Introduction to Institutions and

Development

Yardstick International College (YIC)

Motivation
• Why vast differences in prosperity across countries today.
• Why are some countries rich and others poor?
• Why does affluence co-exist with poverty across different
continents and across people within a nation and even with in a
city?
• What are the sources of growth?
• Income per capita in sub-Saharan Africa on average (1/20) of US
income per capita.
• Mali, Democratic Republic of Congo, and Ethiopia: (1/35) of US
income per capita. Why?
Some stylized facts
• According to WB (2021):
• Global GDP was About $96.1 trillion
• Top 5 Countries by GDP in 2022
• USA---- $22.99trillion
• China --- $17.7trillion
• Japan----- $4.9trillion
• Germany---- $4.2trillion
• UK-------- $3.18trillion

• Sub-Saharan African ( which includes 46 countries ----

$1.9trillion
• Ethiopia ….. $111.2Billion
• Which is less than annual sale of apple company in the
same year ($394.33 billion )

• Toyota company ($257 billion)

In terms of per capita income

• Global Per capita income is about ---$12,262 in 2022

• Luxemburg-----$135,682.8
• USA--------------$69,287.5
• UK---------------$47,334.4
• On the other hand
• Sub- Saharan Africa---------- $1,645.5
• Kenya--------------$2,006.8
• Ethiopia ------- $944
• Eritrea-----------$642.5
• Burundi --------- $236.8
Share of global income, 2005
• Why do we have such a disparity?
• Why are the rich nations gets richer and the poor
nations are poor?

• Standard economic answers:

• Physical capital differences (poor countries don’t save enough)

• Human capital differences (poor countries don’t invest enough in
education and skills)
• “Technology” differences (poor countries don’t invest enough in
R&D and technology adoption, and don’t organize their production
efficiently)
Motivation

• These are, however, proximate causes of differences in

prosperity.
• Why do some countries invest less in physical and human capital
than others?
• Why do some countries fail to adopt new technologies and to
organize production efficiently?
• The answer to these questions is related to the fundamental
causes of differences in prosperity.
• Potential fundamental causes:
• Institutions (humanly-devised rules shaping incentives)
• Geography (exogenous differences of environment)
• Culture (differences in beliefs, attitudes and preference)
Motivation
• The institutional context is largely missing from most neo-classical
economics.
• Neoclassical economics evolved in the late nineteenth century &
assumes that people are perfectly informed (know all of the alternatives)
act on the basis of pure logical calculus (rationality)
• BUT human actions are also influenced by the belief system that
determines the incentive structure.
• The Neoclassical economics objective was to explain efficient resource
allocation in developed economies.
• Thus, Neoclassical economics – happens a world without Friction:
assumes perfect market.
Motivation

• Assuming perfect markets, neoclassical economists argued that price

mechanism (DD=SS) plays a role in exchange while ignoring the
fundamental importance of institutions.
• In the neo-classical view, rules, social norms and preferences are
given – thus understanding of economic institutions and human
behavior that does not conform to economic notions of the ‘rational
individual’ is left to other disciplines such as politics and sociology.

• Two failures
• It was frictionless
• It was timeless, static rather than dynamic in terms of its issues
Motivation

• This give rise to the emergence of institutional economics.

• When transaction costs are non-zero, then institutions matter!
• Transaction costs are those costs born when making
economic exchanges:
• search and information costs;
• costs of negotiating and
• writing contracts;
• enforcement costs
• In a world without institutions we would not know how to deal
with each other.
Motivation
The neoclassical approach could not help more to explain cross country
differences in economic performance.
• Policies that are effective in developed country failed to work in
developing countries. why?

• a number of devastating large-scale financial crises in developing

countries around the turn of the century (Mexico in 1995, Asia in
1997, Russia in 1998, Brazil in 1999, and Argentina in 2002).
resulted a prompt debate on the need to institutional reforms.

