomes a jump variable. In that case, both variables of the model are jump variables and the economy immediately adjusts to either the interior steady state or the one at (β = 0, p = 0).87 What determines where expectations are. If entrepreneurs are optimistic then they will expect there to be an increase in the trustworthy type, which induces a large amount of entry, p AW , with so much entry, type rewards favor trustworthiness and this is reinforcing. Similarly, pessimistic beliefs on both sides are also reinforcing. This, then is a case of successful development as a coordination problem. The government’s role is to create the right expectations and then individual actions will adjust in response. In contrast, when types are slow to adjust, as I would argue is more realistic, and as modeled here, even fantastically optimistic entrepreneurs will not lead to convergence on the good steady state. Unless they can maintain such optimism, unrealistically, for a very long time. To see this, suppose we assumed that, in Figure 6.8, entrepreneurs are optimistic, and expect there will be a large increase in trustworthiness, even though, in reality it remains sluggish to adjust. Let us suppose then that there is no entrepreneurial exit when the change occurs, and instead the level remains at pA , for the period after the change, call it period t + 1. At this point, there are increased incentives for trustworthiness, so we would expect that, in period t +2, there will be more trustworthy types, that is, βt+2 > β A . This point will be slightly to the northeast of the initial equilibrium point (β A , pA ) on the p = 0 locus. However, a consequence of the only slight change in type is that the entrepreneurs who remained in production, on average, incurred losses, since we are below the new p = 0 locus represented by the dashed line. Their optimism was not realized, and if they then reconsider, there will be exit to a point below pBW , and corresponding convergence to the (β = 0, p = 0) steady state. The only way this can be avoided is if the optimism persists for a number of

104 Anatomy of development success and failure periods, and is sufficiently long lived so that the induced increases in β are high enough to eventually ensure convergence on the better steady state. Thus, what is required is unrealistically optimistic (i.e. not rational) entrepreneurs who maintain their optimism above high levels of trustworthiness along the development path even in the light of continued negative profits because of opportunism. This seems unlikely. 6.6.2

Uncertainty on one side of interaction

With the potential for opportunism on both sides of the interaction, contractors would also depend upon the “type” of entrepreneur they were dealing with. Say, for instance, as in some of the examples in Chapter 3, the entrepreneur could damage the contractor by threatening to change the terms of the interaction ex post, then the contractors also would desire to interact with entrepreneurs who are reliable, and if not doing so they would make a loss. This makes things much more complicated, as entrepreneurial actions will now depend on their types, but entry will still depend on expectations of profit. It is possible to imagine that this would lead to a steady state where, with enough honest entrepreneurs, there would be evolutionary incentives for enough trustworthy contractors to persist. However, once again we will obtain a similar result regarding changes as for those in Figure 6.8, if it is assumed that the entrepreneurs’ entry decisions are quick to adjust while type changes are slow. This is because when the increase in openness raises their dependence on trustworthy types, and these again do not change quickly, we will again see an immediate reduction in the numbers of entrepreneurs. Once again, if this is too great, returns to trustworthiness will fall, and this will be orthogonal to the fact that now entrepreneurs also have type considerations, since all this depends upon is reduced opportunities for interaction stemming from the entrepreneurial exit. For the results to persist, it is necessary that, even if an element of entrepreneurial reliability affects outcomes (thus requiring the importance of entrepreneurial types as well) entrepreneurial decisions about modern production (entry or not), are still flexible and rapid to change relative to the changes in population type. 6.6.3

Unit interval and homogeneity of entrepreneurs

The unit interval of entrepreneurs can be relaxed without effect. To see this, note that, even in the best steady state, there is never complete entry of all entrepreneurs. Thus, increasing the number of potential entrants will not affect the configurations. Homogeneity of entrepreneurial ability will have a more substantive effect. With heterogeneous types, there are ability rents in interior steady states, since the high ability make positive net expected profit from risk taking. However, the existence of the zero steady state does not change, provided we persist with an assumption that bounds returns for the marginal type when entry is low away from infinity, as in Assumption 2. With any finite valued project, expected returns must remain negative when there are vanishingly few trustworthy contractors. The

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interior steady states are qualitatively unchanged, and they continue to welfare dominate the (β = 0, p = 0) one because there is now also entrepreneurial rents in these which is not realized without entry. 6.6.4

Division of profits

Varying α will not affect results qualitatively. All this does is shift the β = 0 and p = 0 locuses. The steady states will occur at different values, and existence conditions will need to be modified, but nothing of substance changes. This is also true if the process by which divisions occurs ex post is modified. One could model this through any of the standard means; Nash Bargaining, alternating offers, etc. The one caveat to this is the case when entrepreneurs can gain all of the benefits. In this case, since the risk-taking partners receive the full proportionate benefits to openness, if we start in a situation with entry and entrepreneurship, any efficiency enhancing increases must lead to increased expected returns to entrepreneurship. Hence, the initial impact on entrepreneurship will be an increase, even without a change in types, and the model then guarantees convergence on the new better interior steady state. Thus, a critical feature of the model is that entrepreneurs (the ones bearing most of the risk) cannot be guaranteed the full benefits that arise from openness. A final factor here is the assumed impossibility of contracting over divisions of surplus ex ante. If this could be done, such contracts may perhaps be used as a kind of price by the entrepreneurs to separate out the types. This is ruled out by the assumption of complete contracting incompleteness, which seems reasonable in the LDC context we are considering here, even with some contracting, it is unlikely that such forward looking divisions of a difficult to specify final pie, could be written into enforcing contracts. 6.6.5

Returns to opportunism and fixed costs

It was assumed that the benefit from acting opportunistically, b, did not change with the increase to openness, k → k W . This implied that opportunists found it worthwhile to cheat in all situations, just as in the pre-trade equilibrium. A more realistic assumption would be that, with increased fixed costs corresponding to increased scale, opportunists would have more opportunities for cheating. Once again, this would mean opportunists remain equally unreliable, and moreover they would do even better than they did in the situation we analyzed. This does not affect the (β = 0, p = 0) steady state, but makes the interior steady state’s existence condition stricter. To see why, note that this steady state depends on returns to trustworthiness just balancing with returns to opportunism. The change described now would increase returns to opportunism only, so the range of F values under which existence holds would be smaller and require lower values of F . However, this would not affect any of the model’s qualitative policy implications, conditional upon existence.

