CHAPTER:TWO

Institutions for Rural Development

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2.1 Definition and Concepts of Institution
 Douglas North (1991) defined institution as “humanly devised
constraints that structure political, economic and social interaction
among a given society.”
 According to him, institutions consist of both informal and formal
constraints. Where,
 Informal constraints include sanctions, customs, and codes of conduct,
and
 Formal constraints are constitutions, laws, property rights.
 Institution is therefore defined as, a system of enforceable rights and
obligations in the form of recognized, formal as sanctioned by law, or
informal as sanctioned by social norms.

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Contd..

 Institutions can be sanctioned by;

 Community,
 State or/and other economic agents to coordinate the effort of each and
every agent towards specific goal.
 Organization can be family, particular community, firm, group of
individuals, ministry, and so on.
 Where as, institutions are marriage, the constitution, property rights, the
market, state, and etc that guide organizations.
 Institutions and organizations are important because they generate
incentives that govern human behavior.

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Contd..
 Incentives are;
 Rewards and punishments that accrue to individuals (or groups of
individuals) due to certain actions or behaviors.
 Different organization can create different institutions, and different
institutions create different incentives, which directly affect how well
they achieve their organizational goals.
 Thus, the proper design, implementation, and periodical modification of
development institutions are essential to achieve organizational goals as
they are important to; increase human freedom and the accomplishment
of obligations which facilitates developmental process.

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2.2 Demand and supply of institutions
 Institutions are demanded to move organizations towards higher
levels of efficiency and effectiveness.
 They directly affected by change in the knowledge, development
level, technology, factor endowment, cultures, and the intended
goals of an organization.
 As the economic environment changes, there must be a need for
institutional arrangement, periodical formulations and revisions of
institutions to assure the sustainability of development process.
 The demand for institutions is depends on how they are effective
in achieving the desired goals.

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Contd…

 There are five criteria to differentiate better and effective from worse

institutions.

[Link] and growth: better institutions are more complex, larger

scale, cost minimizing, and tend to increase growth.

[Link] and freedom: better institutions allow ‘freedom to choose’

based on competition and free discussion.

[Link] and pluralism: better institutional systems use different

kinds of agency to provide political, economic, or social services to meet

the needs of the whole people.

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Contd
4. Equity and justice: better institutions create equality of opportunity,
performance based rewards, and elimination of exclusion and insecurity.
5. Connectedness and voluntary cooperation: better institutions
increase voluntary interdependence, and capacity to cooperate freely with
each other.
 The supply of institutions depends critically on:
 The balance of power among interest groups in a society
 Culture of a given community which includes customs, believes,
religion, and ideology.
 Advances in knowledge and technologies also lead to institutional
innovations for their implementations.

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2.3 Market as institution and Rural development
 Under the market-oriented economy, everybody assumed to act rationally
to maximize their own welfare. That is, in product market,
 Producers produce to maximize profit
 Individuals intended to maximize utility
 The labor (factor) market,
 Firms try to hire resources at least cost
 Workers are trying to have better paying job with better working
environment
 In the foreign market, countries are trying to have more foreign income
and more inflow of foreign investment, and so on. Thus, free market is
an important institution for all economic agents so as to maximize their
rational objectives.

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Contd..

 The final outcome of such rational action will depend on the

availability of property right.

 Property right is the only institution that promote efficiency in the

market.

 Enforceable property right provides all market agents a right to

negotiate and make a decisions based on their consents to interact

with their environment.

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Contd..

2.4 Market outcome under its restricted assumptions

 The fundamental assumptions of free market include:
[Link] are large number of buyers and sellers
[Link] is given and fixed technology
[Link] is perfect mobility of factors of production
4. There is perfect information/knowledge
5. Entry and exit is free for all
6. There are no public goods and externalities
7. Economic agents are rational

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Contd..

Under these assumptions, market-oriented economy is

always efficient in allocation of resources. That is, there will

be Pareto optimal allocation of resources which is the

cornerstone of any development effort.

At the Pareto optimal point it is impossible to make someone

better-off without making somebody else worse-off.

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Contd..

 At the Pareto optimal point, there are:

[Link] efficiency in consumption: consumers achieved their best utility
from the limited resource that society posses. Thus, it is impossible to
increase utility of any customer by changing the composition.
[Link] efficiency in production: it is impossible to increase the level of
production by changing input composition and efficiency of input use.
[Link] optimality in distribution: the limited resources that the society
posses are distributed among firms, and goods and services that can be
produced from those limited resources are distributed optimally among
consumers. So, there is no further distribution.

