CHAPTER TWO

INSTITUTIONS FOR
RURAL DEVELOPMENT

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 Definition and Concept of Institution

• “Institutions are humanly devised constraints that structure

political, economical and social interaction” (North 1991)

• They are “prescriptions that humans use to organize all

forms of interactions including those within families,
neighborhoods, markets, firms, sports leagues, churches,
private associations, and governments at all scales”
(Ostrom, 2005)

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 Concept of Institutions

• Traditionally, the terms “institutions” and “organization”

are used interchangeably. But Institutions are “the rules
of the game”

whereas;

Organizations refer to “groups of people with shared

institutions and mutual recognition of opportunity sets”
(Schmid 2004 ).

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 What are Rules?

According to Black (1962) the term “rules” refers

to 4 concepts: regulations, instructions, precepts,
& principles.
1. Regulation refers to something “laid down by an
authority as required of certain persons (or,
alternatively, forbidden or permitted)”
Example: “undergraduate students must have a
cumulative GPA of ≥2 to be graduated”.
Regulations can be enforced, disobeyed, broken,
changed, revoked, reinstated.

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 cont’d

2. Rules as instruction, it seems strategy for how to solve a problem.

Ex: Before start exam write your name, ID, put letter F/T in the box,
and that…

[Link] as precept →a maxim for prudential or moral.

Ex: After toilet wash your hands. No need of enforcing, repealing, or

restating

4. Rule as principles constitute physical laws. Ex: The earth revolves

around the sun. They can't be broken, or repealed.

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 Cont’d

• The 7 groups of working rules that affect

human interactions (Ostrom 2005) are:
[Link] rules
[Link] rules
[Link] rules
[Link] rules
[Link] rules
[Link] rules
[Link]-off rules

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 Features of institutions
1. Institutions are anthropic in nature.

→Institutions are associated with human beings.

Indeed, species like honeybees have also

behaviors and actions. But, it is not given the
name institutions because institutions didn’t
exist before human beings.

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 Cont’d

2. Interaction is key for the existence of

Institutions.
• In the world where a single person dwells,
institutions are meaningless.
e.g Robinson Crusoe!
• This b/c, there is no ruler or subordinate, no
buyer or seller, no employee or employer, or
no neighborhood.
• Therefore, no legal, social or property right
institutions are required to govern such
relationships

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 Cont’d

3. Stability and Predictability

• Institutions require repetitive human

interaction to emerge

• At same time they don’t vanish at once.

• This stability stabilizes expectations of actors

• When institutions are unstable or it is difficult

to predict actions among different actors.

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 Emergency of Institutions

• Institutions are not stagnant, but change,

evolve or vanish over time.
• The way they evolve or change may vary b/n
different types of institutions
• Some authors argue that institutions emerge
spontaneously through repeated interaction
among actors.
• Others emphasize the intentional design of
institutions.

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 a. Spontaneous institutional change
• When individuals continuously interact a
pattern of interaction emerge which yield some
sort of rules that govern their interactions
• Next, the institution is expanded to other
people who copy or reproduce through:
• conformism –tendency to do as others do.
• Pick- up–after finding it as good.
• Reproduced due to authority enforcement
• E.g language, Money, Dressing style

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b. Intentional design of institutions
• Two reasons why institutions may be
intentionally created.
b. Institutional change as designed

1. some types of change become from above to

minimize transaction → efficiency view
2. institution regulating conflicting interests
depends on the intentional creation of the law.
→Authority or power view
1. The efficiency view
a. Institution are the results of effort to enhance
efficiency by minimize transaction costs.
b. Institutions are the results of effort to enhance
efficiency of technological development.
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 a. Institutions to reduce Transaction Costs

The idea of transaction costs reduction give birth to

the following institutional structure:
• Property rights,
It reduces costs since the property holder does not
need to physically protect b/c of exclusive rights.
• Firms are cheaper to coordinate than market
• Williamson (1975), the more specific a good is to
the transaction, the more costly contracting
becomes
• State- reduce costs contract enforcement
-protect market failure

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 b. Institutions to enhance efficiency of
technological dev’t
• When technology changes existing
institutions may not work well as before

• E.g, the introduction of the internet and

mobile phones has required new regulations
and laws in the telecommunication sector

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 b. The Power Perspective

• Scholars within this perspective do not

accept demands in efficiency as a cause of
institutional change
• Institutional change involve continuous
bargaining among actors.
• The major objective of institutional change
is to protect interests.