106 Anatomy of development success and failure 6.6.6

Forward looking replicator in discrete time

The replicator used here was based on average returns in the previous period. However, if families, in deciding on the cultural types of their children, were fully rational and foresighted, they would be able to compute the returns to type given the exogenous change in the current period, without having to base socialization decisions on the average returns from the previous period. As modeled presently, in the period of the change to openness, there is no change in the proportion of trustworthy contractors, since this is based on last period’s returns (which are the returns in steady state). The decline in trustworthiness thus occurs with a lag. However, if families are fully rational and forward looking, they will anticipate the decline in entrepreneurship leads to relatively lower returns for the trustworthy, and immediately engage in less socialization for trustworthiness. This only has the consequence of ensuring even faster convergence on (β = 0, p = 0) than currently modeled. Once again, considering Figure 6.8, this would have no effect on the final outcome. If time was instantaneous here, which is the standard method of computing dynamics in such models, nothing would change, again provided that entrepreneurial adjustment was instantaneous and type adjustment gradual. Moreover, the considerations relating to forward looking versus average returns do not even arise. 6.6.7

Utility function

Any utility function that is increasing in income components will deliver qualitatively similar results to the linear specification here, provided the function  is correspondingly adjusted to still allow a mapping into the [−1, 1] interval that does not bias the model to always delivering a single type only. The separability matters more so, in particular, for existence. If we allow pecuniary components of utility to interact with income components (i.e. the (1−α)π terms to interact with γ , then to preserve the main qualitative results, restrictions are required to ensure that, when entrepreneurship declines, the direction of evolutionary change for trustworthiness remains negative. To preserve this basic complementarity between trustworthiness and modern production, it is necessary that when expected income falls, that is, with fewer entrepreneurs, the intrinsic benefit of trustworthiness, that is, the term γ , does not increase much. The additive separability makes them entirely independent, which is more than sufficient for this, but in any case, as long as there is not too much of a negative dependence of one on the other, the existence of the interior equilibrium will persist. 6.6.8

Uncertainty in production

The only uncertainty in entrepreneurial production is that which arises due to the potential of contractor opportunism. In reality, many other elements of the production process are uncertain. In general, these will have no effect on the qualitative

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results since they will only tend to raise the total uncertainty of the entrepreneurial outcome, with risk aversion they would also lower the expected value of the projects, but again this will not affect anything qualitative. 6.6.9

Reduced form openness

The effects of opening to trade are considered in a completely exogenous and ad hoc way here. What would the implications be if prices and patterns of trade were endogenously determined? As already discussed at the outset of the chapter, it could be the case that openness to trade simply allows a country to specialize in a form of production which does not feature the sort of contractibility problems plaguing entrepreneurship here. In that case, the structure developed here is irrelevant, and we have nothing to say about such situations. In situations that the model does speak to, comparative advantage should suggest production of the modern good, with modern production methods, when openness occurs. This could arise endogenously if the good is relatively labor intensive and the country is labor abundant, as is a not unrealistic possibility. Endogenously determining the comparative advantage and the patterns of trade with the outside world should have no qualitative effect since such considerations are all orthogonal to the area of interest, provided that is, there is the possibility of a comparative advantage in something like what we have called modern production here. Clearly, there may be impediments to modern production other than trustworthiness, for example, infrastructure, skill levels and other factor endowments. Our modeling abstracts from all of these, and by doing so what we are implicitly assuming is that there are at least some areas where these limitations are not critical. Of course, where these are immovable impediments to production, our framework is only part of the story.

6.7

Non-technical summary

The previous chapter has established the possibility of two possible stable steady states. In one of which there is trust and modern production, and the other in which a pervasive culture of mistrust makes modern production unviable. It is tempting to simply posit the good equilibrium, with modern production as the one applying to the developed West, with the low trust one applying to LDCs. However, this puts down to exogenous historical factors explanation of how it came about that the West managed to be in the good steady state and LDCs in the other one. We show here that forces within the model can be instrumental in driving economies towards one of the steady states, and that these are likely to have worked differently for the early developing countries than those of the postwar late developers. These forces have their effect when there is increasing openness in a previously closed economy. This has been suggested as a development path for many late developers. A disadvantage to such openness from the perspective of firms is that the technologies required to compete on world markets require higher

108 Anatomy of development success and failure fixed costs and often involve even greater vulnerability and dependence upon trading partners. In a closed economy, when protected from the influx of goods from abroad, producers do not have to compete with higher quality (or lower cost) goods of competitors in countries with more advanced technology. On the other hand openness to trade is generally welfare improving. This is because allowing access to world markets does allow the implementation of technology which is more productive, and whose use is more profitable, as well as the possibility of exploiting scale economies in the production process and the emergence of complementary suppliers. So that, with open markets, there is the possibility at least of supporting greater levels of modern production and more entrepreneurship.88 In order to obtain these higher welfare levels it is generally necessary that there be more trustworthiness in the economy than in the pre-trade outcome. The emergence of this trust is not necessarily a problem. As already seen in the previous chapter, higher levels of entrepreneurship, which are complementary with trustworthiness tend to increase evolutionary pressures on the creation of trustworthiness and thus bring about an increase in trustworthiness levels. For example, if in more open economies there are greater rewards to entrepreneurs because they are able to sell their goods on world markets, then more entrepreneurs will enter into production. With more entrepreneurs in production the gains to the trustworthy are higher, and this sets in motion evolutionary forces that increase the numbers of trustworthy traders that, in turn, support the entrepreneurs. Thus, the setting in motion of a virtuous cycle of increased trustworthiness and increased entrepreneurship allows the economy to converge on a better steady state. A problem with this scenario occurs if change is too rapid. Recall that the dynamics of the previous chapter argued that, though entrepreneurs are fast to respond to new opportunities, they are also fast to leave production when things turn against it. Social capital, on the other hand, is embodied in the inclinations and proclivities of people, and these things can change only gradually. This can mean that rapid change may cause problems. Consider, for example, a move to openness in an economy already starting off with a nonzero level of social capital. Suppose also that the new technology is very social capital intensive, that is, even though it is more productive and can lead to higher welfare, the technology requires trustworthy individuals to operate, since the higher scale of production requires larger fixed investments which will be lost to opportunists. Opening up to trade now makes it initially more difficult for existing entrepreneurs to stay in modern production. The reason is that they have to now compete on world markets, and though they have access to the same technology as others, because the level of trustworthiness in their economy is not quite as high, modern production is not as profitable there. This level of trustworthiness may and would, eventually catch up to that required to make the modern technology more viable, but it will take time to do so. Until it does, entrepreneurs in modern production will not be as productive as their counterparts in the rest of the world. So the initial effect of an opening

