Introduction to Institutional and Behavioral Economics Chapter 1

Chapter one: Introduction and Concepts of Institution

1.1 Definitions of Institutions and Institutional Economics

1.1.1. Institutions
Imagine you are hungry, and you have a small budget available to buy food. There are various channels you can
use to purchase food, and they all have their own habits and norms. Suppose you are going to a small local
restaurant. In this place you are expected to follow some rules, such as sitting on a chair, making an order,
paying for the food at the end by using money, etcetera. The restaurant employees are also expected to follow
some rules. For example: he/she should serve fresh food, which you ordered, if you ask for water, he/she should
give it or explain why it is not available, he/she should bring the food to your table, etc. Imagine a world
without these rules: it would be very difficult and uncertain for you to do the transaction of money for food.
Rules and norms in this local restaurant facilitate the transaction and reduce uncertainty for the consumer (you)
and the restaurant employees and the restaurant owner. Similarly, all transactional contexts need rules and
norms, to avoid extreme uncertainties and high transaction costs. The field Institutional Economics researches
rules, norms and constraints that facilitate economic transactions.
In English, the word ‘institution’ has several meanings depending on the context,
including:
• an established organization;
• the building in which an organization is housed; or
• a custom, practice or rule.
However, in Institutional Economics the word ‘institution’ has been assigned a specific connotation. What we
mean is closer to the third meaning listed above.
Institutions are written and unwritten rules that influence behavior and social interaction. The behavior of
individuals can be manifested during transaction of goods, services, properties and ideas. Thus, Institutions are
rules that facilitate transactions and which are meant to provide certain safeguards before we enter into a
transaction.
Over the course of time societies have introduced many kinds of safeguards, by developing rules and sanction
mechanisms. In this context, institutions are man-made rules and their accompanying sanctions that are intended
to make interactions less risky and more predictable.
According to Hodgson (2006), institutions are systems of hierarchical man-made rules that structure behavior
and social interaction. They consist of established, durable and stable rules, and vary from social values through
norms to laws with ensuing specific rules. Institutions are systems, in which the rules are positioned in a
hierarchical way: the more general rules set the boundaries for the more specific ones

1.1.2. Institutional Economics

Institutional Economics analyzes how economic systems work. In addition, it is about how the system should
work in order to realize the goals the community has set for itself. Institutional Economics is about designing
effective and efficient institutions to structure behavior in such a way that the system performs well.
It also concerns itself with explaining the different ways in which individuals transact; in other words, how do
they coordinate their transactions? Institutions assist in coordinating transactions smoothly at low cost.
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The subject matter of Institutional Economics is rather complicated. It involves different layers of institutions
that are interrelated and can change over time. Moreover, striving for efficiency can be a reason for institutions
to exist and to change, but equally important is the role of vested interests.
i. Efficiency Approach: Actors at macro level make efficient laws and regulations, and actors at the micro level
choose efficient governance structures. Efficient means that the institution should generate an optimal outcome
given scarce resources, so it means minimizing transaction costs for all actors.
• Efficiency Static Approach --Given the institutional environment and the characteristics of actors, which
governance structure minimizes transaction costs?
• Efficiency Dynamic Approach ---How do institutional changes come about when actors operate out of an
efficiency perspective?
ii. Vested Interest Approach: Actors in the economic system will create opportunities to maximize their own
profits and utility, and they will use their power to protect their vested interests.
• Vested Interest Static Approach--- Given the institutional environment and the characteristics of actors,
which governance structure is chosen when powerful interest groups protect their vested interests?
• Vested Interest Dynamic Approach--- How do institutional changes come about when actors operate out
of a vested interest perspective?