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 2.5 Institutions to deal with market failure
2.5.1. The need for government intervention in agriculture
and rural development
 Due to market failures, inefficient marketing services, and missing
markets, market allocation will not result on the best possible resource
allocation.
 Market forces alone is therefore, will not result in best possible rural
development.
 Thus, we need alternative institutions to give complementary signal and
to coordinate diverse activity of many agents toward achievement of fast
and sustainable development.

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Contd..
The role of state in rural development as complementary to market and its
rationales are given below:
1. To provide public goods and services:
 If the supply of public goods and services are left for the will of the
people, there is an incentive to be a free rider than paying for supply of
public goods and services.
 As a result, the supply of public goods and services will be sup-optimal.
 Thus, in order to supply optimal public goods and services like roads,
schools, defense, public administration, and so on people expected to
pay a mandatory taxation.
 Using the tax revenue, state is needed and expected to supply the
efficient (optimal) public goods and services which are essential for
development.
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Contd..
2. To internalize externality:
 If market demand is the same as social marginal benefit and if market
supply is the same as social marginal cost, market forces will result in the
best possible resource allocation.
 However, when there is negative externality, social marginal cost will be
higher than private marginal cost.
 As a result, market institutions will over supply good or service.
 To make the private marginal cost equal to social marginal cost,
mandatory tax has to be laid .
 When mandatory taxes are laid in production, market forces will result in
efficient and optimal production of good or service.

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Contd..
 For example, factories produce goods and services to maximize their
private profit by ignoring the negative externality exerted on society in
terms of river pollution, air pollution, etc.
 By laying taxes, cost of production will rise and hence, firms forced to
reduce the production of the good or service that generate externality.
 The tax revenue can be used to compensate the adversely affected
parties and/or to invest on the purification of pollution.
 When there is positive externality, social marginal benefit is higher than
private marginal benefit.
 For example, education, health care, sanitation and other social goods
and services have positive externality on society’s welfare.

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Contd..
3. To deal with imperfect information and risk:

 Given rural areas are highly dependent on farming and farming in turn is

dependent on random natural events, there is high level of risk in rural

areas.

 Information, insurance, financial intermediation and future markets are

either missing or highly imperfect.

 Thus, there is a need for state intervention in the form of price

stabilization, safety net, drought relief and other forms which have

significant impact on rural development.

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Contd..
4. To create egalitarian society:
 Even if markets are Pareto optimal (efficient), the final distribution of
benefits may not be egalitarian (equal) if the initial distribution of
capabilities (education, wealth, asset, social network and so on) is
unfair.
 Such distribution of quality of life may not be acceptable to society,
given the fact that the social value of the poor persons’ benefit can over
weight the social loss of the rich.
 Thus, it requires the distribution of resources and capabilities from rich
to poor through tax or subsidies.

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Contd..
5. The need to create rural-urban balance:

 Missing markets, missing public goods(services) and missing

administrative services are common reality of rural areas of developing

economies. These facts coupled with low organizational capital of rural

population, can make development highly urban biased phenomena.

 To solve this challenge, state intervention to organize rural population

into functional political body, economic organization, and to improve

the provision of goods and services is critically needed in rural areas.

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 2.6 .Market Failure

2.6.1. Traditional Market Failures

A market failure is a situation where free markets fail to

allocate resources efficiently from society’s point of view.

Economists identify the following points which possibly

causes the market failure (Productive and allocative

inefficiency).

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1. Existence of externality
 Under perfect (free) market, market expected to provide the socially
desired level of output and price through the forces of demand and
supply.
 Under this condition, transactions are assumed to be undertaken based
on the consent of the involved parties and the benefits and costs of
transaction would be assumed to affect only the parties that involved in
the transaction. But in reality, the action of those parties can affect the
third party that was not in the transaction.
 That is, consumers and producers who attempt to pursue their own self
interest may fail to take into account the effects of their actions on
third-parties, such effects are called externalities.

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Contd..
 An externality is an effect on a third party that is caused by the
consumption or production of a good or service by the parties in the
transaction.
 With the existence of externalities, the market will not produce the
supply of the good that is socially optimal – it will be over or under
produced. That is, equilibrium quantity and prices will be altered.
 Example,
1.A firm who produce chemical products to maximize its own profit might
damp residuals to the river which harm the health and livestock of the local
society that reside around the river.
[Link] horticultural farm can benefit beekeeping farmers.

