Ethiopian Civil Service University

Rural-Urban Development
MDM5061

CHAPTER THREE
RURAL INSTITUTIONS

By Dr. Amanuel K. April 2024

 Chapter Three
CHAPTER 3: RURAL INSTITUTIONS -
 Institutions
 Role and Nature of Rural Institutions
 Formal and Informal Rural Institutions
 Some Rural Institutions
 Key Rural Institutions in Ethiopia
 What are Institutions?
• ‘Institutions are a set of rules, compliance procedures and moral and ethical
behavioural norms designed to constrain the behaviour of individuals in the
interests of maximising the wealth or utility of the principals’ (North, 1981).
• “Institutions are the rules of the game in a society or, more formally, are the
humanly devised constraints that shape human interaction” (North, 1990).
• “In consequence they structure incentives in human exchange, whether
political, social, or economic.”
• a set of humanly devised behavioural rules that govern and shape
the interactions of human beings, in part by helping them to form
expectations of what other people will do.
• Institutions refer to any structure or mechanism of social order and corporation
governing the behavior of set of individuals within a given human community.
• They are identifies with a social purpose and permanent exceeding individual
human life and intensions and the making and enforcing of rules governing
corporate human behavior.
 What are Institutions?
• Standard Neo-Classical economic framework assumes a well-defined set of
property rights with a full set of complete and contingent markets.
• It also assumes that contracts are signed with no fear that they will be cancelled
when it suits one of the parties.
• there exist institutions that establish and protect property rights and
enforce contracts - a system of laws and courts.
• Laws imply a legislator and a police force.
• The legislator's authority may derive from religion, family lineage, or
may be provided by popular support (in a democracy).
• Historically, institutions emerged through a social contract between citizens and
the state in exchange for protection and social order.
• defence, political institutions especially those relating to governance.
• Over time, these institutions were supplemented by economic
institutions like private property rights and markets, all of which
stimulate economic growth
 What are Institutions?
• Institutions can be classified as economic institutions, political institutions, and
social institutions.
• They also can be classified as formal institutions (organizations) and informal
institutions (culture, customs, taboos, belief, norms etc.)
• Some institutions are created by individuals deliberately or intentionally.
• Some others arise, develop and function on the pattern of social self
organization, which goes beyond the function of individual involvement (In-
built in the system)
• How do institutions affect the behavior?
 It affects the rule of games (the strategy sets, utility function of the game).
• The performance of institutions has its own implication for achieving rural
development, sustainable development and rapid structural change process in a
given economy.
 Formation of Institutions
• North’s theory of institutional change explains that formal institutions are a
crystallisation of informal ones (North, 1990),
• both co-evolve through the operation of organisations (informal and formal
social groups, from households and villages to networks, firms, parties and
governments).
• Institutions affect economic outcomes but society will choose those
institutions that maximise social surplus.
• Institutions are not always chosen by all of society but instead by the few,
hence not efficient. i.e. the winners do not fully compensate the losers.
• North (1981) argues that institutions act to constrain the individual in order
