Institutional Economics Lecture Note For WKU, Fourth Year Agricultural Economics Students CH-1

Chapter 1: Concepts and Roles of Institutions

Dear students, there is vast differences in growth and development across countries today.
Where did these differences arise from? Standard economic answers may be: physical capital
differences (poor countries don’t save enough), human capital differences (poor countries don’t
invest enough in education and skills), and technology differences (poor countries don’t invest
enough in R&D (Research & Development) and technology adoption, and don’t organize their
production efficiently.

These are, however, proximate causes of differences in prosperity. Why do some countries invest
less in physical and human capital? Why do some countries fail to adopt new technologies and
to organize production efficiency? The answer to these questions is related to the fundamental
causes of differences in prosperity. Potential fundamental causes: institutions (humanly-devised
rules shaping incentives), geography (exogenous differences of environment), culture
(differences in beliefs, attitudes and preferences), thus, institutions matter. It is necessary to
understand rules of the game. Countries with better institutions prosper, while those with bad
institutions stagnate or decline. Good institutions to be those that encourage investment in
physical, human capital, and in technology, and bad institutions in the opposite.

1.1. Definition of Institution

What are institutions?

Like many terms in the areas of social sciences, there is no universally accepted definitions.
Institutions are different from organizations. The meaning of institution in sense of economics is
much wider, complex and abstract than its literally known meaning.

Definitions of institutions from the perspective of Old Institutionalists

Institutions are "settled habits of thought common to the generality of men." (Veblen 1919)
Institutions are understood as essentially “collective action in control of individual action”
(Commons 1934, 69).
Institution are "way of thought or action of some prevalence and permanence, which is
embedded in the habits of a group or the customs of a people." (Hamilton 1934).
 Institutional Economics Lecture Note For WKU, Fourth Year Agricultural Economics Students CH-1

Notably, in the "old" institutionalism, the concept of habit plays a central role both in its
definition of an institution, as in its picture of human agency.
Institutions from the perspective of New Institutionalists

Institutions are “the humanly devised constraints that shape human interaction” (North 1990).

This definition seems to exclude conventions, habits and even some norms that are not the
product of human design but that just arise autonomously. To include norms and conventions,
North provide an alternative definition: Institutions are “the rules of the game” (North 1994).

According to Douglas North, the rules provide a framework of incentives that shape economic,
political, and social organizations. Institutions are composed of
1. Formal rules (for example, laws and constitutions),
2. Informal constraints (conventions, codes of conduct, and norms of behavior), and
3. Their enforcement.
Together they define the incentive structure of societies and specificially economies. They
consist of both informal constraints (sanctions, taboos, customs, traditions, and codes of
conduct), and formal rules (constitutions, laws, property rights) Formal constraints: rules, laws,
constitutions. Informal constraints: norms, behavior, conventions.

Institutions are the written and unwritten rules, norms and constraints that humans devise to
reduce uncertainty and control their environment. These include: written rules and agreements
that govern contractual relations and corporate governance, constitutions, laws and rules that
govern politics, government, finance, and society more broadly, and unwritten codes of conduct,
norms of behavior, and beliefs. Key point: institutions; are humanly devised, set constraints,
shape incentives, Should have enforcements and economics began as institutional economics.
Organizational arrangements are the different modes of governance that agents implement to
support production and exchange. These include: markets, firms, and the various combinations
of forms that economic actors develop to facilitate transactions, contractual agreements that
provide a framework for organizing activities, and the behavioral traits that underlie the
arrangements chosen. Institutions “structure incentives in human exchange, whether political,
social or economic”. Predatory (bad) institutions: as institutions that do not encourage
investment and economic development. Developmental (good) institutions: institutions that
 Institutional Economics Lecture Note For WKU, Fourth Year Agricultural Economics Students CH-1

permit or encourage investment and growth. Institutions have a broad cluster including many sub
levels:

A. Economic Institutions

Economic institutions are a set of constraints that govern the relations among individuals or
groups in economic activities. The economic activity could be production, allocation,
distribution or exchange. Economic institutions make up the economic system – the
framework that regulates economic activity. Economic institutions as understood as
proving the incentive structure that encourage agents to behave in certain way instead of
other way. Institutions are, therefore, critical to determining economic performance by
influencing the cost of production, the mode of allocations and the costs of transactions.
They may be broadly grouped into two categories: those that define the forms of ownership of
the means of production, and those that define the mechanisms for resource allocation and co-
ordination of economic activity. Markets can thus be considered as one form of institutions
coordinating economic activities.

