4.3 Institutions and resource allocation
Institutional settings will influence decisions made by firms about the factors of production they employ and how they deploy them. Institutions affect the attractiveness of the different resources by changing their availability, flexibility and cost. While firms need a minimum amount of each or some of the factors, they have discretion over how much of each they will use in total.
The effect of institutions on the relative attractiveness of the factors will lead firms to change the mix of resources they use. For example, institutions governing the employment of workers will affect the availability, flexibility and cost of labour and thereby firm decisions about hiring labour and investing in human capital. However, institutions governing the use of physical capital, land and other natural resources can also affect firms’ decisions about labour. These institutions may constrain firms more or less in their production decisions than institutions governing the use of labour, altering the relative attractiveness of labour as an input.
To maximise economic growth, institutions ideally enable the factors of production to flow to where they will generate the greatest return. Institutions will lead firms to change from what would be an optimal mix in an unconstrained environment to what is optimal given the constraints introduced by institutions. If one factor becomes relatively less attractive because institutions make it more costly, where possible firms will substitute other resources for it.
The overall effect of institutions on the use of or investment in particular factors is not a straightforward relationship. Institutions introduced to address issues related to one factor of production can have implications for the use of other factors, which may not have been an intention of the institutional change.
The extent to which institutions influence the relative attractiveness of the factors will therefore affect the levels of investment that firms make in each of the factors. For example, stricter labour regulations may make labour less flexible and more costly, which may lead firms to make greater use of physical capital in their production processes. Greater use of physical capital may require greater investment in the human capital of the firm’s workers.
Figure 2 illustrates the effect of institutions on resource allocation.
Figure 2 – Resource allocation within firms
The effect of institutions on the use of labour, capital and land and other natural resources in discussed in section 5.
4.4 Institutions, transactions and governance
Firms transact with each other to sell their products or to buy inputs into their production processes. As discussed earlier, there are costs associated with transactions, which may deter firms from transacting if the costs are too high. Firms exist to reduce transaction costs. Coase (1937) explains the costs of transacting as the cost of discovering what the relevant prices are and negotiating and concluding a contract for each exchange. Key transaction costs include information, monitoring and uncertainty.
Resource owners will create a firm if they can coordinate resources and produce output at a lower cost within the firm structure than they could acquire inputs for on the open market.
Institutions influence transaction costs and therefore the establishment of firms. They influence the number, size and structure of firms that are established in a market. They affect the relative attractiveness of within firm activities and between firm transactions by changing the costs associated with these two means of organising production. Property rights and contract enforcement institutions determine transaction costs, corporate governance institutions influence agency costs, and product market institutions determine firms’ access to markets.
Institutions that result in higher transaction costs may discourage the creation of new firms, increase the size of existing firms and reduce transactions, if it is less costly to undertake exchanges within the firm. However, if property rights and contract institutions reduce transaction costs, they provide a pressure on management to improve the efficiency of their production processes, to avoid outsourcing of their functions and loss of their jobs.
The influence of institutions on transactions between firms is illustrated in Figure 3.
- Figure 3 – Transactions between firms
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The effects of product market and corporate governance institutions are discussed in section 6.
4.5 New Zealand’s activity-specific institutions
New Zealand’s activity-specific institutions are rated highly in international comparisons. In the World Competitiveness Yearbook, IMD International (2004) rank New Zealand 9th out of 60 countries for its business legislation, which covers institutions related to labour, capital and product markets. In the Economic Freedom of the World, New Zealand is ranked 4th in terms of its business regulation (again, related to labour, capital and product markets). McMillan (2004) suggests that New Zealand’s labour markets and financial markets seem to be doing their job and that there is no need for more or for less government action.
