Debre Markos University

Bure Campus
Department of Economics

Introduction to Institutional and Behavioral Economics

(Econ 4161 )
By : Belete Animaw(Msc.)
Gmail : beleteanimaw@[Link]
Office No : 04
December, 2022
Chapter One: Introduction To Concept of Institutions
Definition of institutions
Neoclassical Assumptions and Axioms

 Zero transaction costs and Perfect information

 Rational Choice

 Resource Scarcity and competition

 Institutions are given and do not matter in the economic analysis

(instrumental rationality)
 Methodological individualism
 The basic motivation to study institution is the inefficiency of Neoclassical
Economics.
 Cont’d….
o In order to determine what institution are and which institution are
relevant for an economic system, it is necessary to define precisely
what is meant by the term “institution”
o Different scholars have different view about institution
 Cont’d….

WHAT IS
INSTITUTION?
 Cont’d….
 Institutions are the rules of the game in a society; more formally, they are the
humanly devised constraints that shape human interaction. D.C. North (1990)
 Rules refer to shared prescriptions (must, must not, or may) that are mutually
understood and enforced in particular situations in a predictable way by
agents responsible for monitoring conduct and for imposing sanctions.
 Formal rules are defined as rules that are formally written down and enforced
by the state
 Informal rules are rules that are unwritten and informally sanctioned (norms
and conventions)
 Norms are prescriptions that are known and accepted yet involve intrinsic
costs and benefits rather than material sanctions or inducements.
 Cont’d….
 In the language of economists “institutions define and limit the
choice of individual’s” (North, 1992).
 Institutions generally defined as “ constraints that human being
impose on themselves”.
 Following this definition institution prohibit, permit or require
specific type of action. i.e Political, economic or social that are
important for reducing transaction cost, for improving information
flows and for defining and enforcing property right.
 Cont’d….

 Institutions are the written and unwritten rules, norms and constraints that
humans devise to reduce uncertainty and control their environment.
 It is a set of formal and informal rules of conduct that facilitate
coordination or govern relationships between individuals.
These include
 written rules & agreements that govern contractual relations; constitutions,
laws, & rules that govern politics, government, & finance; and
 unwritten codes of conduct, norms of behavior, and beliefs.
 Cont’d….
Common Features: Institutions

 Institutions are a structural feature of the society. They are created

with the only reason to decrease uncertainty.
 Stable over time.

 They must create constraints and affect individual behavior of its

members.
 Institutions change through time, why because they do not respond
to new circumstances
 Cont’d….
Summary
 Cont’d….
Institution versus organization
 Institution is “humanly devised constraints that structure political, economic
and social interaction”
 Organization is “working together in a coordinated way to achieve goals. The
organization allowed individuals to specialize and increase efficiency”.
 Institution incorporate/constitute both organization and individual.
 The term organization refers to public bodies(political parties, the senate, city
council, an administer authority), legal persons in economic life( firms, trade
unions, family farms, cooperatives) and agencies of education
systems(schools, universities, centers for vocational trainings).
 Organization consists a groups of individuals who under take joint action.
Because, they want to achieve common objectives (North, 1992).
 If institutions are the rule of the game, organizations are the player of the
game according to the rules.
 Cont’d….
There are two types of organizations.
Formal Organization:
 In every enterprise, certain rules and procedures establish work
relationships among the employees.
 These aptitudes the smooth functioning of the enterprise.
 they introduce a systematic flow of interactions among the
employees.
 clearly outlines the relationships among employees.
Informal Organization
 rises out of the formal organization.
 there are no written or predefined rules for it
 Cont’d….
Difference Between Organization and Institution
Differences Institution:
Organization:
An institution described as a
An organization is a group of
form of organization, which is
people that unite to undertake
set up for an educational,
a common goal, led by a
religious, social or professional
person or a group thereon.
cause.
Goals To earn money, or give service To deliver knowledge to the
to the members etc. people.

Administration Centralized or Decentralized Decentralized

Existence It has a life cycle. It is long lasting

Governing factor Rules and Regulations Customs and Values
 Cont’d….
Functions of institutions
 The Key functions of institutions are:
 Establishing and Protection of property right
 Enforcement of voluntary contracts among individuals
 Define and limit the set of choice of individuals
 facilitating transactions and permitting economic co-operation and
organization.
 Institution affect the cost of exchange and production it results institution
influences the performance of an economy.
 It reduces uncertainty by influences individual’s and firm’s decision making
by signaling which conduct is legitimate and acceptable and which is not.
 Institution establish stable order in order to reduce insecurity in human
interaction. Etc….
 Cont’d….
 How are economic institutions formed?

o Institutions emerge in two ways:

 Informally through repeated interactions between individuals or organizations

that establish expected norms of behavior.
 Formally through deliberate design. It may be government that establishes the
institution, or it might be an initiative from private enterprise or civil society.
 In both cases, it can be argued that institutions are created and evolve in
response to the uncertainty, risk and information costs associated with living
and transacting in an imperfect world.
 Cont’d….
Informal versus formal institutions

 Formal institutions are codified rules, e.g in the constitutions.

 Informal institutions are related to how formal institutions are used, to

distribution of power, social norms and equilibrium.

 formal institutions- property right, legal system, rules of law,

constitution and the like.

 Informal institutions- how to behave in everyday life (like to religion,

history, social acceptability).
 Cont’d….
 Formal institutions are the constitutional framework, which sets out the rules
for economic, social and political ‘players’.
 Informal institutions are the norms of a society, which also set out the rules
for economic, social and political ‘players’.
 When formal institutions is not functional informal institution is resist/exist.