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to trade is a decline in entrepreneurship, with the initial levels of trustworthiness temporarily unchanged. The next steps in this process are critical in determining whether openness will lead to development or to a worsening of the pre-openness situation. Suppose that, even though entrepreneurship has fallen slightly with openness, there is still enough modern production to support evolutionary rewards for the enhancement of social capital. Recall that entrepreneurs are essential for these rewards; without their risk-taking behavior there is no way for the trustworthy to reap benefits to their type. In a world where nobody trusts anyone, being a trustworthy person is merely a cost to individuals which limits their actions and yields no benefits. With enough entrepreneurs still remaining, however, and hence enough trusting behavior, the trustworthy have a chance of reaping rewards to their type. If these are high enough, modern production can sustain positive evolutionary forces for the development of trustworthiness and subsequent periods will see increases in the numbers of trustworthy individuals. If this happens, entrepreneurs will respond to the increased social capital by entering into modern production in greater numbers. But this, in turn, will induce even greater evolutionary rewards for trustworthiness until, finally, trustworthiness levels in the LDC rise to allow them to reach the new welfare improving steady state. However, there is no guarantee that this will happen. Suppose instead that the outflow of entrepreneurs from modern production with the initial opening is so large that the evolutionary balance is tipped away from trustworthiness and towards opportunism. This is always possible since, if there are not enough entrepreneurs willing to risk modern production, the gains from opportunistic behavior become very large. If large enough, parents choose to inculcate their children into shortterm opportunism and away from trustworthiness. If this happens then incentives for entrepreneurship decline even further and modern production declines further still. In turn, this implies that evolutionary forces for opportunism are further strengthened and the population’s social capital deteriorates. The economy finds itself in a vicious cycle of falling entrepreneurship and lowering social capital, the final outcome of which is the complete eradication of any good social capital existing before openness was introduced. This disastrous outcome is always a possibility even though openness itself brings about the possibility of a welfare improving outcome too. The factor determining which outcome ensues is the magnitude of the change required in underlying social capital levels. If the technology that is introduced requires social capital levels that are close to those already prevailing (or even better, lower), then the initial decline in entrepreneurship will be relatively low because prevailing social capital levels will be well suited to use with the technology required. As we have seen, when these declines in modern production are low, evolutionary incentives for maintenance and improvement of trustworthiness are kept intact and the economy moves towards the new better equilibrium under openness. However, when the new technology required under openness requires far higher levels of social capital than originally prevailed, existing entrepreneurs react to this by leaving modern production en masse. This large decline in modern production

110 Anatomy of development success and failure destroys future evolutionary incentives for the creation of social capital and the vicious cycle is under way. This happens even though, if it were somehow possible to keep the entrepreneurship levels in modern production high, it could be avoided. This implies a number of policies that can be used as a safeguard. First, the critical value of social capital implies that it should be nurtured and subsidized. Since it creates large externalities for entrepreneurs in modern production, it is unlikely to be ever provided in sufficiently high levels in decentralized economies. As a policy implication though, this is not so useful as the formation of social capital occurs largely in households, so that it is hard for government policy to directly affect. Policies serving to keep levels of entrepreneurial activity above the critical level in the transition under openness will also help. By doing this, evolutionary incentives for the formation of social capital are maintained, thus allowing the economy to eventually converge on the good steady state. A direct policy that would work is a short-term subsidy to the use of modern technology. This works by keeping entrepreneurship levels high when they would otherwise fall, and thus sustaining incentives for social capital formation. It can be removed once enough social capital has been built to support the higher levels of entrepreneurship, and the economy will successfully coverage to the good equilibrium. Another policy directly targets the speed of change. If it is recognized that implementing the new technology requires large changes in social capital, and if the implementation can be staggered or gradualized, then by implementing it in a partial way, the adverse impacts on entrepreneurship can be spread out. Recall it was the large and dramatic decline in entrepreneurship that lead the economy to start on the vicious downward spiral. Introducing change gradually mitigates this by causing only small declines in entrepreneurship. If small enough, positive incentives for social capital formation remain, and it grows. When it has grown sufficiently, the next step in the introduction of technology can be undertaken and the economy can be regulated towards the good steady state. This last policy implication provides an explanation for why being a follower country may have grave disadvantages. In general it is supposed that the LDCs, that is, those of Africa, South America and Asia, should have been able to quickly catch up with productivity levels, and hence living standards, in the West after World War II. The avenue for this should have been technology transfer. Unlike the West, where these technologies were developed over centuries, postwar developers had the opportunity for off-the-shelf implementation of productivity improving technologies rapidly. This would accompany an opening of the economy to trade since to be useful, the economy required specialization and sale to markets larger than the closed domestic one. Even without access to state-of-the-art technologies, the possibility of implementing even slightly outdated ones would have led to huge increases in productivity. However, attempts at such implementation correspond to the transplanting of a technology requiring much higher social capital than that already prevailing. If attempted too quickly this guarantees convergence on the welfare reducing equilibrium. Not only is the new technology not successful, but

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any initially existing social capital is destroyed and the economy converges on the no-trust equilibrium.

6.8

Conclusions

This chapter has developed the model’s main policy implications. The possibility of change to a welfare increasing equilibrium was considered. But the two preexisting steady states still exist. The framework here has been used to address the question of which equilibrium is selected. As Platteau (2000) has emphasized, the richness of cross-country experiences suggests that models with multiple steady states can be useful: Consequently, establishing the formal institutions of the market by a single act of will cannot solve the problem of the market order on its own. In other words, when some essential features liable to produce generalized trust are absent, the social fabric of a society may not be easily adjusted to accommodate the market mechanism. History does matter, not a surprising fact given that it embodies the social norms prevailing in an particular society and that such norms are indispensable concomitant of formal laws and regulations. (Platteau 2000, p. 336) Norms and social capital also matter, as evidenced by the multiple steady states here. But, the model here also points to the size of required change in the underlying social capital as critical in determining which steady state is reached. There is an important role for risk-taking entrepreneurs in that process and this chapter has explored the policy tools that work to ensure the good outcome. The most straightforward and usual prescription with such changes is that they should be implemented as quickly as possible. Delaying their implementation, delays the flow of benefits. The policy conclusion here is opposite: smoothing out of change can be beneficial. This could be done in a number of ways – lowering the magnitude of changes by sequencing, or protecting and subsidizing some actions that may suffer adverse initial impacts.

7

Conclusions

The framework developed here has posited social capital as the degree to which individuals exhibit inherent trustworthiness. This is a desire to act in ways that are consistent with promised behavior. This approach treats the determination of individual behavior differently, than it is usually treated in economics, and differently to the way firm behavior is determined. Individual behavior is determined largely by personality type which is, in turn, decided by factors that inculcate values. It is thus influenced by economic variables, but in a gradual way only. Firms, on the other hand, respond quickly to economic factors. Another difference is that firm entry and exit is driven exclusively by decisions that are pecuniary in nature, whereas individual type selection includes elements that are non-pecuniary. Market competition tends to drive out firms who are not guided by minimizing costs and maximizing profits. However, non-pecuniary factors may play a role for individuals since the evolutionary selection of behavioral characteristics need not be exclusively payoff based. The view that cultural factors might matter for economic variables is not new. Recently, Putnam (2000) and others have emphasized the important role that civic organizations play in nurturing social capital. These organizations, which are usually voluntary groups comprising individuals sharing common interests, inculcate values, such as concern for others and desire to share, that generate broader benefits for society at large. Though admitting these groups are important, the approach taken here has ignored them. The inculcation of values here has been analyzed as occurring largely through the family, and if not, under the influence of economy wide aggregate characteristics. Moreover, the benefits of the cultural variable, trustworthiness, are only realized through business interaction between firms. The contribution of Putnam and those others who have emphasized these civic organizations is to highlight more varied avenues where such other-regarding behavior is both important, and can be nurtured. Though not modeled here, civic groups are likely to play an important role in practice. Extending our model can provide a new perspective on that role. Civic and voluntary organizations may be another avenue by which societies create returns (of a non-pecuniary sort) for behavioral types (like the trustworthy) which are independent of their usefulness in production. This might be increasingly important when systems of production become entrenched and formal enforcement improves,