to enhance the welfare of the ‘principals’.
 Formation of Institutions
• Acemoglu, Johnson and Robinson (2004) provide the following framework for
understanding the formation of institutions.
1.Economic institutions are endogenous – determined as collective choices of society
– mostly for their economic consequences.
• Some conflict of interests amongst individuals and groups.
2.Distribution of power in society is determined by political institutions. Two types of
institutions – de jure and de facto political institutions.
• Political institutions determine de jure political power.
• De facto - true in fact, but not officially sanctioned, de jure - officially sanctioned
4. De facto political power arises from the ability to co-ordinate and ‘band’ together
to solve problems (e.g. Arab Spring) or military strength or economic strength.
• Distribution of resources leads to de facto political power
5. Two states (exogenous variables – not affected by other variables in the system) –
political institutions and distribution of resources.
• Both change very slowly and knowledge of these variables sufficient to determine all
other variables [de jure and de facto political power, economic institutions, future political
institutions, economic performance and distribution of resources in future].
Institutions and Economic Development
Institutions can be (i) developmental or (ii) predatory
1. Developmental Institutions – encourage investment, growth and productivity.
2. Predatory – extractive institutions that favour the few.
• Problem: institutional quality itself is determined by lack of equity in a society:
inequitable economies develop exploitative and inefficient institutions.
• Unfair wealth distributions can block the emergence of effective democracy
because it makes redistribution too costly for the elites in power.
• Inequality shapes, and is shaped by, political institutions.
• Initial conditions matter and change is very slow and difficult to initiate.
• Economic institutions influence growth because they shape incentives and
affect investment in physical and human capital
• Institutions  incentives investment  growth
 Why do institutions differ across countries?
• Efficient Institutions View
• Societies will choose the economic institutions that are socially efficient. It does
not matter how the surplus is distributed across the groups.
• Ideology View
• Societies choose different institutions because they or their leaders disagree
about what would be good for society.
• Incidental Institutions View
• Popular amongst political scientists and sociologists
• Downplays the role of choice in institution building and thinks of institutions as
by products of other societal interactions or historical coincidences.
• Social Conflict View
• Economic and social institutions are chosen not by whole society but by groups
who control power.
• These groups choose institutions to maximise their rents and this may not be
the same as maximising social benefits.
 Rural Institutions
• Rural Development requires a change in the rural economy - which in turn
implies institutional change within the rural society/economy.
• There are many levels of rural institutions - here distinguish between two.
i. Formal - institutions based on existing legislation.
- Identifiable within the legal framework of the country/region.
ii. Informal - institutions arising due to cultural factors or non-legal conventions
between individuals. May be difficult to detect.
• informal institutions (gender, class, and social capital) shape formal ones
(e.g. the law).
• informal institutions (customs) gradually change the actions and
interactions of agents in all sorts of social organisations (households,
groups, villages, as well as firms and governments).
 Rural Institutions

