Introduction To IE

Introduction to Institutional
Economics
Institutional Economics
• An economics discipline studying how institutions emerge,
persist and change, and what are the results of their
operation.
• Institutional economics is a branch of economics that studies
how economic institutions, such as markets, firms, contracts,
norms, and laws, affect economic behavior and outcomes.
Defining Institutions
• Institutions are the rules of a society, or, to put it in a more formal way, constraints
on human interaction created by the people themselves“ (North 1992, p. 3.)
• “In order to express it in the language of economists: institutions define and limit
the choices of individuals“ (North 1992, p. 4)
• North defines institutions as "humanly devised constraints that structure political,
economic and social interactions”
• Rules of the game
• „The main purpose of institutions is to establish a stable (but not
necessarily efficient) order in order to reduce insecurity in human
interaction“ (North 1992, p. 6)
• Menard and Shirley, 2005: Rules of the game: the written and unwritten rules,
norms and constraints on human actions shaping the incentives of economic
agents.
Why are we motivated to study institutions and institutional
economics?
• What institutions have critical importance for economic growth

and development and how should they be shaped?
• To join the debate on the role of institutions to economic
development
• To investigate the position of formal and informal institutions in
development
• To appreciate the role of transactions costs, property rights
institutions in nations’ economic development
How do institutions form?
• There are different theories and perspectives on
how institutions emerge and evolve, such as
• Rational choice,
• Historical, and
• sociological approaches
• Evolutionary,
How do institutions form?
• Some of the common themes and questions that these approaches
address are:
• How do individuals coordinate and cooperate with each other in the
absence or presence of formal institutions?
• How do institutions affect the incentives, constraints, and opportunities
of individuals and groups?
• How do institutions adapt or persist in response to changing
environmental and historical conditions?
• How do institutions interact and coevolve with other institutions and
culture?
• How do institutions affect the distribution of resources and power in a
society?
• How do institutions promote or hinder economic efficiency, equity, and
sustainability?
Rational choice theory:
• It views institutions as the rules of the game and as the organizations
that shape human interactions and coordination in various domains, such
as production, consumption, exchange, innovation, and development.
• Institutions emerge from the rational choices and strategic actions of
individuals who seek to maximize their utility or payoff in a given
situation.
• Institutions also affect the incentives, constraints, and opportunities of
individuals and groups, and create collective action problems and
coordination dilemmas.
• Institutions can also be changed by the bargaining and contracting of
individuals and groups, who seek to improve their outcomes or reduce
their costs.
Historical theory
• This theory views institutions as the outcomes and legacies of
historical events and processes, and as the determinants of long-
term economic and social development.
• Institutions emerge from the path-dependent and contingent
effects of critical junctures and historical shocks, such as wars,
revolutions, colonization, or natural disasters.
• Institutions also affect the persistence and change of historical
patterns and trajectories, and create institutional complementarities
and lock-in effects.
• Institutions can also be changed by the occurrence of new critical
junctures or historical shocks, or by the accumulation of incremental
changes over time.
Sociological theory:
• This theory views institutions as the social constructions
and manifestations of shared meanings and values, and as the
sources of social order and identity.
• Institutions emerge from the socialization and
communication of individuals who seek to conform to or
challenge the norms and expectations of their society or group.
• Institutions also affect the cognition, motivation, and behavior of
individuals and groups, and create social roles and statuses.
• Institutions can also be changed by the diffusion and adoption of
new ideas and practices, or by the mobilization and resistance
of social movements or groups
Evolutionary theory:
• This theory views institutions as the products of the evolutionary
process of cultural development, and as the sources of social conflict and
change.
• Institutions emerge from the interactions and collective actions of
individuals who seek to achieve their goals and interests in a given
environment.
• Institutions also influence the preferences, beliefs, and expectations of
individuals, as well as their social preferences, such as altruism,
reciprocity, and fairness.
• Institutions can also be influenced by historical, cultural, and environmental
factors that affect the fitness and selection of institutional variants.
Institutions can also be designed or modified by deliberate human agency,
such as through political processes, social movements, or innovation.
Different dimensions and forms of institutions
• There are many levels of institutions - here distinguish at least
between : economic vs political vs social and formal vs
informal institutions.
• Economic institutions (individual property rights, contracts that
can be written and enforced, patent laws etc.
Shape economic incentives, contracting possibilities, distribution
• Political institutions ( form of gov., constraints on politicians and
elites, separation of powers, democracy vs non-democracy,
electoral rules, extent of checks and balances etc.)
Shape political incentives and distribution of political power
Inclusive & extractive institutions
• Extractive economic institutions: Lack of law and order. Insecure property rights; entry
barriers and regulations preventing functioning of markets and creating a nonlevel playing
eld.
• Extractive political institutions: in the limit absolutism: Political institutions concentrating

power in the hands of a few, without constraints, checks and balances or rule of law.
• Inclusive economic institutions: Secure property rights, law and order, markets and state
support (public services and regulation) for markets; open to relatively free entry of new
businesses; uphold contracts; access to education and opportunity for the great majority
of citizens.
• Inclusive political institutions: Political institutions allowing broad participation

