Chapter 1: Introduction

[Link] of economic institutions/Institutional

Economics

❖ What is Institution?

❖ Institutions are strong systems of established and embedded

social rules and conventions that structure social interactions’
(Hodgson 2001 p.295).

❖ Institutions are sets of rules, compliance procedures, moral and

behavioral norms constraining the individual behaviors in the
best interest of the society (North, 1981).
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 Cont…
❑A social institution is a regularity in social
behavior that is agreed to by all members of
society, specifies behavior in specific recurrent
situations, and is either self-policed or policed
by some external authority.’ (Schotter 1981,
quoted in Langlo is 1986 p.11)

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 Cont…
❑Institutions are rules, enforcement
characteristics of rules, and norms of behavior
that structure repeated human interaction.’ (North
1989).

❑‘Institutions are ‘repetitive patterns of

interaction through which society undertakes
certain functions.’ (King 1976).
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 Cont…
❑The most commonly agreed upon definition for
institutions is: a set of formal rules (laws, contracts,
political systems, organizations, markets, etc.) and
informal rules of conduct (norms, traditions,
customs, value systems, religions, sociological
trends, etc.) that facilitate coordination or govern
relationships between individuals or groups.

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 Cont…
❑Institutions provide for more certainty in human
interaction.

❑ Institutions have an influence on our behavior and

therefore on outcomes such as economic performance,
efficiency, economic growth and development.

❑Finally, institutional economics is a branch of

economics that studies the role of institution in
shaping economic function and outcomes.

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 1.2 Function of Institutions
❑ The concept of the function of institutions refers to the roles and
responsibilities that these organizations or systems play in society,
and how they contribute to the overall functioning of the community
or economy.
✓ Their repeated uniformities , patterns and trends become codes of
conduct.
▪ Institutions also act as agencies of coordination and stability for the
total culture.
▪ Institutions tend to control behavior.
▪ Institutions accelerates economic growth.

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 Cont…
❑In general function of institutions are:
✓Simplifying the actions and work of the
individual
✓Controlling society and people
✓Assigning roles and statuses to individuals
✓Maintaining order in society
✓Stimulating and facilitating individual freedom

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 1.3. Economic Institutions
❖ By narrowing the definition to economic institutions, those
institutions that perform economic functions are covered; of these,
three sets can be identified:
• Establishing and protecting property rights;
• Facilitating transactions; and,
• Permitting economic co-operation and organization.
✓ [Link] property rights, contracts that can be written and
enforced, patent laws etc.
✓ Incontrast to this, there is another type of institution as political
institutions (democracy vs non-democracy, electoral rules, extent
of checks and balances etc.

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❑Institutions
Cont…
necessary for productivity and
economic growth are:
– Well-defined property rights
– Political institutions defining legal rules
– Judiciary serving as a third-party enforcer of contracts
and agreements
– Level playing field of equal rights and legal protection
for everyone
– Therefore, the functioning of institutions potentially affects three factors that
help determine economic growth. These are: Investment, Technical
innovation and Economic organization
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 1.4 Institutions and organizations
❑Institutions are rules of the game while
Organizations are players of the game.
❑Institution refers to a structured set of norms, rules,
and practices that govern social behavior. It can be
a formal or informal system that shapes societal
function while organizations is a groups of
individuals bound together by some common purpose
to achieve certain objectives” (North 1993)
✓ Examples: Universities, political parties, regulatory
bodies, firms, family farms, cooperatives, churches,
and schools.
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 Institutions and organizations
❑Institutions are within organizations
❑There is dynamic interaction between institutions
and organizations:
➢ Institutional environment influences which
organizations exist.
➢ Organizations create new institutional arrangements
and lobby for changes in institutional environment.
➢ Constant interplay between institutions and
organizations.

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 Con’t
❑Institutions affect efficiency and productivity by
influencing and coordinating:
❖consumption,
❖savings,
❖exchange,
❖investment,
❖Production, and
❖innovation.

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 1.5. Emergence of Institution
Informal Vs Formal Institutions
❑Formal institutions include rules written into the law
by government, rules codified and adopted by private
institutions, and public and private organizations
operating under public law.
✓ For example, organizations include firms operating
under corporate law.

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 Cont…
❑Informal institutions is created by repetitive social
interaction often operating outside the formal legal
system, reflect unwritten codes of social conduct.

✓Examples include land inheritance norms and

moneylenders using social networks to determine
creditworthiness based on the reputation of the
agents involved.
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 Cont…
❑ People in both rich and poor countries rely on informal
institutions to facilitate transactions, but these institutions
are relatively more important in poor countries where
formal institutions are less developed.

❑ Moreover, poor people in poor countries are often not

well served by the limited formal institutions available.

❑ In poor countries, and poor regions in particular, informal

institutions substitute for formal institutions.

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“Formal is codified and written laws, while informal, as in tacit
and habitual norms of conduct internalized by individuals and
groups”
“One may further distinguish between formal institutions – written
rules enforced by a third party – and informal institutions, which are
enforced by the actors themselves (Knight 1992)”
“Informal institutions are associated with traditions, customs and
cultural backgrounds”
“informal—created, communicated, and enforced outside of
officially sanctioned channels”
“Informal institutions ... informal and unwritten patterns of thought
and action”

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Difference between formal and informal institutions
Formal institutions Informal institutions

Law Social norms

Legal sanctions Non-legal sanctions

Coercive crime control Normative crime control

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 1.6 Outcomes of Institutions
❑ Growth and development cannot take place in an
institutional vacuum.
❑ Economic maturity and the growth of markets require an
institutional framework that allows transactions to take
place in an orderly manner a
❑ Savers, investors, consumers, entrepreneurs, workers
and risk-takers of all kinds need a framework of rules if
rational, optimizing decisions are to be made
❑ Institutions are the underlying determinants of the long-run
performance of economies
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 Prerequisite for good institution:
✓ Property rights and legally binding contracts: market-
creating institutions
✓ Regulatory institutions: market-regulating institutions
✓ Institutions for macroeconomic stability: market-stabilizing
institutions (Fiscal and Monetary policy)
✓ Social insurance institutions: market-legitimizing institutions
✓ Institutions of conflict management: market-legitimizing
institutions

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 Cont…
1. Property rights and legally binding contracts
✓ These are important because agents lack the incentive to
invest and innovate if they do not have control over the
return on the assets they accumulate.