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 Classifications of Institutions

Institutions can be:

• Informals
• Formals
• Conventions
• Norms
• Rules

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 Informal institutions

• They constitute taboos, customs, codes of conduct,

and social conventions
• Common in traditional societies where interactions
are simple, personal and repeating
• Nevertheless, they were also important in
modern societies.
• In most cases, they are reinforced by social
pressure,threat of supernatural penalty, and force
by a warrior group
• They change slowly over time

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 Formal institutions

• They are associated with state in regards to

recognition, protection and enforcement.

Ex. Security institutions, regulations, commercial

codes, civil codes, property laws, constitutions etc.

• Unlike informals, they are usually written and

consciously adopted.

• They change faster than informal institutions.

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 Conventions

• Conventions were institutions that facilitate

coordination.

Ex. Traffic conventions, language, measurement

scales, directions, greeting codes, dressing styles,

etc.

• They simplify the various complexities of life

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 Norms

• Norms are prescriptions intended to guide actors

what is good to do and what is not
• A norm typically says that you „should not do x‟ or
you „should do y‟

• If norms are internalized they will be self enforced

but if not they can be enforced through social
sanctions.

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 Rules

• Formally rules are different from conventions and

norms

• They combine a certain situation with an act that is

required or forbidden

• They carry sanction to be enforced by third party

in the form of punishment such as being fined,
imprisoned and so on.
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There is a “grammar of institutions” called ADICO
to differentiate rules, norms and convetions
Crawford & Ostrom (1995).
• Rules contains all the ADICO components.
• In Norms the „Or Else‟ is omitted
• Ex: of norm: Everybody must wash his/her hands
before dinner.
• For convention both the „Or Else‟ and the deontic
are omitted:
• e.g. Ethiopians greet each other by shaking hands

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 Discussion
• Identify an institutional arrangement which
you know as informal, formal, rules, norms
and conventions.

• Characterize each according to ADICO.

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 The Two Big Institutions in RD

• the market

• the state

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 2.3 Market as Institution & RD

Market is the organization that maximizes social

welfare using the invisible hand of competition.
• Producer to maximize profit
• Consumers to maximize utility
• Workers tries to get more income
• Countries tries to get foreign exchange
But can they continue maximizing social welfare if;
– no private property right;
– no price competition;
– no enforcement rules,
– no free will of supply public good, etc.

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 Cont’d

• The answer is NO b/c it is the matrix of

institutions, which coordinate self-promoting act
of agents towards social welfare maximization.
• Social welfare is assumed to be maximized in
ideal market (PC).
• But on real world market system the optimality of
social welfare is achieved only if optimal
institutions are well defined and enforced.
• Thus, efficiency of market is result of its
institutional efficiency.

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 Market allocation

Under the following assumptions of PC, market is Pareto

optimal or efficient in the allocation of resources.
• Large number of buyers & sellers Everyone is
Homogenous products price taker
• Perfect mobility of factors
• Perfect information: future p, Q, are known, no risk
• Free entry and exit: no monopoly
• Goal of the firm is π - No public good & externalities
• Agents are rational
• If these assumptions are right;
– resource allocation should be by market only.
– the institution needed to achieve RD is PC only.