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because then inherent trustworthiness becomes less necessary. The substitution of formal institutions for inherent trustworthiness might be seen as progress, however, such substitution may weaken the system’s capacity to adjust to change. Economy transforming technologies, like for instance the IT revolution of the 1990s, destabilize the usual work and business arrangements and can undermine existing enforcement institutions. These supporting institutions, whose role is to maintain incentive compatibility, cannot adjust overnight. In the process of re-forming, there is a period where entrepreneurs are likely to be vulnerable to opportunism. As we have seen, this can lead to insufficient production and may even thwart successful development of the new technology. Voluntary and civic organizations may safeguard against this by maintaining the economy’s stock of trustworthy types (and thus its social capital) even when formal enforcement improves enough to mean production does not depend on it. With this stock so maintained, the economy is able to absorb changes, like economy transforming technological shocks, where opportunism would be initially well rewarded. Societies with high stocks of social capital are more able to absorb and accommodate productivity improving shocks that, initially at least, upset incentive compatibility. The stock of inherently trustworthy types cushions entrepreneurs from the potentially large losses that could arise from opportunistic behavior, while the new institutions of enforcement are being founded. The model developed here explored the effect of a productivity enhancing opening to trade. This was modeled as a change that increased vulnerability to opportunism. Significant change can imply the disruption of long-standing relationships and require individuals to forge new ties with strangers. When individuals are initially unknown to each other, and when systems are in flux, the belief that others are inherently trustworthy is clearly useful. New Institutionalist incentive compatibility-based arguments generate a form of other-regarding behavior corresponding closely to what I have called trustworthiness here. The book has treated the New Institutionalist perspective on trust dismissively. Though Chapter 3 argues this perspective is incomplete, such considerations still clearly play a large role in practice. Their off-handed treatment here (all such effects were closed down in the model) was undertaken to focus attention on the present approach’s novel contributions. A cost of this is that the framework does not allow the contrast in two approaches to be explored. An interesting area of contrast is in the effects of new economic opportunities. In the standard approach to trust, based on incentive compatibility, the introduction of new entrepreneurs or increased trading opportunities tends to weaken incentive compatibility.89 Increased trading opportunities lower dependence on any one particular interaction and thus reduce the punishment to violating implicit agreements. The increase in payments required to ensure incentive compatibility, thus reduces the efficiency of informal enforcement. Though not modeled here, the effect of increased opportunities to trade in the present framework will be dramatically different. More opportunities for trade in the current framework allow the trustworthy more chance to realize returns to their type. This tends to raise evolutionary incentives for trustworthiness and can serve to enhance social capital. This may suggest

114 Conclusions that the mechanism forwarded as a solution to the vulnerability inherent to trade here might be more suited to large, growing and anonymous modern economies than the more traditional one based on reputations and incentive compatibility. The division of benefits to trade has been treated as completely exogenous here – the term α. It would be interesting to explore how changes in this affect social capital requirements with modern production. At present, the model’s simplifying structure makes this exploration impossible as changes in this variable have no substantive effect. But, this will not be true for all possible ways of specifying entrepreneurial entry into production. It would be interesting to see if the social capital requirements in the technology can be related to the level of inequality in the population, as affected by the divisions of trade benefits. A stylized fact seems to be that in egalitarian societies, social capital levels tend to be high. Extending the framework here might provide a vehicle of analysis. The extremely stylized nature of production in the framework could also be profitably relaxed. It may be interesting to explore O-ring type production processes, in which there is extreme dependence on key steps in the production sequence. Kremer (1993) has explored the theoretical implications of such production comparing LDCs and richer countries. In the present context it would geometrically increase dependence on trustworthiness. More generally, steps in the direction of realism may lead to insights applicable to particular countries that are worth exploring. Another extension of interest would be to partly endogenize the technology generation process. The model has treated openness as providing a gift of more productive technology, the source of which is not modeled. In an LDC context, this may be defensible assuming that technology is imported from abroad. However, if the degree of social capital dependence is a choice variable in technology creation, the framework may be able to explain why the West’s supposedly “freely” available technology is a mismatch with LDCs. That technology is created to be appropriate for own country social capital. A tradeoff between social capital dependence and cost in technology production may exist since higher social capital allows more emphasis on cooperativeness. Thus, paying little attention to factors that are not critical in the West might be profitable for Western producers if they are worried about copying from cheap labor countries. Thus, property right limits may provide an endogenous account of why Western technologies are inappropriate for LDCs. The literature has long recognized the need for elements additional to those that are purely pecuniary or even institutional in explaining underdevelopment.90 The term social capital has been coined to capture such elements. To my knowledge, the model of economic development constructed here is the first one that provides an endogenous account of social capital’s emergence through the development process.

Notes

1 Platteau (2000, ch. 8) summarizes this literature. 2 Francois and Zabojnik (2001). 3 Weber himself thought that Confucian societies, with their insistence on family loyalty, lacked a broader social ethic and would thus be impeded in development. 4 A fictitious name which he used for the town of Chiaramonte in Italy’s south, where he conducted his study. 5 This is similar to Weber’s (1922) notion of value rational behavior. Behavior that is not undertaken in aim of reaching a particular objective, but instead because the behavior is valuable for its own sake. 6 See Platteau (2000) for a discussion of David Hume and Adam Smith on the same issue. 7 One can also view the role of trust as reducing the economy’s transaction costs, as in Grabowski (1998). We discuss this role in the next chapter. 8 For further on the distinction between trust and trustworthiness, see the experiments conducted in Glaeser et al. (2000). 9 Platteau (2000, pp. 10–17) provides a succinct account of the New Institutionalist paradigm and its use of standard neoclassical tools to explain institutions. 10 The game does not have to be infinitely repeated to generate trustworthy behavior. Such behavior can also be generated with uncertainty as to the termination date, or even with a finite and known termination date using a slightly more complicated strategy space allowing for multiple (ordered) Nash equilibria, see details in Fudenberg and Tirole (1992). Platteau (2000, ch. 6) provides a more extended discursive explanation. 11 Note however, that this would not be classified as trustworthiness according to the definition used in the present book. 12 This is also consistent with the view of norms as equilibrium selection devices in Grief (1994). 13 The distinction between sociological views of trust and cooperation and economic ones is further elaborated by Granovetter (1985). 14 This is similar to what Basu (2000) has termed “choice limiting norms.” 15 I reiterate again that the dichotomy I draw between neoclassical economics and sociologists is meant for exposition and does not do full justice to the breadth of either. Other economists have argued that some degree of inherent trust must be assumed, and that this arises due to concern for others. See, for example, Arrow (1974, p. 26). He suggests that societies have developed implicit agreements to certain kinds of other-regard which are essential to societal survival, or at least greatly help efficiency.

