Rules and institutions in economic processes

Institutions are systems of rules that constrain the actions and choices of individuals and organizations,
that make these rules effective, so agents follow the rules.
Institutions include set of:
1. Formal Rules, like laws and legislation,
2. Informal Rules, embedded in traditions.
3. Different Organizations that are in place to assure that rules are actually respected.
Fundamental for the well-being of agents and societies because they shape the system of incentives
faced by each agent and therefore, they affect the relative performance of the economies.
The systems of rules have a strong impact on societies because
- Rules vary very slowly over time, and link different generations of agents, thus allow agents to
transmit information and knowledge that shape our cultures across each other and along different
generations.
- The knowledge from agents is accumulated and transmitted through the institutions that evolve
with our cultures.  Institutions help accumulate and transmit individual knowledge, by
transforming it into a shared resource for the community, especially in open societies with
common values and principles. This knowledge is then transmitted across generations as our
cultures, together with the ethical principles and values that hold our communities together.
- A share of the knowledge passed through generations isn't formalized but, it is learned as a set of
rules and traditions.

Efficiency of Rules vs. Rational Behavior

We cannot always entirely rely on a rational analysis of the problems as Rational behavior requires a lot
of time and energy (expensive as time is the most important resource). Economic theory normally
assumes that agents are rational, but rationality itself is limited. In many cases behavioral rules are much
more efficient than a rational evaluation of the problems.
 therefore, agents follow a set of rules and change their habits and routines only when it’s
necessary.
Culture of each society plays a very important role:
1. keeps together individuals that take autonomous decisions,
2. affects individual choices
3. affects the learning process of individual agents.
In most of our choices, since it is too costly to gather all the necessary information for fully rational
decisions, we (agents) follow some predetermined rules of action, behavioral routines and customary
habits.
 Rule following saves a lot of individual effort and costs.
  Rule following are even more important for social interactions, as makes our behaviors
predictable and therefore each of us can make expectations on the behavior of other agents.
 Rules allow us to cooperate, as it makes possible to coordinate the actions of different individuals
taking independent decisions.
Institutions have a great impact on the aggregate outcome of individual decision making because
information is costly.  Gathering, analyzing and transmitting information and the knowledge that
follows the analysis of information is extremely costly because the time available to any individual is
severely limited in any circumstance. (time efficiency is important)
Note: written and codified laws are not the only one that matter, as the system is based on a mixture of
equally important formal and informal rules.
 Informal rules emerge/developed spontaneously from the interactions and activities of several
individual that cooperate through a trial-and-error process to solve problems and face any
unexpected issue with the aim to increase the probability of success of each individual and
increase the well-being. Represent behavioral routines adopted when they produce beneficial
outcomes to the individual members of the group.
** These norms involve preferences and needs that can only be realized through actions and
choices made jointly and must be based on shared views on ideas.

 Formal rules are effective only when members of the community are willing to respect them.
1. No system of rules can work if rules are imposed by force and are not accepted at least in
part.
2. Imposing the respect of the rules is in fact extremely costly
3. The system can afford exclusively to punish the deviant behavior of a small minority of
members. (only afford to punish a small number of rule-breakers)
** Whenever the number of deviant members large, imposing the respect of the rules
becomes expensive/unsustainable and the rules become ineffective. = ineffective
system.

Evolution of rules
- Changes in the system of institutions, spontaneous rules and rationally planned laws and
organizations does not necessarily lead to cultural development and economic growth.
- Changing the rules is very costly, because a large number of agents need to learn the new rules
and adapt.
- Any change involves outcomes that are not symmetric among individuals, with some of them
benefiting, while other losing from the changes
- The agents that lose from the changes have strong incentives to hinder the process.
- Developing a general consensus to adopt the innovations is therefore a long, slow and difficult
process.
- Institutional problems do not allow easy solutions.
- Changes and innovations often impose costs that immediately affect a specific and restricted set
of individuals, while benefits accrue to a large number of people and only over time.
- It is difficult to imitate the successful innovations of other communities and countries. Every new
rule has to be introduced in the context of the existing set of rules.
 - State organizations always play a fundamental role because they define the formal rules and
impose the respect of the rules, benefiting in the monopoly in the use of violence and force. But
state organizations need to change too over time to adapt to different conditions and new needs
and aspiration

Market institutions = Market rules

The basic economic problems involve the efficient use of our limited knowledge and resources to take
decisions rationally.
Knowledge is spread among a large number of different individuals and most relevant problems require
the cooperation of several of them, often a very large number of different agents. Thus, we need a system
that allows the transmission of knowledge and information to be able to cooperate efficiently by making
our individual choices, expectations and patterns of actions, mutually compatible.
The market is a set of rules that allows cooperation among a large number of individuals that use their
individual knowledge and make separate planes to fulfill different individual aims and aspirations. This
set of rules work as an “invisible hand” that makes individual choices mutually compatible.
- Every individual in the system acts and takes decision following individual aims and aspirations,
but the system creates a set of incentives that pushes individual agents to undertakes activities
that other agents find useful.
Market rules generate economic benefits, in the form of profits and rents, for all the agents that are
successful in providing goods, services or even intellectual products or spiritual comfort to other members
of the community.
 Success depends on the appreciation from the other members of the community, to the extent that
each of us satisfies any need and desire of other members of the community
 we can make a profit, obtain a rent, or get a good salary for our efforts.
 By creating these incentives, the system of market rules avoids any potential conflict arising from
the willingness among members of the community to conform to the same patterns
e.g.  member of the community would like to provide intellectual services to the others, at the same
time would not desire to give up limited resources to obtain many of these services.
 the system would need to generate right incentives to accommodate these conflicting preferences.
The system of market rules generates the right incentives, by decreasing progressively the benefits that
agents would obtain from selling intellectual services, while at the same time increasing the benefits that
could be obtained from providing anything else
 The system therefore allows to accomplish different individual aims and aspirations while
cooperating with other agents that have different priorities and objectives.