• Informal institutions in developing

countries play a very significant role in
shaping formal institutions and the
operation of markets, and can emerge
as the more significant rules of
interaction when formal institutions
and markets fail.
 Eg. caste, religion or tribe can
influence access to schools, credit
etc.
 They can influence the outcomes of
elections and therefore the benefits
derived from them.
 Agricultural Land Institutions
• Institutions are conceptualized as both formal and informal practices,
arrangements or mechanisms that enable sharing and transfer of agricultural
land for land scarce and landless farmers.
• Formal institutions are mechanisms and/or arrangement of land acquisition
through distribution or redistribution by different level of state authority.
• It is regulated by district and local administrations.
• It includes formal contractual agreement of land market and sharecropping.
• Informal institutions of land sharing and transfer include inheritance,
donation from family, informal rent-out/lease to other farmers,
sharecropping without formal agreement.
• It is a consent by the two parties in exchange and transaction without
the intervention of district or local administrations.
 Rural land institution
 In poor countries land, particularly agricultural land, plays a special role in the
daily livelihood and general social structure of the vast majority of people.
 But the extent of actual land transactions in the land market in a given year
is relatively low.
The market flow is a drop compared with the large stock.
The market is often more active in land-lease than in buying and selling of
land.
How are these characteristics related to the evolution of property rights in
land?
How are they related to forms of agriculture tenancy or contract?
 The history of land rights
 Is quite complex and context specific in parts of the world but some general
patterns can be discussed
Demographic changes (rising population pressure on arable land) or
commercial and technological advances that have increased the
productivity and value of land, and led to a tendency to move from the
earlier communal patterns of landholding to more well-defined private
property rights on land.
Even when land belonged to the community, individuals often had
heritable use rights, given them incentives to take care of the land, but not
the right to sell it or transfer the use right to outsiders.
Sometimes the individual and community rights may be mixed: in
contemporary South India, rights to the crop are private, whereas rights to
the growth after harvesting are communal.
Similarly, in many sub-Saharan Africa the domain of individual rights are
different between land and tree tenure.
 …the history of land rights
 Over time transferable property rights on land evolved because of:
Increased inequalities in labor and other productive assets among
households
Increased outside opportunities and mobility
Erosion of community cohesion and a large increase in land disputes
These changes have led to:
 Individualization of tenure and transferability rights based on public records
and surveys
 It could also reduce uncertainties and thus encourage investment and allow
for a more efficient reallocation of land
 Investment may also be encouraged by the easier convertibility of land into
liquid assets
 The emergence of credit market may be helped by land becoming a
collateral asset.
 …the history of land rights
 In reality many problems in the process could have harmed both equity and
efficiency:
 Public records and the court systems are inadequate in most poor countries
 The system is easily manipulated by the powerful and well connected
 As a result, the evolution of private property rights in land has often been
associated with:
Lost rights of the poor farmers,
Heightened social tensions,
The creation of new uncertainties,
Increase of court case and other transaction costs,
Undermined long term implicit contracts among the traditional
producers on the land and discouraged relations-specific investments
in land preservation and cultivation.
 …the history of land rights
• The land market should have functioned so as to reallocate land to more efficient
farmers. It did not function always that way. Why?
Evidence suggest that economies of scale in farm production is insignificant in many
poor developing countries (except in some plantation crops, mainly in processing and
marketing).
The small family farm is often the most efficient unit of production.
A puzzle: why the large landlords do not voluntarily sell their land to small farmers and
use their power to collect much of the surplus arising from this efficient reallocation?
Explanations:
 Land as an asset serves special functions for the rich but not for the poor, therefore
they are not reflected in land prices offered by the poor.
For example, holding land may offer speculative opportunities, safe investment
opportunities where non-agric investment opportunities are limited or too risky, give
special status or political power, a preferred collateral in the credit market.
 …the history of land rights
 All these suggest that the asking price for land may be above the capitalized
value of the profit stream even for the more productive small farmers.
 With low households savings and imperfect credit markets, small farmers are
incapable of paying the market price of land.
 Another explanation: an inherent moral hazard problem associated with loan
repayment through output produced on the land:
 The poor farmer has a limited liability: in a bad state of nature he/she cannot
be made to repay more than a given amount, while in a good state he must
repay a lager amount.
This ‘debt repayment threat’ reduces the farmer’s incentive to exert effort on
the farm after purchasing it.
Anticipating this, lenders may assess a default risk high enough that they are
unwilling to advance the loan.
For all these reasons land is not transacted from large to small farmers, very
thin market.
 …the history of land rights
 Actually, land is transferred from distressed small farmers to large farmers and
to money-lenders.
 This increases as traditional risk coping mechanisms get weaker and farmers
may tend more to sale land in times of crisis.
 Thus, imperfections of the insurance or credit market may prevent the land
market from bringing about Pareto improving transactions.
 When consenting adults engage in a mutually beneficial transaction that
benefits at least one financial actor while not negatively affecting any other
agents, it is referred to as a Pareto-improving transaction.
• Empirical evidence shows that there is insignificant economies of scale of land.
• Moreover, the small family farm is often the most efficient unit of production.
• Why is ownership not in the hands of the most efficient producer?
• Land is not only a production asset but also an investment
• Large landholdings give status and political power
• Land is used as collateral to raise money for capital investments
 …the history of land rights

