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Laws, customs and rules: identifying the characteristics of successful water\nmanagement institutions. Paper presented to ACIAR [Australian Centre for International Agricultural Research] conference on 'Institutional issues in water resource allocation: lessons from Australia and implications for India', La Trobe University, Beechworth, Victoria, 17-18 July 2003

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ACIAR PRoject ADP2001/014: Improving water resource management in india’s agriculture: search for effective institutional arrangements and policy frameworks AUSTRALIAN WORKSHOP: INSTITUTIONAL ISSUES IN WATR RESOURCE ALLOCATION: LESSONS FROM AUSTRALIA AND IMPLICATIONS FOR INDIA


‘LAWS, Customs and Rules: Identifying the CHARACTERISTICS Of Successful Water management institutions’ P.G. Pagan

Abstract Institutions are the humanly devised arrangements that guide the way people interact. They include the laws, customs, social conventions, regulations and rules that structure our behaviour. This paper discusses from an institutional economics perspective the role that institutions play in water management, and how the outcomes of water management may be able to be improved through better institutional design.

Five generic characteristics are identified that are key to good institutional outcomes: clear institutional objectives; connectedness between formal and informal institutions; adaptability; appropriateness of scale; and compliance capacity. The paper proposes a framework for assessing alternative institutional arrangements, which incorporates these generic characteristics. The paper also includes discussion of empirical approaches to the evaluation of these institutional features within the framework.

1. Institutional arrangements background

The role of institutions in water management has increased in importance significantly over the last decade, in line with the claim by (Ostrom 1993: 1907) that “for the next several decades the most important question related to water resources development is that of institutional design rather than engineering design”. This is particularly true in Australia, where the Council of Australian Governments (COAG) water reform agenda has been the impetus for wide-ranging reform of water management institutions in every jurisdiction since agreement to the agenda was reached in 1994.

The first section of this paper discusses what institutions are, why they are important in the management of economic resources (and water in particular), and how alternatives in institutional design might be usefully analysed.

1.1 What are institutions? Three conceptualisations of institutions are outlined by Aoki (2000). Aoki uses an analogy of the economic process with a game, to demonstrate how institutions are thought variously of as (i) players of a game, (ii) the rules of a game, or (iii) the outcome of a game.

Organisations are often referred to as institutions, and in the analysis of economic processes particular government and non-government organisations are identified as the relevant institutional players (or the players of the game).

Others such as North (1990; 1995) regard organisations and their political entrepreneurs as agents of institutional change (that is, as rule makers), but the institutions themselves are the rules by which interactions between individuals, groups and organisations over any issue are governed. These

institutions include both formal and informal rules. Formal institutions are determined in the “political market” due to pressures that are ultimately derived from changes in relative prices. Informal rules are socially derived and form part of the cultural heritage of a community. Consequently, they are slow changing, and their persistence effectively constrains changes in the politically determined formal rules.

Finally, the “outcome of a game” view of institutions perceives that institutions are determined endogenously as an equilibrium outcome from which agents are not motivated to depart from, as long as others also do not depart (eg. Schotter 1981; Greif 1994; 1994; Young 1998; Greif 1999). This contrasts to the “rules” conceptualisation where institutions are consciously designed and imposed through political processes (subject to cultural constraints).

The conceptualisation of institutions assumed in this paper is the “rules” perspective. North’s specific definition is that “institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction”(1990). Consistent with this definition are others such as by Dovers (2001), “Institutions are persistent, largely predictable arrangements, laws, processes, customs and organisations that structure aspects of political, social or economic transactions in society”, and by Neale (1994) “(Institution is the word used for) the regular, patterned behaviour of people in a society and for the ideas and values associated with these regularities”.

1.2 The theoretical case for the role of institutions Recognition and incorporation of the importance of institutional arrangements in the analysis of economic activity is the key concern of the branch of economic theory known as New Institutional Economics (NIE). The views of three distinguished NIE economists (Richard North, Ronald Coase, and Oliver Williamson) are useful in illustrating the importance of institutions.

North (2000) articulates the importance of institutions as arising from a recognition that laissez-faire markets do not exist. That is, that there is no such thing as an efficient market that is not structured by the players to produce that particular result. North states that all social systems (including markets) are humanly devised and are a complex mix of rules, norms, conventions and behavioural beliefs. Together they form the way in which we operate and determine how successful we are in achieving our goals.

In discussing the contribution that NIE could bring to the field of economics, Coase claims that the limitations of neoclassical approaches are borne from a disregard for what happens concretely in the real world. He says that the key

problem is one of economists studying how supply and demand determine prices, but not studying the factors that determine what goods and services are traded on markets (and therefore are priced). “We study the circulation of the blood without a body” (2000: 4).

Coase illustrates the key role of institutions through the following simple description of an economic system:

“The welfare of a human society depends on the flow of goods and services, and this in turn depends on the productivity of the economic system. Adam Smith explained that the productivity of the economic system depends on specialisation (he says the division of labour), but specialisation is only possible if there is exchange - and the lower the costs of exchange (transaction costs if you will), the more specialisation there will be and the greater the productivity of the system. But the costs of exchange depend on the institutions of a country: its legal system, its social system, its education system, its culture and so on. In effect it is the institutions that govern the performance of an economy, and it is this that gives the ‘new institutional economics’ its importance for economists.” (Coase 2000: 4)

The above description by Coase introduces the concept of transaction costs. Crase (2000) identifies two distinct definitions of transaction costs. The first regards transaction costs as an actor’s opportunity costs of establishing and maintaining internal control of resources. That is, they are the costs of measurement and enforcement incurred to protect values both in voluntary exchange, and against involuntary exchange (such as theft) (Alston et al.