Economic institutions determining the “economic rules of the game” In particular, the degree of
property rights enforcement, the set of contracts that can be written and enforced, and some of
the rules and regulations that determine the economic opportunities open to agents. Examples:
individual property rights, commercial law contract law, patent law, the type of credit
arrangements, etc. shape economic incentives, contracting possibilities, distribution. Economic
growth brought forth by: inclusive economic institutions: Secure property rights, law and order,
markets and state support (public services and regulation) for markets; open to relatively free
entry of new businesses; uphold contracts; access to education and opportunity for the great
majority of citizens that is it creates incentives for investment and innovation and a level playing
field. But most societies throughout history and today ruled by Extractive economic institutions:
Designed by the politically powerful elites to extract resources from the rest of society. Inclusive
and extractive economic institutions do not exist in a vacuum, but are supported by certain
political institutions. They exist following the type of political institution that exists.

B. Political Institutions
 Institutional Economics Lecture Note For WKU, Fourth Year Agricultural Economics Students CH-1

Political institutions determine the “rules of the political game.” Help to regulate the limits of
political power and determine how political power changes hands. Form of government,
constraints on politicians and elites, separation of powers, etc. Examples: the constitution
electoral rules, constraints imposed on the power of the executive by other branches of the
government, the number of veto players, the extent of checks and balances etc. shape political
incentives and distribution of political power. Enforcement of property rights, democracy vs
dictatorship, entry barriers, constraints on politicians and political elites, corruption and
electoral rules in democracy, legal systems.

Extractive political institutions: in the limit absolutism. Political institutions concentrating power
in the hands of a few, without constraints, checks and balances or “rule of law”. Inclusive
political institutions: Political institutions allowing broad participation-pluralism- and placing
constraints and checks on politicians; rule of law (closely related to pluralism). There is synergy
between political and economic institutions.

The Difference between Institutions and Organization

In the context of institutional analysis, institutions are complexes of rules, norms and behavioral
patterns that persist over time by serving some collectively valued purposes, whereas
organizations are structures of recognized and accepted roles, that a groups of individual bound
to gather by some common purpose to achieve certain aim /objectives examples: political parties,
regulatory bodies, firms, family firms, cooperatives, churches and schools. The complex of
formal rules, regulations, code of conducts, norms, conventions, etc. that determine the behavioral
pattern of actors in these organizations could be thought as institution. But institution go beyond the
boundary of the organization. Although there is a great deal of overlap between institutions and
organizations, many cultural and market institutions do not have a corresponding organization, and
certain organizations may exist “on paper” only and have not been fully institutionalized through the
creation of accepted rules. If institutions are the rules of the game, organizations and their
entrepreneurs can be thought as the players of the game. Institutions within organization and there
is dynamic interaction between institutions and organizations. Institutional environment
influences which organizations appear or exist. Organizations create new institutional
arrangements and lobby for changes in institutional environment.
 Institutional Economics Lecture Note For WKU, Fourth Year Agricultural Economics Students CH-1

1.2. Informal and Formal Rules and Norms of Behavior

Institutions are made up of formal constraints (such as rules, laws, and constitutions) and
informal constraints (such as norms of behavior, conventions, self-imposed codes of conduct)”
Formal institutions: Codified rules, e.g. in the constitution. Informal institutions: Related to how
formal institutions are used, to distribution of power, social norms, and equilibrium.

Constitutions in U.S. and many Latin American countries similar, but the practice of politics, and
constraints on presidents and elites very different. Why? Because distribution of political power
can be very different even when formal institutions are similar.

Formal constraints: whether the country in question has a supreme court, separation of power,
parliamentary system etc. Public: laws and constitutions and Private: rules (e.g. sports games and
club membership). Informal constraints: which determine how a given set of formal rules and
informal institutions function in practice Traditions, customs, norms, codes of conduct,
Institutions are everywhere, but may differ a lot from place to place. Institutions change over
time. In general, informal institutions change more slowly than formal. Exception: constitution.