1.2. Types of Institutions

- Formal institutionsare public rules of behavior that are designed by a public authority with legislative
power (parliament or senate) and enforced by (i) a public authority with executive power (the administration
or government, making use of police, regulatory agencies and other enforcement agencies); and (ii) a
judiciary power (judges) that has the right and the power to penalize an individual or organization for
breaking the rule. Typical examples of formal institutions are laws and governmental regulations aiming at
the realization of specific policy objectives. For example, the government dictated that collecting fuelwood
in Nechisar Park is not allowed and may be punished by imprisonment. In this way, the government avoids
environmental degradation of Nechisar Park.
- Informal institutions are private rules of behaviour that have been developed gradually and spontaneously
and do not need any legal enforcement because the rules are sanctioned by the private parties themselves or
because it is in the self-interest of the actors to follow the rules of their own accord.
o The first subcategory contains self-regulating mechanisms; that is, standards and possible sanctions
are agreed on by the private actors involved. For example, a boss may tell his employees that the
punishment for coming late more than three times is losing the job. In that case, the employee will do
his best to follow the norm to be on time. Another example is a micro borrower who repays the loan,
because he will otherwise lose his collateral. Lastly, the producer of smartphones will make good
quality because otherwise customers may return a broken phone in the warranty period of 1 year.
o The second subcategory refers to self-enforcing mechanisms, implying that the rules will be complied
with spontaneously, because of a fear of loss of reputation or other fears. For example, an employee
will always come on time to make a good impression; a person visits church often to pray because he
believes it will benefit him; a company that tries to work environmentally friendly to make a good
impression on customers.

1.3. Institutional Environment

Because of differences in institutions worldwide, each society, be it on a local or a national scale, has its own
specific institutional environment consisting of a hierarchy of different kinds of institutions: values, norms,
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conventions and laws.
o Values are embedded in a society’s culture (all aspects of human behavior and society that are shared by
all, or almost all, members of some social group), are generally held preferences about pursuable goals,
and embody what most citizens in a certain society consider to be ‘good’. Values represent beliefs about
what are considered to be the most important things in life. Important values in a large part of the world
are, among other things, individual freedom, justice, security, peace, prosperity and a civilized
environment. Because values in general give directions with respect to how people behave, they can be
interpreted as general coordinating institutions.
o Norms are generally-held opinions about how to achieve the values. They define agreed ways in which
people should behave, according to the members of a group, so that the values of society are realized, or
at least not violated. Examples of norms include: solidarity (to achieve justice), competition (to achieve
prosperity), and the ‘polluter pays’ principle (to achieve a tolerable environment). Individual members of
the society have sometimes internalized the norms into their own way of thinking in such a way that the
norm has become part of their conscience. Then people adhere to them if only to avoid a guilty feeling.
On other occasions, people are persuaded to follow the norms because of external (social) pressure and
the fear of becoming an outcast.
o Conventions are practical rules that structure behavior in complex situations. Conventions reduce
coordination problems, which is particularly important in an increasingly complex world. Examples of
conventions are the use of a common scale to measure lengths, weights and time with the aid of the same
units, and rules on how to behave in social interaction and in traffic. So, if the norm is that people should
drive safely in order to contribute to the value of security in general, the convention is driving either on
the right-hand side, or the left-hand side of the road. When persons in a society agree about the values,
norms and conventions and they all consider these institutions as functioning in their own interest, each
of them will spontaneously support the values, norms and conventions. They have internalized them into
their own values and behavior and expect that the other members of the society have done the same.
However, that is not always the case. In society, different values can exist, supported by different
interest groups. It can very well be that, in the interests of society as a whole, a specific norm of behavior
is necessary, but that a large part of the population considers the norm not to be in their interest.
Similarly, different groups in society can also disagree and have conflicts about conventions. In such
cases, institutions do not automatically structure the behavior of people in the right direction. Then
formal laws and formal sanctions are needed to further structure the behavior of the members of society.
o Laws (and regulations) are formalized rules enacted by the government, in the shape of codified norms
and conventions. Sometimes people are tempted to break the existing rules when they think this will be
to their advantage. For these situations, third-party sanctioning through legal enforcement is necessary.
Laws result in all kinds of specific stipulations that either enable or constrain actions so as to comply
with norms and conventions, in order to avoid or deal with conflicts. Examples include the tax laws of a
country (to comply with the norm of solidarity); the legal obligation of firms with limited liability to
give information to the public about their profits or losses, thus allowing (prospective) investors to make
a correct judgment (to comply with the norm of competition); and the moral or even legal duty to throw
rubbish in waste bins (to comply with the norm not to pollute). People generally adhere to laws because
breaking these rules could lead to a sanction by the government (such as a fine or a jail sentence)
The way in which values are worked out in norms, conventions and rule differs a lot by culture. For example,
peace is a value, but countries may differ in their opinion of how to maintain peace: one norm may be through
building trust relations with as many other nations as possible, but another may be through building a large
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army.
Menard and Shirley (2008) define institutions in a very complete way: institutions include (i) written rules and
agreements that govern contractual relations and corporate governance, (ii) constitutions, laws and rules
that govern politics, government, finance, and society more broadly, and (iii) unwritten codes of conduct,
norms of behavior, and beliefs.