 Informal institutions allow players to enforce economic exchange, typically

through reputation mechanisms, which provide information about the
behavior of players; identify poor behavior; and exclude and punish players
that ‘cheat’ according to the rules of the game
Cont’d….
 Cont’d….
Formal and informal institution
Degree of formality Example Supportive Pillars

Formal institutions Laws Regulatory

Regulations
Rules
Informal institutions Norms Normative
Cultures cognitive
Ethics
 Cont’d….
 According to Williamson’s framework: there are four levels of
institutional analysis
 Level 1: Embeddedness. Informal institutions, customs, traditions,
norms and religion;
 Level 2: Institutional environment. Formal rules of the game:
property, bureaucracy.
 Level 3: Governance: play of the game - contract.
 Level 4: Resource allocation and employment (prices and
quantities; incentive alignment).
 Cont’d….
Levels of institution
 Cont’d….
Informal institution in Ethiopia
 It has argued that informal institution and institutional mechanism(
governance structure) contribute a lot for development.

What are Informal institution in Ethiopia?

 Cont’d….
 The study by Habtu (2012) obtained that Informal institution in Ethiopia
are Iddir, Mahber/sembete, Eqqub, Elder’s group, Gedaa/cheffe kore,
Debo/wobera/wonfel/ oxen sharing (labor sharing) and women’s
association.
 These informal institutions or governance structure engaged in different
economic and social activities.
 The major benefits include risk coping, provision of credit, common
property regulation, manpower and traction force, conflict resolution and
provisions of information.
 Cont’d….
 We can classified these informal institutions into three major
categories:
 Which covers a large range of governance issues.

 Which avoid specific market failures

 Which serve social duties and conflict resolution

 As a signal of their roles, significant numbers of the people of

Ethiopia is members of these informal institutions.
 Cont’d….
 Some of these institutions played a significant role in various activity.

 Mainly in natural resource management as a means to address the needs of

people and the environment in a way that is also a participatory(elder’
goup).
 In credit and saving (Eqqub), informal burial institution (Iddir) and other
which are greater contribution in development agenda.
 Moreover, these institutions helps the poor in addressing the destructive
effect of shocks and insuring them to cope with the high cost of funerals
and health related issues.
 Cont’d….
Outcomes of institutions
 A very tricky(requiring care) task of High quality institutions are:
 Effective property rights
 Information exchange
 Conflict resolution mechanism
 Risk management
 Generalized social trust
 Cont’d….
The Old and New Institutional Economics
 Institutions are the rules of the game in social, political and economic
interaction.
 Institutions understood as rules. There are two schools. The New and
Classic(Old) institutional traditions.
 The New institutions are “the rules of the game”
 The players of the game are economic (firms), political(parliaments) and social(church’s)
organizations.
 They are external constraints. The individuals are still(mainly) seen as
autonomous(freedom of action). Focus on transaction costs as dependent on
institutional structures.
 The old institutions are “forming individuals”. They offer meaning to the
situation. Support values and protect and produce interest.
 Cont’d….
The Old Institutional Economics

 Emerged as the protest against methodological individualism of the

mainstream Neo-classical Economics.
 Emphasized importance of institutions but lacked accuracy/rigorous
and systematic theoretical foundations, as well as empirical
support.
 Concerned more with description of institutions.
 Cont’d….
The New Institutional Economics

 NIE operates within the framework of neo-classical economics, but

it relaxes some of its assumptions and incorporates institutions as
an additional constraint.
 Imperfect information about the intentions and behavior of other
economic actors – asymmetric information
 Opportunism: “self-interest”
 Cont’d….
 The purpose of NIE is two-fold:

1. Explain (opposed to describe) the determinants of institutions and analyze

the institutional change;

2. Evaluate impact of Institutions on economic efficiency and

distribution.
 Cont’d….
 NIE is a useful tool to address policy issues in developing countries
because:
 Frequent occurrence of market failure & incomplete or
imperfect markets
 Many of the formal rules of behavior that are taken for granted
in developed economies do not exist in developing countries
 Cont’d….
Challenges in 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
 Operational rule
 Collective choice
 Nested rule
 Cont’d….
Basic Behavioral Economics
 In economics, rational choice theory states that when humans are
presented with various options under the conditions of scarcity, they
would choose the option that maximizes their individual
satisfaction.
 This theory assumes that people, given their preferences and
constraints, are capable of making rational decisions by effectively
weighing the costs and benefits of each option available to them.
 The final decision made will be the best choice for the individual.
 The rational person has self-control and is unmoved by emotions
and external factors and, hence, knows what is best for himself.
 Also behavioral economics explains that humans are not rational
and are incapable of making good decisions.
 Cont’d….
 Behavioral economics combines elements of economics and
psychology to understand how and why people behave the way they
do in the real world.
 It differs from neoclassical economics, which assumes that most
people have well-defined preferences and make well-informed, self-
interested decisions based on those preferences.
 Behavioral economics examines the differences between what
people “should” do and what they actually do and the consequences
of those actions.
 Behavioral economics considers people as human beings who are
subject to emotion and impulsivity, and who are influenced by their
environments and circumstances.
 Cont’d….
Assignment
1. Identify a set of rules in one organization.

2. Discuss how the rule is implemented and any challenge associated

with it.

3. Suggest, if any, whether the rule should change or continue to

operate.
THE END!!!