116 Notes 16 It may be contended that nothing in neoclassical methodology explicitly requires omission of cultural influences, or the treatment of all individuals as opportunistic. Strictly speaking this is true. But, to be convinced that the neoclassical construction I am forwarding here is not a mere straw man, simply consult articles in the high impact journals of economics: American Economic Review, Journal of Political Economy, Quarterly Journal of Economics, Review of Economic Studies and Econometrica. It would be difficult to find a handful of papers using anything other than non-opportunistic and self-regarding preferences that are exogenously given as the basis of modeling. Certainly, such approaches would constitute far less than 1 percent of all papers. For articles specifically on development see the main field journal – The Journal of Development Economics – where the same comment applies. 17 See Shleifer (2000) for a survey. 18 See Berger (1987), Berger and Hsiao (1988), Tai (1989) and Khan (1979). 19 For more on this see Doi (1971). This radius extends to a wider circle, the only common denominator of which is Japaneseness. People in that outer circle, called Tanin, are owed civility at least. 20 For example, Inglehart (1990) reports Japanese rates of response to the statement “most people can be trusted” which are comparable or higher than respondents in the United States, below those in Scandinavian countries and well ahead of Spain, Germany, Italy and France. 21 These benefits are explored in detail by Fruin (1994). 22 They cite survey work in Woronoff (1992) showing work does not seem to be a high source of satisfaction for these workers, but a source of stress and expectation. 23 This literature is largely noneconomic, and I will not review it here as its size defies comprehension. Hofstede was recently listed as one of the 4th or 5th highest cited authors in all of the social sciences. 24 See Temple (2001) for a survey of this field. 25 The General Social Survey started in 1974 and is run by the National Opinion Research Corporation from the University of Chicago. The World Values Survey includes approximately sixty countries and is administered annually. 26 A possible exception is the family business in Hong Kong and Taiwan, but this is just ownership and management staying in the family. These businesses employ workers who are not kin, and require business dealings with nonfamily members. 27 The low degree of specialization and subcontracting is found in many LDC studies, see as well Amsden (1977) and Pack (1980), see also endnote 29 of Katz (1987, p. 50) for further Latin American studies. More recent research on Latin America, Altenburg and Mayer-Stamer (1999), which is reviewed later, similarly finds low levels of subcontracting. 28 These were not the only reasons, some of the difference was driven by the small size of the market, and the lack of trained workers in the labor market. 29 A more recent study in the Latin American context by Altenburg and Mayer-Stamer (1999, p. 1709) similarly concludes: “Compared to innovative clusters in industrialized countries, Latin American agglomerations usually comprise only few stages of the value chain, host few complementary services, and lack the social capital necessary to reach cooperative agreements.” Similar gains from specialization and complementarities between producers are consistently emphasized for studies in other regions. However, nonspecialized small scale production is usually found to be the norm in LDCs. Another multi-country collection of studies is Chudnovsky et al. (1983). 30 See Tirole (1989), Section 1.3 for a simple model of this.

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31 See Altenburg and Mayer-Stamer (1999) for further on this. 32 Schmitz (1995) coined the term “collective efficiency” to describe these. 33 The mechanics of this are well known. For a formal treatment see Fudenberg and Maskin (1986). For applications to repeated interaction in labor markets, see Macleod and Malcomson (1989), for a verbal account of the mechanics to this see Platteau (2000). The necessary condition simply corresponds to participants having both low enough discount rates and for the trade to generate high enough benefit compared to the next best options. 34 Despite this the Genoese came to dominate Mediterranean trade of the time. Grief argues this is because, lacking sufficiently good informal enforcement, the Genoese were forced to develop a legal and contractual edifice to support trade. This allowed for expansion of the network in a way not possible to Maghribi who were limited to transacting with those who were personally known. The limits of both group based and formal enforcement as a means of ensuring the viability of modern production will be taken up later in the chapter. 35 That is, in addition to the cooperative equilibrium of the repeated prisoner’s dilemma game, in which agents forego opportunities for short-term gain, there always also exists an equilibrium in which such opportunities are taken, and cooperation breaks down. See Gambetta (1988, p. 227) and Platteau (2000, ch. 7) for more on this, and the unlikeliness of players converging on the cooperative equilibrium. 36 See Fudenberg and Tirole (1991) for more on this. 37 See Platteau (2000, ch. 7) for more on this. 38 It may be tempting, in turning to the empirical work on networks, to think of this as a test of the theory’s validity. This is not the task here. The reason is that it is not clear what would need to be observed to invalidate the theory. If the empirical studies find that networks generally function in a way described by the neoclassical account, and that the start-up problem, unstable interaction and the second order public goods problems do not seem to exert influence, then a conclusion could be that though theoretically possible, these do not end up being important in reality. If in contrast, however, some or all of these factors do seem to hamper networks then this, once again, does not invalidate the neoclassical account – in fact, it shows the account has value, as the theory itself suggests where weaknesses may arise. 39 A broader review of business networks and industrial clusters is provided in Powell and Smith-Doerr (1993). The emphasis there is on regional conglomerates with case studies in North Central Italy, Southwest Germany, Sweden and Japan. See also, Piore and Sabel (1984), Brusco (1990) and Becattini (1990, p. 38) for analyses of such clusters in Italy’s industrial north. Burt (1992), is also an interesting perspective on networks. 40 See Humphrey and Schmitz (1998) for more on this cluster. 41 A similar account of the importance of sociocultural ties in Italian clusters is in Becattini (1990). Fukuyama (1995) also focuses on social factors in explaining how networks grow. A term he coins is “spontaneous sociability” the most useful feature of which is that it gives rise to cooperation under ill-defined terms of reference on mutually beneficial projects. 42 The precondition of trust does not apply exclusively to these environments. A case in which there is very good contracting possibilities is the relationship between the big three US auto manufacturers and their suppliers. Helper (1991) found even there that trust was a prerequisite to making the necessary investments. 43 See also North (1981).