1.4.Functions of institution
Institutions have one main function: to structure behavior. In that sense, institutions increase the predictability
of behavior. Uncertainty about the actions and reactions of others in the market is reduced, which enables
economic actors to prepare contracts and coordinate transactions. Institutions enable economic transactions to
take place – both nationally and internationally.
For example, the market transaction (which takes place in the market between individual buyers
and sellers.), the managerial transaction (between one person in control, one being managed or ordered), and
the political transaction (agreed on by decision-makers, who have the legal authority to determine how wealth
in society should be distributed) is determined by the institutional setting of laws and rules reflecting economic
and political power not merely by competition and scarcity.
One example of a basic institution is money. Products are traded in the market generally using money as the
standard currency, as it has proved to be an effective institution for trade: using money makes it easier to
compare different products and to sell or buy products. Also, a trustworthy financial system to support
transactions is essential. If people lose trust in the system, they might panic and all withdraw their savings from
banks at the same time, leading to a (possibly worldwide) crisis.
As such, the function of institutions is to reduce risk and transaction costs, to make behavior of economic
actors more predictable.

1.5.Institutions versus Organizations

In speaking language, institutions are often equalized with organizations. However, in institutional economics,
these two concepts are different.
Organizations are actors like households, firms, and states that have preferences and objectives. Institutions
are formal and informal social constraints (rules, habits, constitutions, laws, conventions). North argues that
institutions are the rules of the game, while organizations, along with individuals, are players in the game.
Organizations are groups of individuals bound by a common purpose to achieve objectives. They include
political bodies (political parties, the senate, a city council, a regulatory agency); economic bodies (firms, trade
unions, family farms, cooperatives); social bodies (religious groups, clubs, sport and youth associations); and
educational bodies (schools, colleges, vocational training centers).

1.6. Outcomes of Institutions

When are institutions effective? When norms in society exist, but nobody adheres to them, then the norms are
ineffective and do not structure behavior sufficiently. This section addresses institutional successes and
institutional failures to get acquainted with outcome options.

1.6.1 Institutional success

For an institution to be effective, two conditions must hold and three requirements must be met. The conditions
are:
1. A sufficient percentage share of individuals must subscribe to the institution for it to become accepted. For
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example, Child labor, War and Ponzi schemes are institutions that most of us do not subscribe to, whereas
religion and human rights are acceptable for most of us.
2. There must be credible (enforceable) sanctions to prevent the rest of the population (the ones that do not
subscribe) from acting against the norm.
After these two conditions are met, there are three requirements for institutions to work.
1. general, which means that rules must be nondiscriminatory; that is, they must apply equally to all people
and in all circumstances. Class justice (different laws for different types of people) should not apply, and
people must be sure that the rulers themselves are also subject to the law.
2. certain, which refers to the requirement that rules be transparent and reliable, so that all citizens know what
the rules imply and what will happen if the rules are not observed
3. open, which means that rules should be flexible, in the sense that they permit actors to proceed in response
to new circumstances.
There is a certain tension between, in particular, the second and third criteria, because the more open (flexible)
the rules, the less certain (fixed) they become.

To meet the requirements, all effective institutions must be complemented by enforceable sanctions, which may
be informal and based on self-enforcing or self-regulating mechanisms, or be based on formal laws. The
presence of credible sanctions is important. If people can simply break a rule with no consequences, other
individuals may start to do the same, leading to a downward spiral and a complete undermining of the
institution. Sanctions may be negative or positive.
• Negative sanctions are instruments for dealing with norm-violating behavior like Ponzi scheme and War.
Negative sanctions are important to curb opportunistic behaviors. For instance, Nasdaq manager Bernard
Madoff offered an investment scheme with a guaranteed high profitability, but these high profits were
provided by new investors and not by productive activities, so that in the end the system could no longer be
sustained. This Ponzi scheme could be avoided by using the instrument auditing which would have imposed
a negative sanction on Bernard Madoff before the Ponzi scheme resulted in a financial crisis.
• Positive sanctions are rewards or encouragements to behave in a certain fashion. An example of a positive
sanction for students is to be included on the top-scorers list to raise student achievements. Another example
of a positive sanction is performance-based pay to stimulate workers’ productivity.