1996). The second, and broader conceptualisation of transaction costs is that they include all costs associated with the creation, use and change of an institution or organisation (Furubotn and Richter 1992). This paper, in discussing a framework for the analysis of alternative institutional structures for the management of water resources, adopts the second of these definitions.

Transaction cost economics is an important component of the NIE approach, following the early work of Coase (1960) and others, whom brought recognition that market failures have transaction cost origins. Williamson (1985) cites the common characteristic of NIE research being the conceptualisation of the firm as a governance structure, rather than (or in addition to) the conceptualisation of the firm as a production function. Williamson clearly synthesises the concepts of institutions, transaction costs, and their role in the economy with the following observations - “The economic institutions of capitalism have the main purpose and effect of economising on transaction costs” (1985: 17), and “the underlying viewpoint that informs the comparative study of issues of economic organisation is this: transaction costs are economised by assigning transactions (which differ in their attributes) to governance structures (the adaptive capacities and associated costs of which differ) in a discriminating way” (1985: 18).

1.3 Empirical evidence of the importance of institutions and transaction costs The above discussion indicates that there is a strong theoretical case for the importance of institutions in the organisation of economic activity. However, the supporting empirical case is not as complete, due to a range of issues that are discussed in section 3 of this paper. Nevertheless, empirical analysis has and is being undertaken of institutional issues, including some broad empirical studies that indicate the role of institutions and transaction costs in influencing economic outcomes.

Keefer and Shirley (2000) report that World Bank (1998) research investigating different combinations of macroeconomic policy and institutional quality, found that countries with high levels of institutional quality and poor macroeconomic policies grew twice as fast as countries with the reverse combination. Keefer and Shirley achieved corroborating results when they undertook additional analysis using panel data from 84 countries for the period 1982-1994, and investigated whether the quality of institutions affected three policy variables (growth in government consumption, public investment, and public debt).

In a broad study of transaction sector in the U.S., Wallis and North (1986) found that transaction costs as a proportion of GNP had grown from 25 per cent in 1870, to 45 per cent of GNP in 1970. This increase was largely due to the changing institutional environment in which firms operated.

1.4 Transaction and transformation costs It is clear from the preceding discussion that there is a clear link between institutions and transaction costs. North (1990), however, brought forward the proposition that the simple relationships of institutions only determining transaction costs, and techniques only determining transformation costs, actually masked a more complex relationship. In particular, it can be demonstrated that given a desired level of output, institutions will be chosen that minimise the total transaction and transformation costs of production (North and Wallis 1994).

1.4.1 Transaction costs Transaction costs as defined in 1.2 above refers to all costs associated with the creation, use and change of an institution. But transaction costs can be further divided (see Figure 1) according to whether they are incurred through operating within a particular institutional environment (static transaction costs), or are incurred during or because of changes in the institutional environment (dynamic transaction costs).

Static transaction costs involved in market exchanges, for example, include costs such as those associated with product search and comparison (in terms of price and quality information), and any fees or costs associated with transferring ownership, registration etc.

Dynamic transaction costs can be divided into categories of transition costs and intertemporal transaction costs (Challen 2000; Marshall 2003). Institutional transition costs are those incurred in the current period which are associated with changing institutional arrangements. These include costs such as research and development costs, costs of deciding on new institutional rules and structures (eg. lobbying, bureaucratic and political), and payments that may need to be made to those disadvantaged by the institutional changes.

Intertemporal transaction costs are the costs that current institutional structures can impose in the future, in the form of higher transition costs of change in those future periods. The link between current arrangements and costs of future changes is because of “path dependencies” (North 1990). These arise from the interdependence that develops between institutions and organisations, and because of the subjective models of the world that people rely upon in making choices. Transaction costs in political and economic markets make for inefficient property rights, but these subjective models of individual perception often prevent people from recognising preferred property rights arrangements.


Associated with operating under existing institutions (static)

É Static transformation

É Static transaction

Associated with changing institutions (dynamic)

É Technological transition

É Intertemporal transformation

É Institutional transition

É Intertemporal transaction

1.4.2 Transformation costs A similar dichotomy of transformation costs (also see Figure 1) can be outlined, based on the work of Marshall (2003), who described these technology costs in terms of pollution abatement technologies. Static transformation costs are the production technology and production process costs that are borne from operating in a particular institutional environment. Technological transition costs accrue from institutional influences on the choice of production technology and production process. They are the current costs of making technology and process changes. Intertemporal transformation costs are the future technological transition costs that may arise from future institutional or technological changes, and are caused by current institutional choices. Similar path dependency issues from institutional choice operate in relation to transformation costs as were outlined above in relation to transaction costs.

This dichotomy of transaction and transformation costs is central to the development of the framework expounded by this paper for the analysis of alternative institutional arrangements for water management, outlined in section 3.

The following section identifies a number of key historical institutional features of efforts to manage water resources in Australia.

1.5 Institutional effects on Australian water management Since European settlement, formal institutional arrangements for water management in Australia (in the form of legal codification of rights and obligations) have largely been derived from English Common and statutory law.