118 Notes 44 According to Barrett, the rule of law is also little help because, even when respected, it only regulates a small minority of transactions. 45 Hardin (1993, p. 519) takes a similar view that without trust there are many missed opportunities for mutually beneficial actions. 46 Writers of the Scottish enlightenment argued social differentiation (an exponential increase in roles and potential conflicts between them) allowed the emergence of a new form of “innate sociability” (Seligman 1997, p. 60). This lead to Adam Smith’s distinction between the rational calculation of interests and the needs of sympathy and approbation. 47 Cited in Harrison (1992). 48 Most authors are vague on this. It is usually some product of both ideology and history. Some have emphasized the role of formalized religion. See Platteau (2000) for a discussion. 49 Behavior consistent with such other regarding considerations has been formally explored, see Kahneman et al. (1986). 50 Another interesting study of the reluctance to risk when trusting is limited is Lane and Bachmann (1996). 51 Further case studies on the the emergence of such organizations are Di Maggio (1993), Nohria (1992) and Sabel (1993). 52 Seligman (1997, p. 85) also argues individual trustworthiness was central to the “rise of the West” especially Britain. My reading of his view is a similar treatment of such individualized, unconditional trust as exogenous. 53 Fukuyama (1995) places a strong emphasis on such complementarities in production networks. While I am in broad agreement, I believe that these are merely a particularly pure example of situations requiring such inherent trust. Similar considerations are central to the success of modern production more generally. 54 See, for example, Weibull (1995, ch. 2). 55 Recently, however, a formalization of these imitative or learned socialization processes, that works distinctly from biological models has been developed. For reasons that will be made clear subsequently it will be utilized in this chapter. 56 The World Values Survey is administered on a yearly basis to individuals in approximately sixty countries. It asks a broad set of questions relating to cultural and social attitudes. 57 See also Guth and Kleimt (1994) for earlier suggestions of this. Dekel et al. (1998) explore the implications on preference formation of relaxing observability of other’s preferences more generally. 58 See Fershtman and Weiss (1998) and Lindbeck et al. (1999) for examples of such approaches. 59 Another means not included here has been forwarded by Binmore (1996). His is an imitative account of human morality which includes other-regarding behavior. It is based on individuals mistakenly treating individuals from outside their kin groups as they would treat those within. Platteau (2000, p. 328) argues this might be a plausible underpinning of generalized human traits, but is not possible to account for cross-country differences which have emerged over shorter horizons. 60 Noe and Rebello (1994) also use an evolutionary modeling approach departing slightly from fitness maximization in an economic context. 61 His suggestion of a “meme” based approach has lead to much controversy amongst evolutionary theorists. For a discussion see the collection of essays in Aunger (2000).

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62 Many economists have looked at the role of non-rational motives, which are similar to trustworthiness here, in more traditional evolutionary settings, see, for example, Frank (1988), Rabin (1993) and Young (1998) which is more directly concerned with explaining institutions. However, these are also approaches using fitness-based replicators. 63 We will assume enough agents in the structure of the next chapter to allow us to evoke the law of large numbers. Apart from its convenience, this is a reasonable assumption when considering evolutionary forces at the societal level. 64 Note that the formalization of the evolutionary process here does not explicitly allow for the first mentioned component of evolution, mutation, to play an explicit role. The difference equation (3) does not include any mutation mechanism at all. Instead, robustness against mutations is indirectly ruled out by imposing dynamic stability criteria for the difference equations governing the system, which is done in the next chapter. 65 If parents are rational, then instead of basing their decision on the average that prevailed in their own lives, they would correctly anticipate the average that prevails in their child’s life. It will be shown that results do not vary irrespective of which one is taken. 66 Note that this does not mean that the outcome has to always be that both types exist. Only that the model must not exclude the existence of either type at the outset, if it is to avoid being tautological. 67 An implication of this is that when the specification of utility functions changes, which is possible for even the same underlying preferences, it is also necessary to change the function . 68 The model here bears a tangential resemblance to Cozzi (1998) and Fang (2001) in its attempt to obtain an explanation for “cultural” types of phenomena. Though their approaches do not depart from the underpinning of opportunistic types. 69 These total gross returns can be thought of as the lifetime stream of pecuniary benefits that will accrue from the successful interaction. These could include the sale of the good, the benefit that each would obtain from enhanced reputations, the possibility for future trading opportunities etc. The basic point is to capture all the lifetime benefits accruing in case of success. 70 Modeling heterogeneity here makes things unnecessarily complex, but its consequences are discussed later. 71 Nothing would be gained by modeling the underpinning of these divisions more carefully. We can think of these divisions as the outcome of a Nash bargaining game or as the outcomes generated by an alternative offers bargaining game, as in Rubinstein (1982). I discuss this further after the main results. 72 The equivalent numbers of contractors and potential entrepreneurs in modern production buys nothing here. It will be seen that the potential stock of entrepreneurs is never exhausted by entry, so contractors are always in excess supply. 73 The existence of such intrinsic rewards seems an indisputable part of many individuals’ makeups. This is discussed as the process of internalization by Jones (1984, ch. 5) and, more directly, in terms of the emotional satisfaction obtained from actions by Elster (1998, p. 64). See also Jones and Gerard (1967, ch. 3) for analysis of the internalization of rewards through a child’s socialization. For further reading see Platteau (2000, p. 299), Weber (1978), Opp (1979) and Coleman (1990). 74 Recall that though New Institutional economics does have a goal of explaining other-regarding behavior it still assumes that action is motivated by self-interested opportunistic gain.

120 Notes 75 Recall that, from Chapter 4, this type of replicator was constructed from a cultural transmission mechanism used by Bisin and Verdier (2001). Apart from this feature we do not employ other components since their framework only allows variation in one dimension. Here we are concerned with how variations in contractor types is affected by the actions of another set of agents, entrepreneurs and vice versa, so that we will have two dimensions of variability which are mutually interacting. 76 This will also be discussed further later. 77 There can be other benefits to being trustworthy that do not depend on realizing trading opportunities. That is, in reality, it might be possible that the feelings embodied in the term γ could be realized through other forms of interaction, and thus support the evolution of trustworthiness, even in the absence of risk taking entrepreneurs. I rule this out of the modeling here, but it is one way of interpreting the recent discussion regarding the demise of voluntary and civic organizations and its impact on social capital, as raised by Putnam (2000) and others. I return to this in the concluding chapter. 78 Nelson and Winter (1982), in their classic application of evolutionary considerations to firms, also argue that the speed of firm adjustment will be quicker than that of individual types. Here the entrepreneurhip that underlies firms is not evolutionary, but immediate and rational. Thus, as in the equations above, this entrepreneurship simply responds immediately to profit or loss. Modifying the framework to allow for firms to respond in an evolutionary manner would not affect results, provided, that they still changed more slowly than individual types. It may seem strange to treat entrepreneurship, and thus firms, as wholly pecuniary, while at the same time treating individuals as affected by more than the purely pecuniary. However, the evolutionary pressures that come to bear on firms are much more likely to be payoff based. In particular, firms that follow explicitly non-pecuniary motivations should be driven out of the market by the forces of competition. If these firms are incorporated, then their management is not maximizing share-holder value, and the case is quite clear. I have explored elsewhere the possibility that, when the labor donation of workers is a significant component of firm cost, this may not be true (Franc¸ ois 2000), but in the present context such factors are not likely to be important and are thus ignored. 79 It will make no difference to any of the qualitative results here if firms use last periods average returns to estimating returns to entreneurship, that is, the operator A instead of E. We use the expectations operator because modeling firms as rational and quick to react in anticipation of gain, is consistent with the conventional view of the firm. 80 Without this assumption, our evolutionary framework becomes degenerate, opportunism is the only outcome and production can never occur. Necessarily, if we altered the function  in the replicator dynamic then the values in Assumption 3 would also have to be altered, but intuitively the same relationships would have to hold. Of course, the assumption is necessary but not sufficient, since the term F is not included, this is not restricted here, but the main existence result is stated conditional on F . 81 Without this we would have to assume that π  ≤ 0, which is also a natural assumption. It can be verified that this would give the same result, so for simplicity we use the linear specification. 82 Recall that though there are two corner steady states and two interior ones, only one of each is stable. We have ignored the non-stable ones. 83 Katz found that the scale of operation in Latin American firms was between 1 and 10 percent of that in comparable firms in the West. 84 See Krueger (1992) for more on this.