• Within the study of economic growth, the belief developed that an

exclusive reliance on so-called economic factors failed to explain
why some countries had developed economically and others had
remained poor, relatively and/or absolutely.
Motivation

• Thus, the proposition that ‘institutions matter’ for economic growth and
development has received intense attention.
• Nowadays, there is a widespread recognition of the important role that
institutions play in the economy (Stiglitz, 2000; North, 1997; Tridico,
2003; Prasad, 2003).
• Therefore, Institutions are arguably accepted as the ultimate sources of
economic development and income disparities among countries
Motivation
• But, we are still some way away from knowing exactly which
institutions? in exactly which forms are necessary?, or at least useful,
for economic development in which contexts?. For example, everyone
may agree that a ‘good’ property rights system is essential for economic
development.
• Even when we understand what role a particular institution can play in
economic development, we often do not know how we can build such
institution?.
• This foundation for bringing institutions to economics may be tracked
back to the writings of Coase (1937), with the theory of the firm.
Motivation
• Coase argued that, in the world of imperfect information,
enforcement problem and uncertainties, the firm represents an
alternative governance structure to the market by providing an
environment in which the price mechanism replaced by the power
and authority of an entrepreneur.
• He justified that the existence of the firm implies that there are
costs to market transactions.
• Similarly, Williamson (1979) argued that in a competitive world in
which information is costly, different institutional environments
imply differences in commitment and the cost of transaction
Motivation

• Therefore,

• Institutional economics maintains that social,

political and economic institutions set the frame for
economic transactions and thus influence economic
development.
Defining Institutions

• In order to determine what institutions are, and which institutions are

relevant for an economic system, it is necessary to define precisely what
is meant by the term ”institution”.
• Different actors have different views about institutions
• The debate on the function and importance of institutions is
complicated because they are complex and hard to define.
• Moreover, there is a lot of misunderstanding; some people use the term
institutions and organisations as if they have the same meaning.
• This is a mistake because an organisation is just a subcomponent of an
institution
Defining Institutions

• Institutions: the rules of the game in economic, political, and

social interactions.
• Institutions determine “social organization.”
• North (1990, p.3):
• “Institutions are the rules of the game in a society or, more
formally, are the humanly devised constraints that shape
human interaction.”
• Key point: Institutions
• are humanly devised
• set constraints
• shape incentives
Defining Institutions

• “In order to express it in the language of economists:

institutions define and limit the choices of individuals“
(North 1992, p. 4)
• „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).
• Institutions are generally defined as “constraints that
human beings impose on themselves” (North, 1990)
Defining Institutions

• Following this definition, institutions prohibit, permit or

require specific type of action, i.e. political, economic or
social, that are important for reducing transaction costs,
for improving information flows and for defining and
enforcing property rights.

• Veblen (1919): (Institutions are) settled habits of

thought common to the generality of man
Defining Institutions

• Commons (1931): (Institutions are) collective action in control,

liberation and expansion of individual action.
• Bromley (1989): (Institutions are the) rules and conventions of
society that facilitate coordination among people regarding their
behavior.
• Sjöstrand (1995): An institution is described as an infrastructure
that facilitates or hinders human coordination and the allocation
of resources. Institutions thus function as a kind of ‘rationality
context’, which simultaneously emerges from and governs human
interaction.
Defining Institutions

A broad cluster including many sub levels:

• Economic institutions: (individual property rights, contracts that
can be written and enforced, patent laws etc.,.
• Shape economic incentives, contracting possibilities, income
distribution.
• Political institutions: form of government, constraints on
politicians and elites, separation of powers, etc.
• Shape political incentives and distribution of political power.
• Important distinction between:
• 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.
Defining Institutions

• Constitution in US 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.
Defining Institutions

In summary
• A definition that combines and develops the most important aspects
emphasized by classical institutionalist:

• Institutions are the conventions, norms and formally sanctioned rules

of a society.
• They provide expectations, stability and meaning essential to human
existence and coordination.
• Institutions regularize life, support values and protect and produce
interests
Defining Institutions

In summary
• Institutions are incentive systems that guide human behavior “In
consequence they structure incentives in human exchange, whether
political, social, or economic”
• An institution is any structure or mechanism of social order and
cooperation governing the behavior of a set of individuals within a
given human community.
• Humanly devised constraints that structure political, economic and
social interactions.
• Institutions are rules and social norms which structure social
interaction. They can effectively enlarge/diminish capabilities, by the
way in which they affect political rights (freedom, democracy,
participation) and social rights (public resources for collective
purposes).
Institutions VS Organizations

• Institutions understood as organizations

• This understanding is often found in political science and is quite
similar to much of ’every day use’
• We will not use this definition. Organizations are agents. The
‘institutions-as- organizations’ definition hence mixes up institutions
and agents
• Institutions constitute both organizations and individuals
• The term organisation refers to public bodies (political parties, the
Senate, a city council, an administrative authority), legal persons in
economic life (firms, trade unions, family farms, cooperatives) and
agencies of the educational system (schools, universities, centers for
vocational training).
Institutions VS Organizations

• Organization consist of groups of individuals who undertake joint action,

because they want to achieve a common objective“ (North 1992, p. 5).
• If institutions are the rules of the game, organizations are the players
who play the game according to the rules....(North)
• While organisations are the players (in: Shirley, 2004, pg. 3) and can be
defined as “groups of individuals bound together by some common
purpose to achieve certain objectives,” (North, in: Shirley, 2004, pg. 3)
and include legislatures, firms, trade unions, churches, clubs, schools,
etc. (Shirley, 2004).
Institutional change

• Institutional change: Changes in formal rules, informal constraints and

effectiveness of enforcement
• Formal institutions often easier to change than informal
• Incremental change is often the case for informal institutions
• Because exchange is more complex in modern economies → need for
increasing formalization of institutions
How do institutions form?

• Institutions can and will likely result in an elite forming who will attempt
to retain their position of power. There may be successful or may not
be, but they can be replaced by an alternative elite.
• For the basis of this lecture we assume that institutions can be
• (i) developmental or
• (ii) predatory/extractive
• (i) Developmental Institutions – encourage investment, growth
and productivity.
• (ii) Predatory – extractive institutions that favor the few.
Institutional Variations

Big differences in economic and political institutions across countries:

• Enforcement of property rights
• Legal systems
• Corruption
• Entry barriers
• Democracy vs. dictatorship
• Constraints on politicians and elites
• Electoral rules in democracy
More on Formal and Informal Institution

Formal Institutions:
• 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.
More on Formal and Informal Institution

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.
Purpose of institutions- What do institutions do?

• Protection of property rights

• Enforcement of voluntary contracts among individuals
• Provision of the physical and regulatory infrastructure
• Define and limit the set of choices of individuals
• They structure and shape incentives in human exchange (be it
economic, political or social) while they make interaction (both formal
and informal), in consequence, are the underlying determinants of
economic performance”
Purpose of institutions- What do institutions do?

• „Institutions affect the cost of exchange and production and, in this way,
have an influence on the performance of an economy“ (North 1992, p.
6)
• “Institutions (have been designed by human beings) to create order and
reduce uncertainty in exchange” (D.C. North, journal of economic
perspectives, 1991)
• „Institutions reduce insecurity by providing us with a certain degree of
order in our every day life (north 1992, p. 4)
• Influence level of transaction costs
• Institutions and how they are enforced determines the cost of
transacting (north 1990)
Purpose of institutions- What do institutions do?

• A means of living and working together (Knight, 1992)

• Allow social actors to act with others to produce benefits they would fail
to achieve by acting alone.
• Knowledge of stability shared by the members of a group enable
behavior necessary to achieve these benefits.
• So institutions may encourage collective action and cooperation