The extent to which the original statutory law base of water management in Australia is both consistent with and diverges from English law can in no

small part be attributed to the influence of Alfred Deakin. Deakin’s report to the 1884 Victorian Royal Commission on Water Supply (Deakin 1885), provided the base for not only the (Victorian) Irrigation Act 1888, but also the base for water legislation developed subsequently in other jurisdictions across Australia. Smith (1998) identifies the importance of Deakin’s report as arising from his concentration on administrative arrangements rather than engineering or agricultural aspects of irrigation and water management.

Smith (1998: 152) summarises the key beliefs underlying the report (and subsequently Victorian and other states’ legislation) as being that “responsibility, care and custody of water can only be invested in the state, the state’s right to water must not be compromised by riparian rights to anyone else, and the rights of the individual and the state need to be properly defined in order to avoid lengthy and costly legislation”. While individual Australian jurisdictions each have evolved somewhat different formal and informal institutional arrangements that are bound up in the political, physical, social, and economic circumstances of each state (and regions within them), these beliefs and Deakin’s report were instrumental in setting the path of institutional development.

The use of Australia’s land and water resources has always been managed in a way that supposedly pursued the best interests of the nation. But the more specific objectives of government and the community (from which institutional change is sourced), have evolved considerably over time. These have included objectives such as: development of a sturdy yeomanry husbanding the land; reasons of security from northern invaders; and broader economic development. Phases of water management have included development under ignorance of the environmental consequences, conscious exploitation (under assumptions of minimal harm), and more recently, management based on the need to maintain a broad range of (ecosystem) services through sustainable management (Barr and Cary 1992).

Institutional change in water management over the last decade has principally been linked with the Council of Australian Governments (COAG) water reforms. A range of interrelated factors were relevant in providing the enabling environment for political agreement amongst the jurisdictions to the COAG National Agenda for Water Reform. These included:

• Informal institutional changes in the form of the new supportive cultural values of environmentalism (which had dramatically affected the preferences of the community towards conservation and preservation of the environment), and economic rationalism (which supported conservation from the view that it was necessary to conserve land and water resources to the extent that doing so maximises community wellbeing);

• Specific direct effects in the form of poor water management outcomes, particularly from salinity and its demonstrated effects on farmers in irrigated regions of the southern Murray Darling Basin, and urban populations through increasingly poor water quality in Adelaide; and,

• Generally positive experiences of jurisdictions in NRM focussed cross-jurisdictional bodies such as had followed the creation of the Murray Darling Basin Initiative (including the Ministerial Council, Community Advisory Committee and Commission). Participation in these bodies demonstrated the common nature of many of the water management issues being faced, and the capacity to compromise and cooperate for the longer term mutual benefit of the jurisdictions involved.

As a consequence, the COAG water reform agenda was agreed to by the Commonwealth and all States and Terrritories in 1994. The COAG water reform agenda included a broad range of reforms, but were underpinned by the desire to achieve five key outcomes:

• water pricing based on full cost recovery and the amount of water used;

• the clear specification of water entitlements and arrangements to enable trade in those entitlements;

• the allocation of water to the environment;

• establishment of regulatory and water service institutions that have clear roles and responsibilities; and,

• public education and consultation (National Competition Council 1998).

In 1995, the COAG water reforms were also linked to the National Competition Policy (NCP) process. This means that the States and Territories progress with respect to water reform are assessed by the National Competition Council (NCC) and that the outcomes of these assessments have direct implications for the level of NCP tranche payments made by the Commonwealth to each jurisdiction. This significant fiscal influence has ensured that all jurisdictions have persisted with the significant and often difficult institutional reforms embodied in the 1994 agreement. The final NCC assessments of water reforms under this process are planned for 2005.

The first section of this paper has demonstrated the nature and importance of institutions in the management of economic resources in general, and to water management in particular. It has also introduced the concepts of transaction and transformation costs, and indicated that a framework based on the minimisation of these costs can be used in the analysis of alternative institutions. The next section identifies a number of key institutional design features that are important in explaining differences in the transaction and transformation costs associated with alternative institutional arrangements. Following that, section 3 brings together these features and the consideration

of transaction and transformation costs into a framework for assessing alternative water management institutions.

2. Generic institutional design features 2.1 Introduction Section 1 of this paper has provided an introduction to the nature and complexity of institutions, and their influence. North (2000) identifies the analysis of formal institutions (how they are formed through the aggregation of choices in political markets), and informal institutions, as of key importance to improving the management of economic resources and in improving economic performance. Institutions are critical to the way in which societies work, yet little is known of how they work and how they evolve through time, or what makes them work well or poorly. This section of the paper aims to identify some of the characteristics that make for good institutions.

Researchers in recent years have examined the specific institutional rules for a wide range of industries and different systems from within individual industries (eg. Ostrom 1993; Ostrom, Gardner and Walker 1994 specifically for common property irrigation institutions), and Goodin (1996). This type of

analysis enables the identification of design characteristics that are consistently associated with successful management of resources (and low transaction and transformation costs). Following an analysis of the literature, the following generic institutional design characteristics are proposed to be of key importance: clear objectives; interconnection with other formal and informal institutions; adaptiveness; appropriateness of scale; and compliance capacity. These are discussed in detail below.

2.2 Clear institutional objectives The attributes of this characteristic that make it vital in determining the success of institutions include:

• clarity of institutional purpose; and,

• transparency in the process of adjustment, where the purpose changes or evolves.