1.3. The Function and Role of Institution

Institutions (what do institutions do, what is the role of institutions?) define property rights,
define rules of exchange, and define incentives and constraints for individual decision makers,
influence transaction costs and Influence perceptions, interests and values, Influence rationality.
Effective institutions of economic exchange play the following role: coordinate exchange,
facilitate low cost exchange (transaction costs) and provide the necessary incentives for agents.
Institutions have many roles in economics but the major or key roles of institutions in
economics: are three, these are:-
1. Coordination roles: institutions coordinate exchange at several levels. At its most basic
level, coordinated exchange involves the reliable bringing together of buyers and sellers.
2. Facilitative roles: institutions facilitate efficient exchange by reducing information problems
and by limiting opportunistic actions. The idea is as transaction costs increases, the potential
gains from economic exchanges declines and hence economic activities decline.
3. Allocative roles: institutions providing the incentive structure affect the pattern of allocation
of economic resources.
 Institutional Economics Lecture Note For WKU, Fourth Year Agricultural Economics Students CH-1

If the institutions provide incentive to piracy, more resources will be devoted to capture the
economic gains from piracy. If on the other hand institutions make production a profitable
activity, then it provides agents to invest their resources on productive activities. If institution
(the rules system, the belief, culture, etc.) enforce and protect private property rights, then
agents will have the incentive to accumulate private property which affects the extent of
economic activity, saving, investment and so many other economic variables.

Institutions emerge to minimize transaction costs and to facilitate market exchange. Every set
of institutions creates different losers and beneficiaries. Certain groups obtain high incomes,
rents and privileges. Efficient institutions require either the losers to be compensated or the
beneficiaries to impose their choice. Thus “distributional” implications from institutional
choices. Economic institutions shape incentives and determine distribution of resources,
Preferences over institutions determined by their distributional implications and institutions
chosen for their economic consequences.

Features of Institutions: institutions are a structural feature of the society or polity. They are
created with the only reason: decrease uncertainty. Stable over time, they must pose constraints
and affect individual behavior of its members. Perhaps the following key features of institutions
help you to understand what institutions are:
 All institutions involve the interaction of agents, with crucial information feedbacks.
 All institutions have a number of characteristic and common conceptions and routines.
 Institutions sustain, and are sustained by, shared conceptions and expectations.
 Institutions have distinct social boundaries in which they effectively work.
 Unenforced rules are not component of institutions.
 Institutions generally are thought to serve collectively valued purposes but sometimes
institutions may exist without collective intentionality e.g. merely by virtue of shared
conventions and habits or by virtue of sustained enforcement by certain groups;
 Although they are neither immutable nor immortal, institutions have relatively durable, self-
reinforcing, and persistent qualities.
 Institutions incorporate values, and processes of normative evaluation. In particular,
institutions reinforce their own moral legitimation: that which endures is often-rightly or
wrongly-seen as morally just.
 Institutional Economics Lecture Note For WKU, Fourth Year Agricultural Economics Students CH-1

1.4. The Interdependence of Institutions

The focus of interdependence of institutions is just answering; central problems, pubic goods,
delegation by gaining and agenda control. Institutions are used for cooperation of multiple
issues, gradually expanding membership and great interdependence.

Interdependence the rationale for international organization, and the rapid proliferation of
institutions, broadening of membership and expansion of functions and increasing demand for
coordinated solutions to problem that state cannot solve unilaterally. Interdependence, however,
fails to predict the shortcomings of internationally governance. International cooperation is
negotiated, and bargaining depends on the resources and outside options that state bring to the
table. Generally, to the detriment/damage of the common interests emerging in an increasingly
interdependent global society.

1.4. Institutions and Development

There is a strong support for the overwhelming importance of institutions in predicting the level
of development in countries around the world. Protection of property rights, effective law
enforcement, and efficient bureaucracies, together with a broad range of norms and civic mores,
are found to be strongly correlated to better economic performance over time. Institutions
support economic development through four broad channels: 1) determining the costs of
economic transactions, 2) determining the degree of appropriability of return to investment, 3)
determining the level for oppression and expropriation, and 4) determining the degree to which
the environment is conducive to cooperation and increased social capital. Determining the degree
to which the environment is conducive to cooperation and increased social capital. Institutions as
underlying determinants of long-run performance of economies of countries.