➢ Intellectual property rights are particularly important to

encourage invention. Control is more important than
ownership.

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 2. Regulatory institutions

❑Markets fail if there is fraud or anti-competitive

behavior. Regulatory institutions are needed if
markets are to function properly.
❑When markets are liberalized, a regulatory
framework is also required to avoid the
consequences of risky behavior, such as financial
crises if the banking system is not properly
regulated.
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 Cont…
❖ Institutions to compensate for capital market imperfections and
coordination failures must also be an integral part of a
‘regulatory’ framework for promoting innovation and growth.
❖ All successful economies have an array of regulatory
institutions that oversee different markets such as the product
market, financial markets and the labor market.
❖ Developing countries may need more regulatory institutions
because market failures are more pervasive than in developed
countries.
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3. Institutions for macroeconomic stability
❑ Monetary and fiscal policy institutions are necessary to
provide an enabling environment in which private
investment can flourish.

❑ Market economies are not self-regulating, and

macroeconomic instability creates risk and uncertainty.

❑ The minimization of risk is vital if entrepreneurs are to

take informed, long-term investment decisions.

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 4. Social insurance institutions
❑These are necessary if individuals are to accept
change. In rural, peasant societies on the margins of
subsistence, change may spell disaster, but progress
(particularly in agriculture) requires willingness to
take risks.
❑Insurance against unemployment, crop failures and
price fluctuations for agricultural commodities are
all important if traditional agriculture is to be
transformed.
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 5. Institutions of conflict management
❑ Many developing countries have deep ethnic, tribal and
religious divisions. Social conflict damages economies because
it diverts resources from directly productive activities, and
creates uncertainty, which deters investment.

❑ To minimize conflict requires a full range of institutions: the

rule of law, a fair legal system, and a political voice for
minority groups, which make it clear that the potential winners
of social conflict will not benefit and potential losers will be
properly safeguarded.
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 Cont…
❖ In contrast, the following institutional arrangements are
conspicuously absent in poor countries:
✓ A clearly defined system of property rights
✓ A regulatory apparatus curbing the worst forms of fraud, anti-
competitive behavior and moral hazard
❑ A moderately cohesive society exhibiting trust and social
cooperation
❑ Social and political institutions that mitigate risk and manage
social conflict
❑ The rule of law and clean government
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 1.8. Old Institutional Economics
❑ In the past, neoclassical economics was the dominant
economic theory. This theory assumes that markets
provide the necessary incentives through the forces of
demand and supply. This theory implicitly assume as
institutions to have no role or as they play only frictional
roles and its assumptions are:
✓ profit or utility maximization.
✓ Perfect information.
✓ Homogeneous, private products.
✓ No barriers to entry or exit (costless).
✓ Large numbers of buyers and sellers.
✓ No economies of scale or production externalities
✓ Complete set of markets.
✓ Clear, enforced property rights
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❑ The criticisms of “old” institutional economics, as
institutional economics lacked rigorous and systematic
theoretical foundations.
❑ It lacked comprehensive supporting empirical analysis.
❑ It was often country-specific or even case- specific and
little effort (or non-credible efforts) to generalize were
made.
❑ It tended to become politicized and driven by political
agendas.
❑ The identification of institutional economics with
Marxist economic theories and political agendas was
especially damaging, though many institutional
economists (e.g. John R. Commons) were hardly
Marxists.

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 1.9 New Institutional Economics
❑The concept of transaction costs is the
foundation of New Institutional Economics.
❑The idea is costs of transactions determines what
goods and services are produced and the capacity
of any economy to take advantage of the division
of labor and specialization – the two key concepts
of economic theory since Adam Smith.
❑Thus, transaction costs profoundly influence not
just individual firms but the size and activities of
the entire economy. But in addition to the concept
of transaction costs, two other concepts are also
central to NIE: the concepts of property rights
and contracts.

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❑The main contribution of NIE to the field of
economics are:
✓ Its stress on rules and norms,
✓ Its explicit consideration of socio-cultural
elements in the explanation of economic
evolution, and
✓ Its openness towards interdisciplinary approaches
and towards case studies and other less
mathematical methodologies.
✓ The efforts to move economics beyond the
limitations of neoclassical methods and models,
and the progress that is being achieved, is truly
exciting.
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 1.10 Basics of Behavioral Economics
❑Behavioural economics is a field that combines
insights from psychology and economics to better
understand how people actually make decisions.
❑Unlike traditional economics, which assumes
people are fully rational and always make choices
to maximize their own benefit, behavioural
economics recognizes that humans often act
irrationally due to biases, emotions, and cognitive
limitations.
❑It also examines the implications of these insights
for public policy, such as designing policies that
take into account the biases and limitations of
human decision-making.
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❑Behavioral economics has been applied to
various fields, including finance, health care,
and environmental policy. For example, it has
been used to design retirement savings plans
that encourage individuals to save more, and to
develop interventions that promote healthy
behaviors.
❑Overall, the function of behavioral economics
is to provide a more realistic understanding of
human decision-making and to use this
understanding to improve individual welfare
and societal outcomes.