• For small family farms the plots are too small to benefit from these advantages
• In total, land is more beneficial for landlords than for small family farms
Therefore, land is owned by landlords
Because of this situation micro-economic land models are often in terms of a
landlord tenant situation
• For Ethiopia the government serves as the only landlord
Ethiopia does not have a land market in the sense of transfer of ownership
All land is owned by the government
This is not typical for all developing countries
 The land lease market: fixed rent tenancy and sharecropping
The land lease market is more active than that of buying and selling land
 Sometimes land legislation restricts or prohibits tenancy.
 Or the risk of land reforms deter leasing since the landlord worry that the
tenant will acquire occupancy rights on the land.
Various forms of leasing land/various contractual forms:
Fixed rent contract: landlord charges fixed sum of money, per year or per
person, for the rental of the land.
Sharecropping: sharing of the tenant’s output in pre-assigned proportion
between landlord and the tenant, proportion varies across countries, 50-50 is
commonly observed, sharecropping is an ancient institution in most
developing countries. Sometimes cost of inputs is also shared.
• It is an often observed land arrangement
• The landlord owns the land
• The tenant works on the land
• Both get part of the output (value)
 …land lease markets
Stiglitz (1974) introduced the first principal-agent model used to study the
moral hazard problem with respect to unobserved work effort.
There are models of tenancy where the problem of adverse selection rather
than moral hazard is emphasized.
For example, a model that introduces a screening model of tenancy:
 The farmer ability is private information
 His choice of contract is to reveal something about this ability
 The most able farmers will self-select themselves by choosing fixed-rent
contracts
 The least productive will work for a wage,
 The intermediate ability will prefer share tenancy.
 Are tenancy contracts important as screening devise in a small village setting
where the landlord has good information about the ability of the members of
the village work force?
 …land lease markets
In this principal-agent model, the agent has only one decision variable: that
relating to its labor effort. The land owner may control more than one
decision variable and the terms of the share cropping contract may reflect
this.
Take as an example the use of fertilizer.
 If the tenant has to pay for these costs, there will be an under application of
this input.
 If the owner share this cost, say by the same share ‘α’ as in output, it will
lead to an efficient application of this input.
 However, this result does not hold in case of informational asymmetry and
uncertainty.
 With Constant Return to Scale, sharecropping has no extra risk advantage over
a suitable mix of fixed-rent tenancy and wage labor contracts
 Rural Financial markets
We shall seek to explain
 Why the poor often cannot borrow on the formal market.
Why the poor pay so much interest on their loans, if they are able to
borrow.
The role of institutions.
What can be done to improve the situation.
Credit is needed for efficient production as well as smoothing out
of consumption.
Production requires investments.
 Income streams often fluctuate.
 Rural Financial markets
There are two basic (and related) problems
Moral hazard: Lenders cannot monitor the actions of the borrowers.
Adverse selection: Lenders cannot distinguish between borrowers with different
characteristics. They don´t have personal knowledge regarding the clients.
These problems are severe for formal lenders
They cannot monitor how the loans are used.
Limited liability implies that borrowers take to much risk or default voluntarily.
 Collaterals may solve this problem, but this is infeasible for the poorest.
Informal lenders
 Often have more information about the clients.
Are often able to monitor the clients.
Often accepts different types of collateral (including labor).
 Characteristics of rural credit markets
Information problems (also for informal lenders) leading to:
 High interest rates
 Segmentation
 Interlinkage
 Interest rate variation
 Rationing (restricting the amount of credit that lenders will extend to borrowers who want money)
 Exclusivity
Information asymetries and rationing
 Information asymetries may also cause credit rationing as lenders are not able to fully
observe if a borrower is of high or low risk.
Too high interest rates may drive away the low risk type of borrowers.
It may therefore be optimal to have a lower interest rate and a higher probability of
receiving the money back.
Adverse selection: If banks raise interest rates the project mix will become riskier.
Moral hazard: If interest rates increase, borrowers themselves choose more risky
projects and/or put in less effort to repay.
• Overall, access to credit is an indispensable component to
the daily functions of many poor households and businesses
throughout the developing world.
• Improving access of the poor to finance is critical
• Micro credit and microfinance
• Microfinance has been broadly defined as ‘banking and/or
financial services targeted to low-and-moderate income
businesses or households, including the provision of credit’.

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Best example of microfinance:

Nobel prize winner,

Mohammad Yunus
who founded the Grameen
Bank
 Need for Microfinance

• Without banking facilities, the poor farmers go to money-

lenders who give them loans and exploit them with high
interest rates by taking advantage of their situation and also
their lack of education.
• The earning of the farmers is so meager that they don’t have
any savings and are highly prone to the sudden need of credit.