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85 This corresponds precisely with what Lipton (1985) has described occurring. Bowles (1998, pp. 95–96) also includes a fascinating discussion of the impact of change in a context that seems closely related to the present one. 86 For particular industry examples in South Korea and Taiwan, see Wade (1990). 87 Ruling out the B interior steady state on the grounds of instability is more difficult when both variables are jump variables, but I will continue to ignore it. 88 A more basic reason for trade being welfare improving is the reallocation of resources to their true comparative advantage. This is not a factor that I consider in the model here, but if included it would further enhance the benefits of openness. 89 The forces at work in such a process are well explored in Kranton (1996). 90 This argument is made forcefully in Platteau (2000).

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Index

Africa 85, 110 agents, speeds of adjustment 77 Agra footwear producers 55 Altenburg, T. 25, 33, 84–5, 98 alternating offers 105 “amoral familism” 8, 74 Asia 110 Asian Tigers 102 Baden Wurtemberg 31 Baier, A. 79 Banfield, E.C. 8, 37, 74 Barret, C.B. 1, 36, 56 Basu, K. 8 Beale, H. 38 benevolence 9 biological analogies for culture, problem with 43 Bisin, A. 47–8, 53, 72 Bologna 31 Bowles, S. 46 Boyd, R. 47 Brazil 25, 30 buyer–seller relationships 32 Cannon, J.P. 32–4 capital equipment 23 capitalist economic development 9 Capri 31 caste-based antagonism 32 Chiaromonte 74 Chile 98, 102 Chinese traders 33 civic organizations, role in nurturing social capital 112 Clarke, L. 37 Confucian ethos 15 “Confucian work ethic” 7

continuous production: disadvantages 23; impediments to 24; process 23–4; requirements 24 contract enforcement mechanisms 97 contract, enforcement of 27 contractor opportunism 106 contractors 55 cooperative production 20 cross-country cultural differences: behavioral evidence 18; opinion-based surveys 18 cultural characteristics 43 cultural construction, elements of 14 cultural differentiation problems 31 cultural selection model 72 cultural surrounds 11 cultural transmission, model of 47 cultural variation documented 17–19; mechanism of transmission for 43; sociobiological approaches 43 culturalist view 20 culturalists 7, 11 custom ordered changes 23 Daiichi Kangin 17 DaMatta, R. 75 Dasgupta, P. 10 Dawkins, R. 47 debt servicing problems 84 decision making, on the job 23 Denmark 102 determination of types 76 development economics 4; postwar 8; literature 8–9 development: and welfare 83; failure of 93–5, 97; literature 100; modeling 86; success and failure 83 development trap 2

130 Index discontinuous technology 23 division of benefits to trade 114 Doney, P.M. 32–4 Dugdale, A. 38 Durkheim, E. 8, 11 Durlauf, S. 19 “dynamic externality” 100 East Asia 84–5; late industrializers of 84 East European and Russian reform 96 economic interaction, and culture 6 economic methodology 20 economic opportunities, effects of new 113 economic underdevelopment 14 economy transforming technologies 113 economy, development paths of 86 Egypt 25 Elias, N. 13 Ely, J. 44 embeddedness argument 38 Embree, J.F. 15 Empresas Integrados see Mexico enforcement institutions 113 entrepreneur and contractor, relationship between 56 entrepreneurial ability, homogeneity of 104 entrepreneurs 55; and entry decisions 76, 104; risk-taking behavior of 60; short-term protection of 101 entrepreneurship: and trading on world markets 90; kick-start initiatives 102 evolutionary balance 109 evolutionary condition governing change 88 evolutionary incentives 79 evolutionary paradigm 46 ex post flexibility 23 export led industrialization 84 external constraints13 Fafchamps, M. 75 fitness-based replicator 45 fitness-based selection mechanism 44 follower country 3; disadvantage of being a 101, 110 Foucault, M. 13 “fragile social fabric” 33 Fremdzwange see external constraints Fuji 17 Fukuyama, F. 9 Gambetta, D. 36 GDP per capita, differences across countries 101

General Social Survey for the United States 18 generalized morality 8, 36 Genoese 27 Germany 102 Germany: modern capitalism in 7 Gintis, H. 46 Gouldsblom, J. 13 gradualizing change 100 Granovetter, M. 12–13, 37–9 Greif, A. 27, 29 Gresham’s law of trust 73 group guarantees 98 group selection 45 Harris, M. 9 Harrison, L.E. 8, 15, 75 Helper, S. 26 Hofstede, G. 18 homo economicus 7, 48; social influence on 13 Hong Kong 84 Hoselitz, B.F. 8 Hume, D. 13 Humphrey, J. 25, 28, 38, 102 Ichino, A. 18 ILO 25 IMF 84 impact of openness, model of 84–8; agents in 85; application to Russia 95; division of profits 105; effect of openness on steady states and welfare 88–93; forward looking replicator in discrete time 106; gradual change 98; implications of openness 87; interpretation 95; non-technical summary 107–11; policy implications of 97–103; profits, effect of trade on 87; simplifying assumptions 103; trustworthiness, effect of openness on returns to 88; utility function 106; welfare in 85–6 implications of openness to world markets 88 import substituting industrialization 84 Inada conditions 61 India 25 Indian footwear industry 31 individual behavior, differences in approach to determination of 112 individual preference formation, process of 76