2.2.1 Clarity of institutional purpose Institutions can have a wide range of objectives, such as efficiency, unbiasedness, sustainability, equity and fairness (Loehman and Kilgour 1998). The objective that is chosen as the principle aim of any institution will ultimately affect the welfare of those people influenced by the institution. For example, institutional arrangements for the management and allocation of

mineral exploration licences that pursued an equitable distribution across the community as its principal objective, will provide different welfare outcomes to that community than an objective of sustainability. But clearly articulating that objective is critical in an institutional design sense because it facilitates the achievement of that stated objective in as efficient manner as is possible.

This straightforward aspect of good institutional design is regularly violated simply because there are multiple institutional objectives, and it is not made clear which is the key objective and which others should be viewed as constraints on the pursuit of that objective. The Tinbergen principle makes it clear that at least as many instruments are required as independent objectives (Tinbergen 1950). An example of a possible dilemma of this type is the desire to use a single policy instrument, water markets, to simultaneously pursue multiple and sometimes-conflicting objectives.

It is worth noting at this point that a potentially perverse relationship exists between the desirability of having clear objectives, and another desirable feature discussed below, adaptiveness. Hence, while adaptive capacity is a highly valuable feature of institutions, this extends to adaptiveness in objectives as well, and this may make objectives less clear.

2.2.2 Transparency in the process of adjusting institutional objectives A transparent process of adjusting institutional objectives is relevant because of the role that “power” plays in setting institutions. Transparency limits the exercise of power used by individuals and groups to influence institutional objectives in ways that are inconsistent with community objectives. To quote North (1990: 16),

“Institutions are not necessarily or even usually created to be socially efficient; rather they, or at least the formal rules, are created to serve the interests of those with the bargaining power to devise new rules. In a zero-transaction-cost world, bargaining strength does not affect the efficiency of outcomes, but in a world of positive transaction costs it


Transparency in the process mitigates the potential use of bargaining power to effect institutional change that is not in the interests of the broader group governed by the institution, by ensuring that feedback is provided to the broader group. This lessens the incentives to political actors to make inconsistent changes in objectives. The role of informal institutions in constraining this whole process of formal institutional change is an issue pursued in section 2.3. There are also obvious links between this issue and the institutional characteristic of “adaptiveness” discussed in section 2.4 below.

2.3 Interconnection with other formal and informal institutions It is widely recognised that bringing about change in the way a social system operates requires changes in the formal and informal institutions of society

(eg. Williamson 1985; Ostrom 1993; North 2000; Dovers 2001). However, the only group of rules over which there is direct control are the formal institutions. In addition, there are claims by some that informal institutions play a crucial role. For example, North (1990) claims that the relative success of the US economy through modern history in comparison to countries with similar formal institutional structures has been because the underlying informal institutional framework of the US has persistently reinforced incentives for organisations to engage in productive activity (whereas the informal institutional framework in some other countries have not).

Therefore, the nature of the relationship between formal and informal institutions and the influence of each in determining overall institutional performance in the management of any system is of key interest.

The cultural values and governance system of a society to a large extent determines the internal values of organisations, and these in turn rule the organisation (Ruys, van den Brink and Semenov 2000). In the same way, the informal institutions of society can be seen as determining or constraining the scope of actors with political power to alter the formal governing institutions

(of society broadly or of some other social organisation). This view is consistent with Challen’s (2000) conceptual model of the process of institutional change (see Figure 2 below).





Perceived costs and benefits of political


Economic change

Social technology

Political tastes and preferences


Perceived costs and benefits of private actions

Relative scarcity

Priv ate

Investment in political lobbying

Invest ment



Source: (Challen 2000: 49)

This model stylises the interactions between private entrepreneurs (who are the firms, households, producers and consumers typical of the actors in economic models), and political entrepreneurs (members of the polities that develop and implement formal institutions of social and economic change). It illustrates how:

• both sets of entrepreneurs react to changing incentives;

• the capacity of political entrepreneurs to bring about formal institutional change (through the political collective) is constrained by private tastes

and preferences, political tastes and preferences, and states of social technology; and,

• the resulting formal institutional arrangements affect future change (ie. it is a cycle).

An example of the complexity of this relationship between formal and informal institutions and the relevant actors to their management, and the incremental pace of institutional change is provided in relation to water management within the following quote from Barr and Cary (1992: 206)

“The salinisation of irrigated lands seeped into the public consciousness in the 1980’s. Bureaucrats, engineers, agricultural scientists and farmers knew of it earlier, there was plenty of evidence of failures of irrigated agriculture and horticulture in the 1950’s when the last great irrigation engineering feats were being wrought”.

The above discussion illustrates the interrelationships between formal and informal institutions, but also highlights the degree to which active institutional design may be restricted to consideration of formal institutional

arrangements. Yet, in other circumstances it may be found that the formal institutional arrangements are unresponsive to changes in the informal institutional environment. The level of effect that formal and informal institutions can individually have on overall institutional performance is considered below.

Experiments by Ensminger (2000) show that the existence of formal and informal institutions matter in determining the attitude of people in terms of risk, fairness, trust, cooperation, self-interest and altruism. Ensminger found that many characteristics important in supporting generalised trust in society are significantly affected (positively in this case) by formal institutional arrangements, rather than being purely an outcome of social norms, conventions and social networks (informal institutions). This would indicate that some barriers to institutional performance which appear to be within the domain of the informal institutional environment, may be able to be influenced effectively through the design of formal institutions.