-pluralism- and placing constraints and checks on politicians; rule of law (closely related to
pluralism).
• But also some degree of political centralization for the states to be able o e ectively
enforce law and order.
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Synergies
Growth is much more likely under inclusive (economic and political)
institutions than extractive institutions.
• Inclusive economic and political institutions (or inclusive institutions for

short) create powerful forces towards economic growth by:
• encouraging investment (because of well-enforced property rights)
harnessing the power of markets (better allocation of resources, entry of
more efficient firms, ability to finance for starting businesses etc.)
generating broad-based participation (education, again free entry, and
broad-based property rights).
• Key aspect of growth under inclusive institutions: investment in new
technology and creative destruction.
• Schumpeter -Creative destruction : the process that sees new
innovations replacing existing ones that are rendered obsolete over
time.
Why are extractive institutions so prevalent throughout history and even today?
• Why wouldn’t every dictator, tyrant and elite wish to create as much
wealth as possible?
• The reason is that growth, and inclusive institutions that will support it, will
create both winners and losers….Creative destruction
• Thus, there is a logic supporting extractive institutions and stagnation!
– Economic losers: those who will lose their incomes, for example their monopolies,
because of changes in institutions or introduction of new technologies
– When inefficient economic institutions convert to efficient, some groups get worse off and
such groups hinder the institution transformation
– Political losers: those who will lose their politically privileged position, their unconstrained
monopoly of power, because of growth and its supporting institutions fear of political
creative destruction
• Both are important in practice, but particularly political losers are a major
barrier against the emergence of inclusive institutions and economic growth.
Botswana
• Around Independence 1966: Only a handful of university graduates,
and the first government secondary school was not established until
the eve of independence .
• There were five kilometers of paved road in a country the size of
France.
• From 1965 to 1999, Botswana achieved the world’s highest rate of
growth of per capita income: over 7 percent per annum
• By 1999, Botswana’s income per head was six times that of the rest
of SSA, and 60 percent of the world average.
• Diamond revenues invested in education and health
• Botswana held its first multiparty elections in 1965, eighteen months
before independence
Cont’d
• Since independence, Botswana has held elections every five
years, from 1969 to 2004.
• The Botswana Democratic Party (BDP) won 81 percent of the
vote in 1965, and its majority shrank over the succeeding thirty-
four years. Twice (1969 and 1984) a sitting vice president lost
his seat in the elections.
• Transparency International has ranked Botswana as having the
lowest perceived corruption in Africa.
• Impressive growth but HIV epidemic….public policy failure?
• Will this be sustained?
Formal and Informal institutions
• A broad cluster including many sub levels:
• Important distinction between : Formal and Informal institutions
• Formal institutions: codified rules, e.g. in the constitution
• Informal institutions: related to how formal institutions are used, to
distribution of power, social norms, and equilibrium.
• Constitutions in U.S. and many Latin American countries similar,
but the practice of politics, and constraints on presidents and elites
very different.
• Why? Because distribution of political power can be very different
even when formal institutions are similar.
Formal and Informal institutions
• Formal - are those whose norms, rules and sanctions are guaranteed
through formal processes that are usually but not always official and are
written and enforceable through legal recourse or arbitration; can be
associated with organizations of the state, market or civil society.
• Rules that are readily observable through written documents or
rules that are determined and executed through formal position, such as
authority or ownership
• Institutions based on existing legislation. Identifiable within the legal
framework of the country/region.
• Example: constitutions, laws, property rights, rules and regulations put
in place by the government, explicit incentives, contractual terms, and
firm boundaries
Informal institutions
• Rules based on implicit understandings, being in most part socially
derived and therefore not accessible through written documents or
necessarily sanctioned through formal position.
• Are social norms that represent evolved practices with stable rules of
behavior outside the formal system
• Are how to behave in everyday life (linked to religion, history, social
acceptability).
• Institutions arising due to cultural factors or non-legal conventions
between individuals. May be difficult to detect.
• Examples: social norms, routines, and political processes, Sanctions,
taboos, customs, traditions, and codes of conduct, norms of behavior,
conventions

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Introduction to Institutional

• What institutions have critical importance for economic growth

• Extractive political institutions: in the limit absolutism: Political institutions concentrating

• Inclusive political institutions: Political institutions allowing broad participation

• Inclusive economic and political institutions (or inclusive institutions for

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