How Institutions Affect Outcomes in Laboratory Tradable Fishing Allowance Systems

Agricultural and Resource Economics Review, Oct 2004 by Anderson, Christopher M

The objective of this paper is to illustrate that economic institutions matter, i.e., that different rules of trade present different incentives for bidding, asking, and trading in new markets, and that these different incentives lead to different price discovery patterns, which yield materially different outcomes. In a laboratory tradable fishing allowance system, when trade takes place through a double auction, which parallels an institution common in extant tradable allowance systems, markets are characterized by high volatility, and equilibrium does not obtain. However, when only leases, and not permanent trades, are permitted in the early periods, volatility is significantly reduced and equilibrium obtains. This dependence of equilibration and outcomes on institutions implies policyoriented economists must consider institutions in designing new market-based management systems.

Key Words: asset markets, experiments, fishery management, ITQs, tradable fishing rights, transferable allowances

Policy makers are making increasing use of tradable allowance systems to address environmental and natural resource management problems, including water use, pollution, and over-fishing (Tietenberg, 2002). A management authority that applies a tradable allowance system typically sets an allowable level of activity, allocates the allowance among users, and gives users the right to trade their allocations to others.1 In doing so, the management authority effectively establishes a market for an entirely new asset, which can be of great value, and represents a significant portion of the wealth of the resource users, particularly in water and fishing applications where the users are often small or family businesses. However, because the asset is new, there is little basis on which the market participants can draw to determine the prices that are likely to emerge.

Participants in this new market know only their private values, and have little idea of the marketwide marginal value of allowance, which the competitive model predicts will emerge as the equilibrium price. As a result, each participant must rely on the information she can glean from the market-the bids, asks, and trades of others, as well as the market reaction to her own bids and asks-to determine whether or not a prospective trade constitutes a good deal. It is not surprising, then, that different institutions, which provide different amounts and different types of information, and possess different incentives for revealing information through bids and asks, yield systematically different sequences of bids, asks, and contracts, and therefore equilibrate differently.

The objective of this study is to illustrate that economic institutions matter, i.e., to show these different patterns of equilibration yield materially different outcomes. Specifically, in a laboratory evaluation of a significant tradable fishing allowance system, one commonly used institution performs poorly while a simple modification leads to reliable equilibration. While the research being discussed is ongoing, there is sufficient evidence to argue that policy makers and economists must consider the equilibration process, and the institutions affecting it, in developing new market-based management systems. The wrong institution can lead to so much volatility during initial trading that effective price discovery cannot occur, and equilibrium is never reached. Alternatively, bad outcomes can arise during price discovery, and although the market eventually stabilizes, perhaps even at competitive equilibrium prices, trades made during equilibration lead to gross inequities among similar participants based solely on when they traded.

The implication of outcomes' dependence on institutions is that policy-oriented economists must begin asking a question which has previously not been posed: How should the rules of trade be designed to best achieve policy objectives? This question is new because there is nothing in competitive microeconomic theory which suggests equilibrium outcomes depend on institutions; there is no mention of institutions in popular graduate microeconomic theory texts such as Varian (1992); Silberberg (1994); or Mas-Colell, Whinston, and Green (1995). As a result, there is a common perception among economists, politicians, and the public that if regulators establish property rights for natural resource use or environmental harms and allow trade, markets will emerge and efficient allocations or least-cost abatements will arise (e.g., Gwartney et al., 2002). Unfortunately, it is not so simple.

Economists have not devoted attention to the equilibration process, or to the institutions on which it depends, because most of the markets historically of interest are already well established, or can be based on established markets, so the initial price discovery process has already occurred. Consequently, there is not, and has been little need for, a theory of equilibration.2 However, markets for tradable natural resource or environmental damage allowances are created, and the associated price discovery process can have important effects on outcomes for the market participants. Therefore, effectively implementing market-based management measures requires considering the effect of institutions on price discovery, and on the market outcomes that are determined during equilibration.