Developing countries remained poor as institutional constraints do not encourage productive

activity; there is a need to redirect incentives to productivity –increasing paths (North, 1990,
1994). Economics Institutions: encouraging investment through incentives, human capital,
entrepreneurship, innovation, occupational choice, and land ownership.

i). Institutions that protect individual property rights e.g. defend against expropriation of
resources.
 Institutional Economics Lecture Note For WKU, Fourth Year Agricultural Economics Students CH-1

ii). Institutions related to democratic political rights (Sen) and

iii). Institutions correcting co-ordination failure efficiency of government for example in
implementing policy (e.g. South Korea). Institutional determinants “trump” all geography and
integration (trade) in determining the differences in incomes between the worlds’s most
developed countries and the poorest ones. It is not a new intuition that for the prospering of
economic activity institutions matter.
Adam Smith had already noted this is surprising detail, referring to the importance of a justice
system, private property rights, and the rule of law (The Wealth of Nations).

Why institutions appear so important to economic development?

Economic institutions influence growth because they shape incentives and affect investment in
physical and human capital.

A. Costs
Institutions conducive to economic development reduce the costs of economic activity. The
costs include transaction costs such as search and information costs, bargaining and decision
costs, policing and enforcement costs (Coase, 1992, Dahlman, 1979). They lower transaction
costs by providing common legal frameworks (e.g. contracts and contract enforcement,
commercial norms and rules), and they encourage trust by providing policing and justice
systems for the adherence to common laws and regulations. Communities in LDCs typically
rely on kinship or ethnic and religious ties for trade. Norms and networks of common
language and religion may be enough to ensure compliance with agreements on economic
exchange; collective punishment and social reputation may be enough to ensure the
enforcement of (often informal) contracts even in the absence of a third party.
To take advantage of opportunities for trade with different groups and increase the size of
economic transactions, however, cultural ties are not enough. There is need for greater
information about trading partners, and for institutions which ensure agreements on the
details of exchange and compliance to the agreed conditions. These take the form of
contracts, codes of conduct, standardized weights and measures, disclosure agreements, and
enforcement through courts and policing.
 Institutional Economics Lecture Note For WKU, Fourth Year Agricultural Economics Students CH-1

Where transaction costs are small, the private enforcement of contracts may still be preferred.
But as economic relations develop and become increasingly impersonal, the role of a third party
to enforce compliance to rules is increasingly necessary.

B. Property Rights and the Return to Investment

Such institutions increase the security that the risk of incurring in an economic transaction is
matched by the full appropriation of its eventual benefits. This includes the presence of
individual private property rights. If property is protected individuals are more willing to
invest and to incur sunk costs. Where individual perception of security of land tenure is low,
investment in the land is significantly reduced, and output consequently drops (except when
land is obtained through commercial transactions). Property right increases output and thus
is conducive to economic development. The protection of property rights requires an
expanded role for state authority. However, there is a risk that states which have the power
to enforce property rights may use that power to expropriate property too. Thus property
rights are by no means sufficient to spur economic growth, and must be balanced by
institutions which limit the extractive capacity of state power. These typically involve
independent parliaments and judiciaries. Democratic institutions of political representation
strongly contribute to this process.

C. Power of Expropriation
Thus institutions determine the extent to which those in power are able to expropriate the
economy’s resources to their private advantage. Unequal institutions strongly limit development
by reducing the capacity of individuals to access resources, expand production and increase their
incomes. A comparative analysis of development trajectories of countries indicates that
institutions which benefit elites and allow their appropriation of resources and products have
perpetuated underdevelopment.
Countries which have undergone colonial domination tend to be plagued by such extractive
institutions. These have outlived the gaining of independence on behalf of these countries, and
their control has largely been taken over by local elites. There is evidence that it limits the
development of greater rural employment and higher rural incomes.
 Institutional Economics Lecture Note For WKU, Fourth Year Agricultural Economics Students CH-1

Greater equality and functional economic institutions are also seen as the cause for the successful
development, where high inequality has concentrated power in the hands of restricted elite, and
governments have failed to adequately invest in infrastructure and public welfare.