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 Market Failures

• The situation under which one or more of the

assumptions of PC practically fails is called
market failure.
• These short comings of PC market can be:

 Existence of externalities Traditional

 Existence of public goods market failures

 High transaction cost

 Monopoly Non-traditional
 Imperfect information market failures
 Factor immobility

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 Externalities

• If more output is produced, the social marginal

cost of production (SS) > the social marginal
benefit (DD).
→ less SS to reduce social cost
• If less output is produced, the social marginal
benefit (DD) > the social marginal cost (SS).
→ more SS to generate more utility
• In general, market allocation is Pareto optimal
by itself only if demand is equal to supply.

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 +ve and –ve externalities

• Given persistent -ve & +ve externalities in any

economy, market will not result in optimal
allocation even though market is in equilibrium.
• If market of good X is at equilibrium but the
SMC of production > the SMB then:
 Good X is said to have –ve externality
 need to tax SS to ↓SS or to reduce Social cost
• If market of good X is at equilibrium but the
SMB of production > its SMC then:
 Good X is said to have +ve externality
 need to subsidize SS to ↑ Social utility

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 Eg. For -ve externality on market equilibrium of
cement factory

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 Eg. Of +ve externality on market
equilibrium of private school.

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 Existence Public goods
• A good or service that is non rival and non
excludable is said to be public good or service.
• E.g. policing, defense, Road, street Light, etc
• For these goods & services market fails to
allocate and the state have to supply them by
imposing mandatory taxes. b/c:
• Less may be volunteered police
• Less may go for defense
• Less may construct road while some
individuals use it for free → free riders.
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 Non-traditional market failures
High transaction
• Rural areas are known for their sparse settled
low population.
• Given low population density, the transaction of
supplying goods & services is very high.
• Facing such high cost market will under supply
goods & services.
As the result, most of the private market were
missing in rural areas.
e.g Banking, Insurance, recreation, etc.
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 Imperfect or asymmetric information

• Imperfect information – unsure about future

• Asymmetric information – biased about future

• How do farmer make rational decision in order

to fetch higher return while uncertain about
state of nature and market in the future?

• Thus they need information, irrigation, price

regulation, crop banks etc.
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 State as Complementary Institution to Market

• Markets are efficient only if they have rules that

enforce its transactions.
• This means, market forces alone will not result
in best possible rural development.
• Example, the 3 basic market institutions are:
1. Private property right
2. Free will of exchange
3. Contract enforcement
However, if market is imperfect it requires beyond
these basic rules_ State to complement.

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 The role of state in rural development
Under condition of market failures mandatory state
institutions are needed than free will based market
institutions. The rationales are:
1. To provide public goods and services
- mandatory taxation
2. To internalize externality- mandatory tax /subsidy
3. To deal with imperfect information and risk - price
stabilization, safety net, drought relief, insurances , etc.
4. To create egalitarian society– taxing rich to invest on
poor. i.e providing capability to poor (educ, health, land
etc).

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 State role Cont’d

5. The need to create rural urban balance

- supply missing markets in rural areas.
6. To Narrow the gestation period of dev’t
-no need to wait for markets in the long run to
solve its problem.
Thus all the market failures should be filled by
the state on time to bring rural dev’t.

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 State Failures
• State complementarity doesn’t mean state alone
is best for rural dev’t.
• from weak to patronage state –its failures are:
• Information asymmetry of the state
- failure to detect the right market demand
- failure to detect the free rider
- failure to detect source of externality
2. Information asymmetry of the public
- choice of bad gov’t due to existence some
political secrets from public.
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 State failures cont’d

3. The Hel with majority rule in voting

choice of bad policy
4. Lack of incentive and high inefficiency in
public sector
- bureaucratic rigidity –work inefficiency
- Lower payment –inefficient worker

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 Institution to deal with state failures
• Cooperatives – to avoid transaction costs
• Value chain and contract farming –to avoid
problems of information asymmetry
• Micro finance institutions
• Warehouse receipt system
• Commodity exchange
• Social capital
• Civic societies and NGOs

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 THE END

U ! !
YO
ANK
T H

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