Conversely, there is also research evidence that informal institutions can substitute for formal institutions in particular circumstances (North (1990), Greif (1994), Greif (1993), and Ensminger (1992)). Keefer and Shirley (2000), however warn that informal institutions do a poor job of protecting against expropriation by private actors and government officials, and may not provide consistent institutional support to all people with a stake in a particular issue.

Closer investigation by Keefer and Shirley (2000) indicated that an important factor is the complementarity of formal and informal institutions. Keefer and

Shirley analysed differences in the growth in foreign investment throughout the 1990’s in China and Ghana, and the proposition that high foreign investment in China (in the absence of strong formal institutions to protect

investment capital) was due to the strength of Chinese informal institutions. This proposition becomes difficult to support in the face of similar formal and informal institutional capacities in Ghana, which has low growth in foreign investment. They found instead that a key difference was the extent of

complementarity between formal and informal institutional arrangements in China compared to Ghana (due partic ularly to differences in political decentralisation between the two countries).

Finally, the above would indicate the desirability of having as high a level of consistency as possible between formal and informal institutions. Others, however, such as Dovers (2001) and Goodin (1996), identify the need for an

element of inconsistency, or ill-fit in order to generate a tension for institutional change.

In summary, the evidence suggests that:

• both formal and informal institutions are important to overall institutional performance;

• a balance of “power” needs to be shared between formal and informal institutional actors;

• political actors (responsible for formal institutional change) need to be accountable;

• informal institutions should be well connected to, but retain relative independence from, political actors; and,

• where there is a poor interconnection between the formal and informal institutional environment, there is some scope for cautious substitution.

2.4 Adaptiveness Institutions associated with the management of natural resources need to be adaptive because of the inherent complexity of natural systems. This creates uncertainties in relation to the adequacy of management actions to address specific issues, and produces uncertainty with respect to the consequences of these actions on other parts of these complex dynamic systems. In addition, all institutions (even those where full knowledge of the consequences of actions are known) need adaptive capacity because changes in technology, and private and political tastes and preferences will generate pressures for institutional change. Dovers (2001) identifies the following principles for adaptive institutions: persistence, purposefulness, information-richness and sensitivity, inclusiveness, flexibility and scale appropriateness.

Adaptive management allows resource managers to continue to manage despite inherent complexity and uncertainty (Holling 1995). It has

increasingly been adopted as a guiding management principle by natural resource managers in Australia, particularly as the focus of resource management has moved from objectives of “efficient exploitation” to “sustainable use” (Allan and Curtis 2003).

However, there is a range of different forms of adaptive management. Evolutionary adaptive management describes a trial and error approach to management. Passive adaptive management uses lessons from the past to develop a single best policy to adopt in practice. Active adaptive management is learning focussed and uses policy and its implementation as tools for learning. Active adaptive management is also participatory and uses policy implementation to test hypotheses (Allan and Curtis 2003).

The above would appear to indicate that the increased experimentation and learning, which is key to effective adaptive management, will necessarily have positive institutional and management performance outcomes. Unfortunately, the existence of dynamic costs of change, and specifically intertemporal transaction and transformation costs (outlined in section 1.4), create perils from the adoption of broadscale institutional experimentation. In discussing the history of water management in Australia and its implications for future management, Smith (1998: 138) quoted the following from social scientist George Kennan (1973),

“Every mistake is in a sense a product of all that has gone before it, from which it derives a sort of cosmic forgiveness, and at the same time every mistake is in a sense the determinant of all the mistakes of the future from which it derives a sort of cosmic unforgiveableness”.

Challen (2000) concluded that these dynamic costs might in fact favour conservative decision making which ensures institutional flexibility is maintained. This implies that caution is required with institutional experimentation. This may be particularly true with innovative, but risky institutional variations, because the long-term costs caused by path dependency outweigh the benefits. The opposing view to the cautious approach is that while the costs of poor institutional innovations may be magnified when viewed in the real (dynamic) environment, it is also true that

the opportunity costs of not undertaking good institutional innovations are also magnified through path dependency. The key would appear to lie in maximising the level and effectiveness of institutional learning, without compromising institutional flexibility. This requires the adoption of “active” adaptive management approaches, and a thorough evaluation of the potential dynamic costs and benefits of institutional experimentation, not just the static benefits and costs.

2.5 Appropriateness of scale The spatial and administrative scales that institutions are based upon are extremely important to their success (Dovers 2001).

Spatial scale refers to the physical area over which the institution operates and to the basis by which the boundaries of this area are determined. For example, a spatial scale could be determined on the basis of a river catchment or habitat type (ecological), state, local government or electorate areas (political), the people living in a particular street or town, or who are members of a particular organisation (social).

The boundaries of natural resource institutions are occasionally based on catchment areas. However, as institutions are the constraints that shape human interactions, it is also important that the social context is considered in the process of determining an appropriate scale over which to construct institutions. Curtis et al. (2002) claim that the establishment of local groups using social boundaries is key to the success in sustaining water management groups over time. This is because of the effects on community cohesion and sense of purpose that are generated when groups are established on social and not just catchment boundaries. It could be argued that the potential for success of these groups is raised because they are based on a scale that reflects their shared informal institutional foundation.

The administrative scale of an institution refers to the group whom is responsible for its implementation. This may be some level of government, a small or large social group, or the community in general. Challen (2000) illustrates the importance of scale through the analysis of institutional

functions within hierarchies (for example defining the entitlements of potential water users). The administrative and spatial scale ascribed to a particular institution within an institutional hierarchy can be demonstrated to

dramatically affect the transaction costs associated with management decisions.