1.6.1. Institutional Failure

If the two conditions and three requirements are not met, institutions do not facilitate transactions, so they may
run into difficulties and end in conflict. Disagreements can sometimes be resolved by the private parties
themselves, but quite frequently a public authority must settle the dispute. These events may lead to new
institutions being introduced. It can also happen that no solutions are found at all, in which case the transaction
fails altogether. Several reasons for failing institutes are discussed in this section.
The first main reason is opportunistic behavior, which is self-interest seeking by an actor in a deceptive
(secret) way. Basically, actors show opportunistic behavior because they think they can get away with it. They
take advantage of the fact that others cannot always observe their actions. For example, employees may work
less hard than they are supposed to if they can pull it off. Shopkeepers may profitably sell poor quality products
if consumers can only discover the quality after they have bought the product. Or managers who have been
entrusted with other people’s money may spend it rashly or for their own benefit.
Alternatively, people take advantage of the fact that others are dependent on them. For example, the sole
supplier of an indispensable product may be able to raise its price because there is no competition (monopoly).
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Or one of the few employers in a region may be able to succeed in forcing employees to accept less
advantageous terms of employment. It could also be that certain individuals form a powerful interest group that
is able to manipulate the government so that rules are made or maintained in their favour, to the disadvantage of
the majority (corruption).
Therefore, a lack of good institutions often leads to economic inefficiency: two persons can benefit from a
transaction, but they are not able to reach an agreement because they mistrust each other too much, or they are
unable to reduce uncertainty sufficiently.

1.7 Old vs New Institutional Economics

Institutional Economics (IE) as a field of study dates back to around 1900 G.C. when Veblen was the first to
analyse institutions from an economic perspective. He argued, together with other scholars, that it is too
simplistic to observe economic actors as individual rational agents. Instead, institutions like markets, and all
small sub institutions that shape markets (e.g. money, agreements about pricing, etc) must be studied by other
mechanisms, by studying their norms and rules. Old Institutional Economics deviated much from classical
economics, by leaving concepts like perfect information and instrumental rationality, scarcity and competition.
Unlike old institutional economics, New Institutional Economics (NIE) does not abandon neoclassical
economic theory. While new institutionalists reject the neoclassical assumption of perfect information and
instrumental rationality, they accept orthodox assumptions of scarcity and competition.
NIE tries to answer questions that neoclassical economics does not address and this has given NIE a distinct
identity and a strong following. As North has pointed out “neoclassical economics was not created to explain
the process of economic change, much less political or social change. Institutionalists, in contrast, aim to
understand change by understanding human incentives and intentions and the beliefs, norms and rules that they
create in pursuit of their goals” (see North 2004).
NIE’s breadth and innovation is possible due to a multi-disciplinary approach. Institutional analysts adapt useful
concepts and methodology from political science, sociology, law, anthropology, cognitive science, evolutionary
biology, and any other discipline that sheds light on the rules, norms and beliefs that govern human interactions
in the process of production and exchange.

Review questions
1. What is meant by institutions in Institutional Economics?
2. What is the difference between formal and informal institutions?
3. Why do societies usually have both formal and informal institutions?
4. Which economic institution exists in Ethiopia but not in all other countries?
5. What is the link between market imperfections and institutions?
6. What is the difference between efficiency and vested interest approach?
7. Describe opportunistic behaviour.
8. Give one example of institutional failure that you experienced.
9. Select your own real-life case and identify at least three institutions.
10. Select one institution in your university life and suggest how it should change.
11. Write about one case in your life where a formal institution contradicts an informal institution.
Prepare PRO and CON arguments for the following statements:
- Students follow norms only if there is explicit enforcement of the norm
- AMUs ‘first day first class’ policy is an example of an effective institution
- Arba Minch University lacks institutions for optimal teaching learning