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Contd..

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 The case of negative externality
 A negative externality is a negative spillover effect on third parties.
 In free market, such effects are not taken into account by the producers
or the consumers.
 For example, producers recognize only costs of production that they
directly incur (only prices of factors of production). Hence, they set
their products’ prices based on only those costs.
 With negative externality however, there could be costs to the society
which are not considered by the firms (health and environmental
damage due to water and/or air pollution for example).
 Consequently, since the costs of those externalities are not accounted in
the price of the good, the price is lower than it should be, and too much
of the good is produced and consumed.

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Contd..
 Figure 2 illustrates that, based on the market demand (benefit) and
supply (cost) curves, the market offer the optimal level of output and
price.
 qm and Pm are therefore, the market clearing quantity and price which
maximizes both producer and consumer surpluses respectively.
 If there are negative externalities exerted on other economic agents
and/or the environment, social cost would be higher and it will not be
equal to the private marginal cost of each additional output.
 As a result, qm can not be a Pareto optimal point since the social
marginal cost is higher than the marginal benefit (i.e. since there is a
deviation between cost and benefit).

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Contd..

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Contd..
 Fig.2 clearly shows that, when there are negative externalities, market
allocation will not result in Pareto optimal resource allocation.
 The society want less supply of the good which generate negative
externality. Thus, by introducing taxes equal to P* - Pm, socially
desirable level of resource allocation can be attained.
 Taxes raise the cost of producers and it forces the private marginal cost
curve to shift upward and equal to the social marginal cost curve.
 The intersection between social marginal cost and marginal benefit will
therefore, gives us a socially desirable level of quantity (q*) and price
(P*).
 Any production beyond q* will cost more than the benefit it can generate
to society.
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  The case of positive externality
 Positive externalities are consequences that benefit society. Under
market mechanism, such benefits are not accounted in the price of the
good.
 As a result, the price is higher than it should be, and too little of the
good is consumed and produced.
 Merit goods and services like education, health care, etc will not only
benefit the individual person, but also the society.
 Educated person for example, can have better production and
management skill and will earn high payment for his/her services on
one hand.
 On the other hand, educated person will benefit the society by
introducing and providing better production techniques and managerial
services.
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Contd..

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Contd..
 qm and Pm in the above figure are the optimal level of output and price
based on market allocation. However, qm is not the optimal level of
output with positive externality.
 This is because, at qm social marginal benefit is much higher than the
social marginal cost of production. This permits increment in social
welfare by producing and consuming more output.
 Socially optimal level of output (q*) can be supplied at efficient price P*,
if a subsidy equal to P* - Pm is given to the providers of education
services and to their customers.
 Summing up, the state or other third party must use tax in case of
negative externality and subsidy in case of positive externality in order to
improve market inefficiency with the existence of externalities.
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2. Monopoly Power
 Markets may fail to control the abuses of monopoly power.
 In real world, markets are imperfect. There are restrictions to firms to
enter the market, there are also restrictions on the mobility of factors of
production.
 These situations limit the degree of competition and leads to the
suboptimal supply of output at higher price.
3. Property Rights
 Markets work most effectively when consumers and producers are
granted the right to own property, but in many cases property rights
cannot easily be allocated to certain resources. Failure to assign
property rights may limit the ability of markets to form.

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 2.6.2 Market failures related to imperfect information and missing
markets
1. Information Failure
 Markets may not provide enough information during a market
transaction, it may not be in the interests of one party to provide full
information to the other party.
 In real world there are manipulative middle man who are working
between producer and consumer to signaling information.
 Market is the most effective institution in allocation of resources if
there is perfect mobility of factors of production. But, since
information is imperfect, factors cannot be freely move certainly from
one firm to the other or from one sector to the other.

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Contd..
2. Unstable Markets
 Sometimes markets become highly unstable, and a stable equilibrium
may not be established.
 Example, agricultural product markets, foreign exchange, and credit
markets are not stable. Such volatility may require intervention.
3. Inequality
 Markets may also fail to limit the size of the gap between income
earners, the so-called income gap.
 Market transactions reward consumers and producers with incomes and
profits, but these rewards may be concentrated in the hands of a few.

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Contd..