Index individual satisfaction, non-pecuniary components of 48 individual types, sluggishness in adjustment 103 individual, conception of 20 Indonesian industrial clusters 33 industrial clusters 84 industrial networks 25–30; advantages, neoclassical explanation 26–7; case studies of 30–5; instability of interaction 28; second order public goods problem 29; sociological account 37; start-up problem 27; study of 25; traders’ strategies in 29 infant industry protection 4 interaction based on kinship 37 internal rewards 57 International Institute for Labour Studies 25 IT revolution 113 Japan: cultural versus institutional explanations 15–17; early postwar 73; manufacturing company practices 16; post-World War II 14 Japanese business groups 16 Japanese socialization 15 Japanese society 8 Japanese subcontracting system 15 Jatavs 31–2 Johnson, P.A. 18 Katz, J. 22–4, 92 Keefer, P. 18 Kingston-Mann, E. 96 Knack, S. 18 Knorringa, P. 31, 55 Kremer, M. 114 Krueger, A. 100 Landes, D. 6 late developer country 3 late developers and early developers, differences between 3 Latin America 84–5; manufacturing production in 22 LDCs see least developed countries least developed countries (LDCs) 110; economy, pre-modern 55; industrial clusters in 30; industrial networks in 21, 24; industrial production in 22-4; literature on production in 21; production networks in 4; production processes in 22; sociocultural ties in 30

131

levels of indebtedness 84 Lewis, M.R. 15, 17 localized interaction and modern production 35 Luhmann, N. 72 Lyons, B. 10 Macaulay, S. 38 Maggi, G. 18 Maghribi 27 Maluccio, J. 18, 100 Marx, K. 7 Mayer-Stamer, J. 25, 33, 84–5, 98 McCormick, D. 33, 37, 85 Mediterranean merchant traders, in the eleventh century 27 Mehta, J. 10 Menkhoff, T. 33 meta-norm 29 Mexico 98 “micro” clusters 33 micro enterprises, financial services for 98 mimicking types 45 Mitsubishi 17 Mitsui 17 Modena 31 modern manufacturing production 84 modern production, complementary elements 2 modern societies, emergence of 36 “Montegrano” 8, 37, 74 “moral decider” 12 Morocco 25 Nadvi, K. 30 Narayan, D. 18 Nash Bargaining 105 neoclassical networks, complications 27 neoclassical view of networks, implications for 34–5 networks of business alliances 16 New Institutional economics research paradigm 10 New Institutionalist: approach 4; perspective 20; incentive compatibility-based arguments 113 New Institutionalists 11, 13 noncultural variation 18 non-observability and payoff maximization 45 non-payoff maximizing behavior 46 non-pecuniary benefit, psychological 57 North, D.C. 96

132 Index North-central Italy 31 no-trust equilibrium 83 “no trust” situation 79

role segmentation 36 Russia: post-Soviet changes 97; criticism of reform process 96

opening to world markets 87 openness as a path to development 92 optimistic development scenario 73 Otero, M. 98

Sabel, C.F. 11, 15, 28, 102 Sanwa 17 scale economies 23; exploitation of 83 Schmitz, H. 25, 28, 30, 38, 102 Schultz, T.W. 8 Selbstwange see self-constraints self-constraints 13 Seligman, A.B. 8, 11–12, 36, 72 shared ethnicity and trade 35 Short, J.F. 37 Sialkot 30 Singapore 33, 84 Sinos valley 30 Smelser, N.J. 13 Smith-Doerr, L. 31 social bonds and trade 35 social capital: concept 18; cross-country variations in 17; definition of 6; dependence, and cost in technology production 114; elements 40; endogenous determination of 54; nonzero level of 108; policy conclusions 4; positive definitions of 9 socialization process 49 South America 110 South Asia 84 South East Asian development, postwar 7 South Korea 84 Southwest Germany 31 standard models of selection 46 standard trade model 87 standardization of processes 23 steady state in an evolutionary system, analysis of stability 68 steady states: analysis of dynamics in the vicinity of 69; country specific considerations 80 steady-state configurations 88 structural adjustment programs 84 Sub-Saharan Africa 75, 84 subsidy, temporary 102 Sumitomo 17 supplier networks 26 supply networks 84 surplus ex ante, divisions of 105 “survival” clusters 33 Sztompka, P. 37, 39 Szymanderski, J. 96

Pakistan 30 parental socialization 47, 50 Pareto criterion for improvement 85 Parma 31 Parsons, T. 13 peasant societies, literature on 37 Pejovich, S. 96 Pi, C.-R. 18 Platteau, J.-P. 8, 13, 36, 40, 49, 57, 75, 96–8, 100, 111 policies as a safeguard 110 policy initiatives, and business networks 98 population, two types in 48 population’s degree of trustworthiness, analysis 54 post-Soviet Russia 36, 95 potential entrepreneurs, unit measure of 55 Powell, W.W. 31 “predestination”, Calvinist belief in 7 preference evolution, model of 2 preference transmission, cultural model of 47–52; analytical treatment 48; utility realizations 51 preferences, selection process 51 Prescott, E.C. 3, 101 prices, modeling determination of 14 primary good production 84 prisoner’s dilemma game 11 Pritchett, L. 18 production and trustworthiness, model of 87 productivity improving shocks 113 Protestant work ethic 7 Proyectos de Fomento see Chile Putnam, R.D. 8, 18, 112 “radius of trust” 8 rationalists 7 “rationality limiting norms” 8 Ray, D. 83 reliance on social capital 91–3 Rhyne, E. 98 Richerson, P. 47 risks and modern production 76

Index Taiwan 84 Taylor, C. 12, 48 Tchernina, N.V. 96 technology generation process 114 technology, social capital requirements of 3 Temple, J. 18 Tidmarsh, K. 96 Tokugawa household society 16 Tokugawa regime 15 Tomkins, C. 38 traditional economic evolutionary models, limitations of 43–6 transnational corporations 26 trust: locus of 4, 8; method of building 34; neoclassical analysis 41; role in enabling modern production 39; sociological account 38 trustworthiness in production, model of 54; agent types and returns to production 55; contractor type returns, analysis of 63; dynamic adjustment of entrepreneurs 60; evolutionary selection of preferences 58; existence proposition 64; interpretation 72; non-technical summary 75–9; preferences 57; steady states 62–72; utility realizations and entrepreneurship 59 trustworthiness: additional features 10; analytical techniques 1; and personality disposition 6; as a cultural variable 9; as a tautology 12; as slow moving social capital 99; as social capital 17; cultural interpretation of 39; definition of 6; encouragement of 98; incentive differences 6; levels 4; need for 2; observability of 44; oversocialized position on 41; population’s degree of 79; returns to 62; sources of 40

133

trustworthy behavior, systematic variation in 6 trustworthy equilibrium 78 trustworthy individuals: evolutionary models of 42; in population, proportion of 65 Turkey 25 uncertainty in production 106 UNCTAD 25 UNIDO’s Small and Medium Enterprises Programme 25 upgrading technology: gradualism 3 US auto industry, study of 26 Verdier, T. 47–8, 53, 72 views of individual: economists 12–13; sociologists 7–9 Vincent-Jones, P. 38 virtuous cycle of increased trustworthiness 108 vulnerability to opportunism 73 Weber, M. 7 Weijland, H. 25, 33 welfare improvement, definition of 85 Western Europe, early industrializing countries of 101 Williamson, O.E. 11, 73 World Bank 25, 84 World Values Survey 18, 43 Yilankaya, O. 44 Zabojnik, J. 5 zaibatsu see Japanese business groups