INSTITUTIONAL ECONOMICS
IPPG Briefing Paper No. Three
by Steve Wiggins & Junior Davis
Assisted by comments from Adrian Leftwich & John Morton
Introduction to Institutional Economics
• Institutional economics is more grounded in reality, it has refuted
some of the simplification of economic reality by resorting to using
assumptions.
• Basic assumptions of the neo classical school has lead to the
development of models and sophisticated mathematical tools.
• In institutional economics, markets were not considered autonomous
entities ,functioning independently, but are interlinked with
institutions.
• Early proponents of this branch of economics are Cyert and March
(1963),Simon (1972), Willamson (1975).
Core issues of Institutional Economics.
• Bounded rationality
• Information Gap/ Information Asymmetry.
• Positive transaction cost
• Institutions are endogenous to economic markets.
• ‘Essentially, institutions are durable systems of established and
embedded social rules and conventions that structure social
interactions’ (Hodgson 2001)
• The institutional context is largely missing from most neo-classical
models of market exchange and human interaction.
• Institutional economics may be seen to bring economics closer to
other disciplines by arguing that individuals make choices that are at
least partly culturally determined.
• – thus moving beyond the longstanding focus of economics on
individual utility as the main guide to resource allocation.
• Institutions establish the rules of the game’
• – that is, they condition and modify the behavior of individuals and
groups so that their actions become more predictable to others.
• They do so through both formal rules that include laws and contracts
and, as well as through informal means such as social norms and
conventions that evolve over time
• ‘Institution’ is quite different and not synonymous with
‘Organization’, when taken in the context of Institutional economics.
• Institutions are defined as helping form stable expectations, hence
institutions can only be changed infrequently.
• Institutions operate at a deeper level and are, in effect,
constitutional.
• They establish the framework of rules within which more routine
decisions take place.
• Whereas Organisations can be formed to carry out a function, a
specify need, and can be dissolved once its purpose is served.
• By narrowing the definition to economic institutions, according to
economic functions carried out 3 main types according to function
performed are:
• Establishing and protecting property rights;
• Facilitating transactions; and,
• Permitting economic co-operation and organization
The debate and definition of economic institutions can be expanded
and discussed by asking three key questions about institutions
FUNCTION EXAMPLES TYPICAL FORMAL REGULATING INFORMAL REGULATING AGENCY
AGENCY /INSTITUTIONS
Property rights Land tenure Land registries Oral history,
Establish rights; decide between chiefs & other
competing claims; local political authorities
inform non-owners & police Inheritance law Intellectual Probate registry Patent
Custom
property rights: patents, offices
copyright
Reciprocracy: Weights, measures, Standards bureaux
facilitating transactions standards
Establish rules of exchange, Contract law; dispute Civil courts; arbitration Elders, religious courts
respect for contracts arbitration councils Market information
Provide information Reduce or Public information on markets agencies
re-allocate risk Physical provision & Local authorities; stock Customary points for
organisation exchanges/ bourses exchange (crossroads, etc.)
of markets (e.g. auction Market hierarchies (Market
rings, stock exchanges, mammies/ queens/etc.)
futures markets) Bank regulatory agencies Haveli systems
Banking conventions,
instruments (letters of credit, Professional
etc.) Auditing & accounting associations
conventions Insurance
companies
Co-operation & Laws on limited liability & Register of companies
Organisation: bankruptcy
Competition policy Commissions on
• Interactions within monopolies & mergers
organisations Co-operatives ministries, Social norms of co- operation
• Collective action & co- Regulations on co- operatives, bureaux
operation (in labour, price charities, civil associations
negotiation) Auditing & accounting Professional Custom
• Realising economies of conventions associations
scale and managing Min labour,
diseconomies of scale Employment regulations employment tribunals
• The debate and definition of economic institutions can be expanded
and discussed by asking three key questions about institutions
• How are economic institutions formed?
• How do economic institutions function?
• How do institutions affect economic growth and poverty reduction?
• How are economic Institutions formed?
• Institutions are created and evolve in response to the uncertainty,
risk and information costs associated with living and transacting in an
imperfect world.
• Institutions emerge in two ways: either informally through repeated
interactions between individuals or organisations or formally through
deliberate design
• In latter case, it may be government that establishes the institution,
or it might be an initiative from private enterprise or civil society.
• Institutions are thus rational mechanisms designed to cope with the
imperfections of markets, including the asymmetry of information
• So that different actors, example tenancy farming where the
principals ensure that their agents pursue the same goals.
• It explains why inefficient institutions such as tenancy farming have
persisted as ways to solve such imperfections.
• To give it a legal standing institutions require the support of
governments, remove ambiguity and to provide legal backing for
the norms in question.
• Institutions are not lightly changed, even when clearly imperfect or
outdated.
• Institutions are valued for their predictability, frequent change and
experimentation to established norms is thus not usually encouraged.
• Institutions can confer rights and advantages to particular groups in
society who will use their power to prevent changes that undermine
their advantages.
• Institutions most of the time reinforcing patterns of development
and restricting the range of options for policy.
• The political economy of institutional change is therefore important
in that they may evolve to confer privileges on particular groups,
whether or not the institutions are efficient and effective for society
as a whole
How do economic institutions function?
• The functioning of an institution is not necessarily to be inferred
from its form.
• Similar institutions exist in many countries carrying out similar
functions ,but with different outcomes, and efficiency may vary.
• It depends on the details of administrative machinery and the
efficacy of the legal system.
• It requires detailed investigation of actual functioning, rather than
merely studying the apparent form of the organization.
• Institutions are often embedded in social and cultural characteristics
of the particular context.
• Institutions success is dependent on deeper underlying norms in
society on matters such as the extent of generalised trust, and
individual freedom versus obligations to wider collectives.
How do institutions affect economic growth and poverty reduction?
• Institutions potentially affects four factors that help determine
economic growth
Investment :
• When property rights are secure, owners of capital are more likely to
invest.
• Trade laws ,credit facilities, insurance, company formation etc are not
tangled in red tapism.
Technical advancement
• Encourage R&D in private sector
• Protect Intellectual property
Economic Organisation
• Institutions should be effective and efficient, delivering the benefits
of specialisation and economies of scale
• Facilitate transactions and co-operation between individuals,
whether in formal companies or less formal co-operatives.
• Generate technical innovations.
• Direct the pattern of economic growth and the distribution of
rewards within economies and societies – and thereby affect levels
of poverty.
Human Capital
• When Institutions function efficiently and foster economic growth
• Development of human capital is a natural progression.
• Education and skill development is prioritised.