2.6 Compliance capacity North (2000) identifies enforcement as a key issue in understanding how to develop better institutions, and claims that there is imperfection in the enforcement of all formal and informal institutions. The reasons for these differences in enforcement of formal rules and informal norms are not well understood. Ostrom (1993) also identifies compliance as being central to the design of long-enduring irrigation institutions.

The reason why compliance and enforcement are important is because there are costs involved in the making of a contract. These costs mean that contracts will rarely be comprehensive in covering all conceivable outcomes (ie they are incomplete). This incompleteness creates the incentive for parties to spend resources trying to capture the unallocated potential for benefit under the

contract. In addition, compliance capacity is required to deal with violations of contractual elements that are specified.

Menard (2000) cites previous research by Levy and Spiller (1994), and Shirley (1995), and reports new research findings indicating strong links between the enforcement capacity specified in particular contracts and the success of particular institutional forms. Appropriate enforcement arrangements exhibit themselves through the persistence and success of particular contractual arrangements within the same sector and within the same institutional environment.

There are two forms that compliance mechanisms can take. Barzel (2000) refers to these compliance mechanisms as self-enforcement and third-party enforcement. They are also referred to as internal and external compliance measures. The essence of both of these enforcement mechanisms is the ability to punish. The costs of punishment can be imposed in a variety of ways, falling into two broad categories:

• by third parties reducing the level of valuable long-term relations between the enforced and others (eg. by tarnishing the enforced’s image); and,

• when there is no enduring relationship between the enforcer and the enforced, by imposing harm, generally through violence. Violence is defined as impersonal means of imposing costs. This includes the threat of physical violence such as incarceration, and the confiscation of valuable assets (Barzel 2000).

While a range of individuals and groups can provide third party enforcement, the state generally has a comparative advantage because of its ability to impose immediate large costs. Self-enforcement works well where there is positive value to all the parties from maintaining a contract. Where the value of a venture is believed likely to become negative to one party during the period of a contract, third party enforcement is likely to be required. Significant differences exist in the transaction and transformation costs of different enforcement arrangements.

3. Empirical techniques for measuring institutional performance 3.1 Capacity to empirically estimate transaction costs As discussed in section 1, New Institutional Economics (NIE) provides a theoretical framework for the evaluation of alternative institutions through the assessment of transaction and transformation costs. This cost-effectiveness approach runs into problems in empirical analysis, particularly regarding

measurement of intertemporal transaction and transformation costs. This is generally seen as being due to a lack of procedures and techniques for measuring and quantifying the different types of transaction costs (eg. Coase


Benham and Benham (2000), outlines a broader range of reasons why there are relatively few empirical studies undertaken of transaction costs, given the importance of transaction cost information in determining economic performance. These include:

• the lack of standard terminology defining transaction costs;

• problematic estimation problems because production and transaction costs are jointly determined;

• an understanding of the opportunity costs of the full range of alternatives which determine choices of individuals is difficult when many kinds of transaction do not take place in open markets (if at all); and,

• the law of one price does not apply, with individuals facing very different transaction costs.

Overall, however, they reach a similar conclusion regarding the evaluation of transaction costs “the opportunity costs of measuring the opportunity costs of exchange is likely to be very high” (Benham and Benham 2000: 372). In addition, they conclude that most attempts are in ex-post analysis, which brings little assistance to the more pressing problem of ex-ante evaluation of alternative institutional forms.

Nevertheless, while being ex-post oriented, a range of empirical studies of transaction costs can be identified. The methods employed vary, but include hedonic pricing methods (and analyses of price dispersion that is not explained by product heterogeneity or imperfect information), and the evaluation of standard exchanges in alternative institutional settings (eg. land title exchange, purchase of equipment).

Examples specifically concerning water management also exist, particularly relating to water transfers. In the investigation of water allocation issues, Colby (1995) identifies a small number of studies that attempt to quantify transaction costs in relation to water transfers. These include studies by Khoshakhlagh et al. (1977), Anderson (1983), Nunn (1989), and Macdonnell(1990). Easter et al (1999) cites Archibald and Renwick (1998),

Hearne and Easter (1997), Howe (1998), and Colby (1998), all in relation to research on transaction costs associated with water transfers. Recent Australian studies on transaction costs in water management include Challen

(2000) and Crase (2000).

Crase (2000) includes a review of empirical studies of institutional design issues related to water markets. Crase distinguishes between “quasi-

empirical” analyses (which employ observations from related input and output markets to infer behaviour under idealised water trading scenarios) and “pure-empirical” analyses (which have a clearer focus on the behaviour of genuine economic agents in water markets). A total of 25 quasi-empirical studies were reviewed, employing a wide range of simulation and optimisation methods. There is little indication that the consideration of transaction costs were more than a minor consideration in the specification of these models. The group of 12 pure-empirical studies, which by the nature of Crase’s delineation were ex post evaluations, placed much greater emphasis on transaction cost influences, and or their estimation. Nevertheless, Crase concludes that:

“the explorations to date have employed a relatively narrow definition of transaction costs focussing on conventional market failures, third-party effects, infrastructure impediments, policy induced costs and administratively-induced transaction costs. In most cases analyses have used empirical evidence to acknowledge the existence of transaction costs

without quantifying the extent of specific costs” (Crase 2000:191).