D. Cooperation and Social Capital

Institutions which are conducive to development ensure greater self-expression, allow the
free flow of information and encourage the formation of associations and clubs. These form
prosperous social relationships, which are conducive to greater economic interaction by
increasing levels of trust and wider availability of information. Institutions conducive to
development pool resources to provide the investments in education, health and
infrastructure which lie at the basis of economic interaction and are necessary and
complementary to private investment. Informal institutions lie at the basis of an economy.
They include public agencies, trade unions, community structures and professional
associations. NB: Social capital refers to features of social organization (in particular,
horizontal associations) such as networks, norms and social trust that facilitate coordination
and cooperation for mutual benefit.” It is defined as the norms and social relations
embedded in the social structures of societies that enable people to coordinate action to
achieve desired goals.

1.6. Institutions in Economics

Economics is found as an institutional economics when it was first emerged. But latter, since
economists believe that it is impossible to solve economic problems theoretical, the concern of
professionals focuses only quantitative economics. Latter again, economist found that it is
difficult to solve all economic problems quantitatively. Now days, the institutional view of
economic problems is an essential component of economic and a thematic area for research.

Why Institutions Matter in Economics?

Adam Smith said that the productivity of an economic system depends on specialization.
Specialization will be useful only if there is an exchange, and the lower the costs of exchange
(transaction costs) the more specialization there will be and the higher economic productivity
will be. Level of transaction costs however depend on institutions, its legal system, its political
system, its culture etc. Institutions have three key roles in economics: allocative, facilitative
 Institutional Economics Lecture Note For WKU, Fourth Year Agricultural Economics Students CH-1

and coordination roles. The performance of an economy as a whole or a given activity then
depends on the efficiency of institutions to perform these roles.

Four Levels of Institutional Analysis; Williamson’s framework: 4 level of social analysis

The Economics of Institutions

Level Purpose Theory
1 Embeddedness: Protection , preservation, power Social theory
( informal institutions , traditions,
norms, religion ,culture , socio-
political imperatives , etc)
2 Institutional environment: First order economizing : get Economics of
Formal rules of the game : ( property the institutional environment property rights
right, laws , constitutions , etc ) right Positive political
theory
3 Governance : Play of the game : Second order economizing: get Transaction cost
( Aligning government structures the governance structure right economics
with transaction s)
4 Neo classical analysis : Third order economizing : get Neo classical
Performance ( optimality , prices , the marginal conditions right economics
quantities , incentives , etc) Agency theory

Adapted from Williamson 1999

The confession is that we are still very ignorant about institutions. Chief among the causes of
ignorance is that institutions are very complex.

Challenges for institutional analysis: Confusion with definition, Institutions are invisible,
multiple inputs from different disciplines are needed, given multiple disciplines and concepts a
coherent institutional framework is needed, multiple level of analysis and configural analysis
rather that additive.

Summary

You have noted that, as any other social science terms, there is no generally agreed single
definition of institutions. The old institutional economics emphasize habits and customs and the
underlying way of thoughts. New Institutional Economists define institutions generally in terms
of rules and norms that structure interaction of people. Rules, norms, conventions, codes of
conduct, custom, and the like play important roles in explaining institutions. But rules and norms
 Institutional Economics Lecture Note For WKU, Fourth Year Agricultural Economics Students CH-1

are particularly emphasized in the discussions of institutional economics. While both rules and
norms refer to shared prescriptions, they differ in the way they are realized. Rules are understood
and enforced; norms are known and accepted.
Economic institutions are a set of constraints (rules, norms, convention, etc.) that govern the
relations among individuals or groups in economic activities. Institutional economics offers a
theoretical framework for studying how individuals respond to the set of constraints (institutional
and resource) in their choice decisions and how these evolve. Institutions and organizations are
different. While institutions can be thought as the rules of the game, organizations can be
thought as player of the game.
NB: Institutional environment refers to the complicate relationship between various
institutions in the economy, institutional arrangement refers to the institutional structure
governing a specific transaction: exchange, allocation and distribution transactions.
Institutions have three key roles in economics: allocative, facilitative and coordination roles. The
performance of an economy as a whole or a given activity then depend on the efficiency of
institutions to perform these roles.
The origin of the concept of institutions is old. But the institutional economics gained wider
acceptance since recently due to the contribution of Coase and others. Transaction cost has
provided the conceptual foundation for the New Institutional Economics. Yet, institutional
economics remained a crude theory.