4. Missing Markets
 Markets may fail to provide all goods and services to meet a need or
want of the society. Public goods and services such as, defense, street
lighting, highways, and so on cannot be provided by the market
mechanism.
 By their nature, such goods and services are non-excludable and non-
[Link] normally reject to pay for the provision of public goods like
for road construction, but if road is built on the expense of others, they
will use it without any exclusion. That is; people want to be a free rider.
The provision and administration of such goods also requires high cost
especially in rural areas since it needs the coverage of wider areas.
 Private sectors will therefore not provide them since they cannot
profitable from them.
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Contd..

 For such goods and services private (market) allocation will result in
sub-optimal resource allocation and the state has to supply them by
imposing mandatory taxes in order to meet the need of the society.
5. Incomplete Markets
–Markets may fail to produce enough merit goods, such as education and
healthcare.
6. De-merit Goods
–Markets may also fail to control the manufacture and sale of goods like
cigarettes and alcohol, which have less merit than consumers perceive.

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[Link] Role of State in Rural and Agricultural Development

 According to Robert Chambers (1989), the state has three universal

functions which are fundamental for the rural poor. These are:

 Maintaining peace and democratic rule of law

 Provide basic infrastructure and services

 Manage the economy

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 Maintain peace and democratic rule of law
 Peace and rule of law are the base for any development. In many
developing counties, civil disturbance and war were the critical
problems which resulted in underdevelopment due to:
 Fear, pain and torture
 The destruction
 Theft or loss of property
 The insecurity of tenure
 The disincentive to invest
 Less production and productivity when adults are fighting, guarding or
killed
 The interruptions to education
 The disruption of services due to corruption, etc

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 Providing basic infrastructure and services
 With the absence of market, it is the role of the state to provide the rural
society with basic infrastructures and services.
 The provision of social and economic infrastructures such as, roads,
schools, health care, agricultural and veterinary extensions, water
supplies, telephones and electricity supplies, basic information, etc are
the fundamental role of the state.
 Although, NGOs and other civil organizations can complementarily
deliver such infrastructures, the state remains the logical long-term
institution to provide and maintain much of a country’s basic
infrastructure and services.

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  Manage the economy
 Starting from the formulation of rural development policies strategies,
there are three points in which the state should mange the economy in
the rural areas.
[Link] stabilize the price of agricultural products
 in order to help the farmers and urban poor.
[Link] create efficient marketing organizations
 In order to support the exchange of agricultural products by providing
necessary market information
[Link] fulfill basic necessity needs
•In order to eradicate the absolute poverty, the state has to provide basic
goods and services to fulfill the basic needs of the society.

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2.8 State failure to coordinate rural development
 State can solve some market failures, but it cannot solve every market
failure problem everywhere. The state may fail due to:
[Link] asymmetry and managerial diseconomies from the state side:
 State faces series information asymmetry related to economic agents
actual income and wealth, actual provision and managerial costs related
to public goods, and the behavior of individuals in the use of public
goods and services.
 If the state lacks adequate information on economic agents’ income and
wealth, expenditure, the demand for and behavioral use of public goods,
it is difficult to the sate:
 To provide public goods, and
 To internalize externalities.

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Contd..
2. Information asymmetry from public side

 The society might be less or miss informed about the states policies and

strategies importance, implication and possible outcomes.

 This situation gives higher freedom for politicians to divert from their

electoral promises they made to the society and helps them stay in

office.

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Contd..
3. The failure of voting to consider intensity of want
 In democratic system every person is given equal voting right.
 For example, if there is newly introduced policy, all citizens given
equal chance to vote. However, some group of the society may support
it and others may reject it. In this case, the application of the policy
depends on the vote of majority. Such application of policies does not
consider the intensity of wants of the whole society. Thus, voting can’t
necessarily lead to maximum social welfare.
 Some states are also weak in maintaining peace and securities of the
society and also are politically and economically corrupted and fail to
meet the want of the society.

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Contd..
4. Lack of incentive and high inefficiency in public sector
 The bureaucratic system in public sectors are less flexible and the
incentive that given for public servants are lower. These situations lead
to:
 Corruption
 Less productive, inefficient and ineffective public servants
 These undesirable practices and inefficiency in public sectors hindering
the development process and slowing its pace.