Criticism of the studies that have been undertaken of transaction costs associated with institutions for use of natural resources also comes from Challen (2000). He does so on two bases. First, that they lack a consistent conceptual approach to identifying, classifying and quantifying transaction costs, and second, for their failure to generalise their research findings within a conceptual model of institutional choice. Without these attributes, Challen claims these studies are little more than data collection exercises.

Williamson (1985) and Marshall (2003) also agree that there are significant barriers to the empirical evaluation of transaction costs, but suggest that there may be alternative approaches to the evaluation of alternative institutional forms other than through direct measurement of transaction costs. Williamson (1985), proposes that as transaction costs are always assessed in a comparative institutional way, it is the difference between rather than the absolute magnitude of transaction costs that matters. Further, Williamson claims that evaluative emphasis should be placed on determining the consistency of institutional form with the type of transactions.

“Empirical research on transaction cost matters almost never attempts to measure such costs directly. Instead, the question is whether organisational relations (contracting practices; governance structures) line

up with the attributes of transactions as predicted by transaction cost reasoning or not” (Williamson 1985:22).

Marshall (2003) approaches the problem of transaction cost measurement from a similar angle, proposing the use of inductive (rather than deductive) approaches to the analysis of institutions. This involves searching for

regularities in the behaviour and performance of particular institutional forms in relation to associated transaction and transformation costs. Marshall’s approach is outlined below, and forms the core of the framework adopted in this paper.

3.2 Framework for assessing alternative institutional forms The framework proposed links five elements that have been discussed above. First, it adopts North’s (1990) recognition of the effects of institutions on both transaction and transformation costs. Second, it also includes Challen’s (2000) emphasis on the dynamically determined costs of institutions. Third, it incorporates Marshall’s extension of these dynamic cost dimensions to transformation costs as well as transaction costs, and fourth, Marshall’s proposed use of heuristics in assessing the transaction and transformation costs of alternative institutions. Finally, the framework also uses the generic institutional design features identified in section 2, to guide the comparison of alternative institutional structures.

Marshall builds on the framework for institutional choice developed by Challen (2000). Challen proposed that the criterion for institutional choice is cost-effectiveness in achieving a given policy objective. The relevant costs in his framework include static transaction costs, transition costs and intertemporal opportunity costs. Marshall augmented the framework by also including recognition of the effects that the institutional environment has on the technology employed. Marshall’s extension was developed in the context of institutions for pollution control, and consequently refers to the technology effects as static abatement costs, technological transition costs and intertemporal abatement costs. For the purposes of this paper the terminology outlined in section 1.4 will be used. That is, optimal institutional structure can be analysed as the minimisation of transaction costs (static transaction costs, institutional transition costs and intertemporal transaction costs) and transformation costs (static transformation costs, technological transition costs and intertemporal transformation costs).

The next component of the framework involves the use of heuristics to replace some elements of empirical evaluation. Clearly, the sum of transaction and transformation costs is important in empirical comparisons of institutions. It is also clear that the complex web of transaction and transformation costs are unlikely to be comprehensively evaluated either because of evaluation resource constraints, or because of the inherent difficulty in evaluating some aspects (such as intertemporal transaction and transformation costs).

The final element of the framework is the use of the generic institutional features that have a demonstrated role in determining institutional performance. Focussing empirical evaluation (either formally or through the

use of heuristics) on those aspects known to be important in determining institutional performance (because they are the source of considerable variability in transaction and transformation costs) will generate much higher returns to the resources invested in institutional evaluation. This addresses the concerns of Benham and Benham (2000) in relation to the high opportunity costs of measuring transaction costs, and is also consistent with Williamson’s (1985) position that it is the difference between rather than the absolute magnitude of transaction costs that matters.

3.3 Empirical measures relevant to assessment of generic institutional design features Having established a range of key institutional features, and the need to evaluate the transaction and transformation costs of different institutional options in relation to these features, this section identifies potential empirical analyses of these costs, which may be relevant in analysis of particular institutional problems. While the development of useful heuristics requires the consideration of a wide range of circumstances in order to determine reliable patterns, some possible heuristics are also proposed.

Institutional design feature 1: Clear objectives Potential empirical measures

• Non-monetary measures of consistency of water management legislative objectives between jurisdictions, and of community awareness and agreement with water management objectives.

• Time and financial resources invested in altering legislative objectives (which is related to dispersion of political power).

• Cost of legal disputes centred on water management objectives.

• Measures of price dispersion (which is not explained by imperfect information) as a measure of static transaction costs for heterogeneous resources for which there is a market.

Potential heuristics?

• Institutions with clearly defined objectives will lower static and dynamic transaction costs (eg. classification of ACT sub-catchments according to principal management objective).

• Where political influence over the determination of institutions is concentrated, transformation costs will be lower under conditions of clearly defined objectives in comparison to transformation costs where objectives are unclear (eg. determination of bulk water pricing in NSW and effect on agricultural production costs).

Institutional design feature 2: Interconnection with other formal and informal institutions Potential empirical measures

• Cost of creating formal institutions, which replicate institutions that in other circumstances could have existed as informal institutions.

• Extent to which formal institutions reflect norms and values evident in the management of other resources/circumstances.

• Difference in cost of collecting information, monitoring and decision making to support formal institutions, compared to operation in presence of supporting informal institutions.

• Difference in welfare outcomes of similar formal institutions within different informal institutional environments.

Potential heuristics?