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 How microfinance helps:
• Microfinance come useful to poor households as they protect them against
external shocks like crop failure etc., and prevent unwanted incidents of
farmer suicides and other activities, by providing them with micro-credit at
low interest rates.
• Subsidies from donors and government can be successfully channelized by
micro-finance institutions to the correct people who actually need them.
• It also helps the poor to develop saving habits by letting them save the smallest
of amounts that are feasible for them to save.
• In this way, they can use the savings in times of need and would not need
outside financial assistance.
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Microfinance: 10 lessons from international experience
• Lesson 1: The Poor Are Bankable
• Lesson 2: Micro-credit Benefits the Poor
• Lesson 3: Penetration of the Poorest of the Poor is Difficult
• Lesson 4: A Realistic Interest Rate is Vital
• Lesson 5: Saving Mobilization Strengthens MFIs
• Lesson 6: Governance and Financial Systems Require Strengthening
• Lesson 7: Strong Regulatory Framework is required
• Lesson 8: No Single Model of MFI
• Lesson 9: Most MFIs Require Outside Funding
• Lesson 10: Credit Alone Cannot Achieve Objectives
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 Labor Market
• What makes employers not to undercut the wage rate?
• That is the question for development micro economists dealing
with labour issues
• The efficiency wage theory says that below a certain optimal wage
rate, demand is rigid.
• However this is not observed in practice
• Another answer to the relatively high wage in case of high
unemployment is that it is costly to recruit.
• The higher wage is a way to make workers loyal
 Labor Market
• Several aspects of the evolution of rural labor-market institutions in developing
countries are not well understood.
• the relationship between 'permanent' and 'casual' labor arrangements.
• Permanent labor arrangement - are contracts that link a worker to an entrepreneur
for a 'long' period of time (from slightly less than 1 year to a lifetime), and involve the
payment of a fixed wage (i.e., task independent) on a regular basis.
• Casual labor arrangements - denote temporary--mostly daily--contracts, involving the
exchange of a particular task in a (typically) 'peak' season for a once-and-for-all
payment.
• The historical and contemporary evidence on these institutions and their interaction is
puzzling.
• There are several locations in time and space in which the two forms of rural
employment have co-existed or co-exist.
• However, in other areas and periods either one of the two is almost absent.
• More generally, the relative proportions of tied labour and casual labor vary
widely over regions and over time in the same region.
 Labor Market
• Two regularities, however, can be singled out.
i. this two-tier structure of the rural labor market is only present in pre-industrial economies.
ii. there seems to be a steep decline in the incidence of labor tying in developing countries
• Hence, any theory that proposes to explain the emergence of permanent labor should also be
consistent with its eventual demise as the economy develops.
• The literature has offered two main interpretations of tied labor.
• Bardhan (1983) describes labor tying as an implicit contract, by which risk-averse workers
accept employment at a lower overall expected cost to the entrepreneur in exchange for
insurance against fluctuations in consumption.
• Eswaran and Kotwal (1985a), instead, propose an efficiency wage explanation of labor tying:
there is a set of tasks--some of which must be performed outside the peak season-- which are
crucial to the efficiency of the farm, but whose performance can be monitored by the
entrepreneur only with delay.
• To avoid shirking on such tasks, the entrepreneur offers to some of her workers a permanent
contract.
• However, to the bulk of the labor force--which performs tasks that are easy to monitor--it is
more efficient to offer only casual contracts.
 Rural Institutions in Ethiopia
• Rural land is an asset of great importance in Ethiopia.
• Control of agricultural land is a life and death concern for peasant societies.
• In the absence of much economic diversifications, access to land and other
natural resources is of special importance for improving the livelihoods of poorer
groups and providing greater security
• young adult people remain in rural areas either unemployed, as landless
labourers or as sharecroppers.
• The peculiar attachment of Ethiopian farmers to their land may have negatively
been affecting the mobility of peasants out of farming and subsistence living.
• This is mainly because of disorders of the institutions of land acquaintance and
transfer coupled with absence of attractive non-agricultural employment
opportunities like industry and commerce
• Moreover, there is a fear and the belief of losing land if the farmer engages in non-
farm activities.
• Rural Policy as an institution
• Intervention in the rural economy is itself an institution -
rather than taking a laissez-faire approach (opposes
government intervention).
• Rural policies are authoritatively/commandingly
determined, implemented, and enforced by government
institutions.
• Hence, it is argued that the relationship between Rural
policy and government institutions is much closer.
• For the successful implementation of rural development policy, the following
are required:
• Effective Communication
• Resources allocation
• Dispositions
• Merit Based Bureaucratic structure

Communication

Resources

Implementation

Dispositions

Bureaucratic Structure
 Linking New Institutional Economic Ideas and Rural Development

New Institutional Economics

Collective Action School Transaction Cost School

Institutional Environment Institutional Arrangement

Conditions under which Focus on power relations Focus on efficiency problems
economic agents achieve within instituions e.g. private due to institutions - specifically
successful cooperation in property, market structure etc. imperfect information
economic or political spheres

Ownership of rural resouces; Imperfect information affecting rural

Car-sharing for rural transport, Market Structure in rural areas; economy; e.g. within and about
overcome diseconomies of scale; Market Failure in rural areas; rural markets;Information used as a
Partnership building 38
Legislation relating to rural areas. source of economic power - rent seeking
Thank You!!

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