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 2.9. Institutional innovation to deal with market and state failure in
rural development .
 With the prevalence of perfect market and well functioning state, both
institutions are the most important for the development.
 In such case, what is to be needed for efficient attainment of
development is just the mix of market and state institutions.
 However, in our real world, we have imperfect market and state. Due to
this reason, we need complementary institutions in order to improve the
efficiency of the market and state.
 Some of the complementary institutions include: service cooperatives,
Value chain and contract farming, Microfinance institutions, Social
Capital and community development, Civic societies and NGOs etc.

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2.9.1 Service Cooperatives
 In order to improve the bargaining power of small scale farmers and
to minimize their transaction cost and to close the information gap,
there is a need to organize them into service cooperatives.
 This will enable them to have more market power that can balance the
power of manipulative middle man.
 It also helps them to have access to credits at least cost
 It helps them also to use new farming technologies, experience
sharing, and efficient use of their resources

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2.9.2 Value Chain and Contract Farming
 Contract farming refers to the formation of linkages among farmers
and other economic agents such as exporters, a wholesalers and
manufactures, research centers and extension workers to insure the
provision of agricultural inputs and hence the supply of agricultural
outputs.
 Such activity can solve lack of credit, lack of appropriate farming
technology, lack of extension service, and market uncertainty.
 Value chain on the other hand refers to adding value to the agricultural
products, and managing the process of collection and the transaction of
an output from farm land to the final consumer.
 It helps to insure the supply of quality product that demanded by the
consumers.
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2.9.3. Microfinance Institutions (MFIs)
 Rural economy is mainly depend on the risky and uncertain natural
random which affects agricultural products.
 So, it is impossible for the formal and modern banks as well as insurance
companies to provide credits and to insure the agricultural sectors.
 In addition, banks request collateral that farmers may not have to lend
their money.
 Local money lenders are also inefficient in providing credit for small
scale farmers since they can exploit farmers by forcing them to pay high
interest rate.
 Due to these facts its MFI which has the nature of formal and informal
money lenders can play a great role in providing efficient financial
support and credits for the farmers.

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2.9.4 Social Capital and Community Development
 The use of socially developed cultures, norms, beliefs, and established
community networks help the process of development at high rate.
 Socially developed practices and norms help:
 To shape the behavior of individuals and groups towards the desirable
goals.
 To solve the problem of information asymmetry and work ethics
 Participation of community in the development process help to
formulate and implement the socially desirable development policies.

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2.9.5 Civic Societies and NGOs
 Thus, it is important to allow Civic Societies and other None
Governmental Organizations (NGOs) to provide and hen ce meet the
need of the society.
 Civic societies and NGOs are basically established based on
individuals or groups consent to provide voluntary services to the
society especially for the poor rather than their self interest.
 Due to this fact, their participation is important in the provision of
public goods where market and states are inefficient in providing
such goods.

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2.10 The Institution of Property Right

 Property is considered as an asset that benefits the owner, and right is a

set of actions and behaviors that allows the owner of the property to use

and to prevent others from using its own property.

 That is, property rights over assets consist of the rights, or the powers, to

consume, obtain income from, and alienate these assets.

 Under free market, producers and consumers can make their transaction

based on their consents if they possess property rights over their assets.

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Efficient property rights structures

 The structure of property rights that could produce efficient resource

allocations in a well-functioning market economy has three main

characteristics:

[Link]: All benefits and costs accrued as a result of owning and

using the resources should accrue only to the owner.

[Link]: All property rights should be transferable from one

owner to another in a voluntary exchange.

[Link]: Property rights should be secure from involuntary

seizure or encroachment by others.

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Types of property rights based on the degree of control

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Contd..

 Based on the nature of the property and right holders, there are four
property right regimes.
[Link] property: Individuals have a complete control over a specified
resource.
 The right-holders enjoy both the right to use and the right to regulate
resources.
[Link] Property: Common Property is the private property of a
group of co-owners.
 The users abide by common rules in relation to the specified resource.
 Individuals have only rights to use but have no right to exclude others.

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Contd..

3. State Property: The state retains direct control over the resources and will

determine to what extent individuals have the access and uses.

 For example, in many developing countries, land belongs to the state and

agriculturalists and other stakeholders have only the right to use.

4. Open access: When resources are owned by no one and are used by all

without any restriction, they are called open access resources.

 In such case there is no property right and it leads to resource destruction

and increases behavioral uncertainty.

 This is often termed as “tragedy of open access” or formerly coined as “the

tragedy of the commons”.

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