• Formal institutional arrangements that are highly consistent with informal institutional norms and values have lower static transaction and transformation costs (but may not be highly adaptive).

• Where formal and informal institutions are inconsistent, informal institutional capacity can lower the static and dynamic transaction costs (eg. management of water resources to meet aboriginal cultural needs).

Institutional design feature 3: Adaptiveness Potential empirical measures

• Estimation of costs of reversing institutional change

• Estimation of option values of learning for particular circumstances.

• Salvage value of technology employed which is specific to institutional environment.

• Static transaction and transformation costs of property right attenuation and transition cost effects of property right attenuation.

• Trends in static transaction and transformation costs over time.

• Measure of heterogeneity in management processes between management units.

• Heterogeneity in transformation technologies between production units.

• Analysis of extent that evaluation and experimental evidence has in the past been incorporated into future management principles for particular types of institutional arrangements. Pertinent characteristics include relevance, comprehensibility, validity, and comprehensiveness.

Potential heuristics?

• Institutions that facilitate experimentation and innovation are likely to induce lower transformation costs.

• Institutions that support clear monitoring and review processes are likely to have lower institutional transition and intertemporal transaction costs.

• Institutions that incorporate flexibility in how outcomes are achieved are likely to have lower transaction and transformation costs than institutions that prescribe processes (as learning is correlated to variation and experimentation).

• Experimentation and innovation will lower the intertemporal transaction costs of institutional change under conditions of uncertainty.

• Institutions with active adaptive management processes will have higher static transaction costs.

• Institutions which incorporate evaluation as an integral component of operational process will have lower institutional transition and intertemporal transaction costs, and lower technological transition and intertemporal transformation costs.

Institutional design feature 4: Appropriateness of scale Potential empirical measures

• Analysis of information collection costs at different scales (to support particular water management decision the institution is intended to guide).

• Type and level of interest or stake (direct, indirect, public/private goods) that individuals and groups in the community have in water management outcomes as an indicator of institutional transition costs at different scales.

Potential heuristics?

• Intertemporal transaction costs tend to be higher the more that property rights are decentralised (eg.future costs of changing institutional rules over water access are higher when property rights to access by final users are fully specified).

• NRM institutions which have common social and ecological scale have lower static and dynamic transaction costs (eg. local supply channel management).

Institutional design feature 5: Compliance capacity Potential empirical measures

• Measures of internal enforcement costs (relative to value of resource use).

• Measures of external enforcement costs (relative to value of resource use).

• Levels and cost of non-compliance.

Potential heuristics?

• Institutions that have high levels of internal enforcement support will have lower static and dynamic transaction costs where maintaining a contract for its full duration is mutually beneficial (eg. government and irrigators undertaking actions which both improve agricultural productivity and improve water quality in a river).

• Institutions that have high levels of external enforcement support will have lower static and dynamic transaction costs where maintaining a contract disadvantages any party at any time during the life of a contract (eg. compliance with Cap).

• External compliance measures that monitor indirect attributes based on specified production technology or processes will have higher intertemporal transformation costs (eg. compliance measures to monitor water use by stipulating production technologies and practices).

Undertaking these analyses or applying these heuristics in the assessment of alternative institutions is still no straightforward task. In particular, the aggregation of costs when heuristics are used remains problematic. Heuristics only provide an indication of relative costs for a particular type of cost, and for particular features of institutional design. In addition, insights gained from the consideration of transaction and transformation costs in relation to specific features is invaluable, but a clear understanding of the interactions between institutional features is also required in the overall assessment of alternative institutions.

4. conclusion

New Institutional Economics (NIE) theory indicates the importance of transaction and transformation costs in institutional choice. Empirical approaches exist which attempt to either measure transaction and transformation costs in aggregate forms, or measure individual elements of

these costs. The measurement of individual elements is required in order for the process to inform researchers and policy makers of relationships that are important in determining institutional performance in different circumstances. This is particularly necessary when considering the potential

transfer of institutional arrangements from one context (industry, resource, region, country) to another. It needs to be remembered that it is the lessons of successful institutions that need to be transferred, not the (apparent) institution itself.

A framework for assessing alternative institutions has been proposed. Under this framework optimal institutional structure is analysed as the minimisation of transaction costs (static transaction costs, institutional transition costs and intertemporal transaction costs) and transformation costs (static

transformation costs, technological transition costs and intertemporal transformation costs). The framework focuses on this range of costs in relation to five particular institutional features that have been shown to be important in explaining differences in institutional success. These five institutional features are:

• clear institutional objectives;

• connectedness between formal and informal institutions;

• adaptability;

• appropriateness of scale; and.

• compliance capacity

A range of empirical measures of static and dynamic transaction and transformation costs have been discussed in regard to these institutional features, and potential heuristics proposed that in certain circumstances may be able to be applied in lieu of full empirical evaluation.

The use of a framework such as has been proposed, significantly increases the value of undertaking institutional analysis. First, the framework provides a means to gain a better understanding of specific elements of institutional design (for example, the static transaction costs associated with alternative compliance measures, as part of institutional arrangements for unregulated

water allocation in a catchment). But it does so in a way that those findings are integrated with other elements of institutional design critical to the management of that particular resource or situation (for example, what effect the adoption of particular compliance rules may have on the costs of reallocation of the water, or of changing production practices or technologies in the future).

Second, the framework allows for the generalisation of research findings about alternative institutional design to other contexts. This is because the findings are linked to specific institutional features, the nature of which can be compared to the features of the new context.


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