In this system of cooperation, every agent becomes dependent from the others, but agents can at the same
time specialize their knowledge and skills and become much more productive, as they obtain most of the
goods and services needed from other similarly specialized agents. Trade allows specialization and
therefore a massive increase in the productivity of labor.
  The system of market rules allows agents to cooperate by trading final goods and services, rather
than by coordinating ex ante their efforts.
It is a complex system that has slowly emerged only in a limited set of communities sharing some deep
common values. The benefits generated and the success of these communities and societies has produced
imitation from other communities and groups. The adoption of market rules has generated great benefits,
allowing a substantial improvement in living conditions in all the communities
 The system allows and generates incentives that promote the development of new ideas, solutions
and products, allowing every individual to improve her or his skills and competencies.
Agent can become as specialized, to the extent that she or he is capable to provide to other members of
the community anything that others appreciate and for which other are willing to give up some of their
resources or their goods.
 The system is therefore based on free trade, but trade makes everyone dependent on others and
therefore vulnerable.
 The fundamental rules of the system need to assure:
1. the freedom to trade without coercion,
2. the freedom to innovate and develop new goods and services,
3. the freedom to copy the choices, the products and the skills of others.
To coordinate our choices and efforts, we need to pool information and knowledge regarding five
different sets:
1. The aims and objectives of agents (what people desire and their preferences).
2. The availability of resources.
3. The constraints imposed by the natural environment.
4. The available technologies.
5. The opportunity to choose a technique instead of another.
These problems are very complex because many of these fundamental factors, including preferences
technologies and resources available, change over time.
 changes and innovations are not predictable, they generate uncertainty. Every innovation
complicates the individual’s planning and decision-making process, because of the need to
coordinate with other agents that have to change their plans too.
 The more complex the institutional environment, the larger the number of agents involved in the
process, the more difficult the process of coordination of individual choices and plans.
 systems of rules are fundamental to face uncertainty and the rules themselves need to adapt to
face any new problem and the uncertainty caused by the shocks.
 Institutions need to evolve to allow every member of the community to act while using less and
less specific information regarding the choices and actions of others and the complex mechanism
generated by their interactions
 Market rules provide the incentives necessary to push individual agents to find new solutions to
face problems, to find new resources, to find new ways to satisfy other people’s needs and even to
create new needs and desires.

The price system

Market prices are the fundamental mechanism allowing the transmission of relevant information among
agents.
- rise in prices generates the incentives for both adjustments to take place. Higher prices make
existing wells more profitable and producers have an incentive to invest more, subtracting
resources from alternative investments in other sectors of the economy
- Entrepreneurial profits are the fundamental incentive mechanism pushing agents to change their
plans to answer to changes in the environment
- The price change at the same time induces rational responses on part of the consumers
The information transmitted by the change in prices allows every individual agent to take decisions
coherent with the new reality, no need to gather specific information regarding the choices of the
innumerable other people interacting with them  All of the processes described before happens without
the need to understand the initial drivers of the price changes
In the absence of prices every agent would have to try to:
1. analyze the global market by studying the demand in all of the local markets and therefore all of
the sectors that directly or indirectly consume the well.
2. coordinate her or his choices with those of other agents just by communicating plans and
expectations.
** When considering the costs of information acquisition and transmission, this not a
challenging task, it is an impossible one.

Transaction costs and firms

Transaction costs – design all the costs that is necessary to bear to make exchanges freely and efficiently.
*** These costs, depend on the use of our time, which is a scarce and precious resource.

Trade requires the acquisition of a substantial amount of costly information and in addition substantial
resources are necessary to process the information obtained.
Transaction costs include:
1. Costs to obtain the necessary information.
2. Costs to take decisions and to negotiate the agreements among the contracting parties.
3. Costs to verify and eventually impose the respect of the contractual agreements.
These costs make the use of markets to conduct transactions too costly  coordination among
cooperating agent must be achieved by means of hierarchical rules inside specific organizations, such as
private sector or government agencies. These organizations are necessary to use market transactions only
when necessary and efficient to do so.
Private sector firms are organizations in which coordination among different agents is achieved by means
of power relationships.
** Firms hire workers by means of a contract that does not specify in detail the task that each worker has
to accomplish, but instead defines the rules that the worker needs to follow and the hierarchy inside the
structure. Firms are then structured by a mix of formal rules stated in contracts and informal rules and
habits that shape the peculiar culture of each organization. These organizations are necessary whenever
the production and delivery to the customer of the service or good requires the contribution of several
different sets of skills, from different groups of people. In these cases, the structure of the firm allows to
further specialize the work skills by allowing investment in human capital that would be too risky and
expensive to conduct individually, because they benefit the buyer with monopsonistic power.

Property rights and market rules

The market system of rules is based on the definition:
1. of individual property rights
2. of rules that allow to freely transfer these rights by means of contracts freely underwritten by the
parts.
Property rights allow individual agents to benefit in a partially exclusive way from the use of certain
goods, resources or services. This right is never absolute, since the extension of property rights is always
defined by the law.
The definition of property rights affects primarily the relative shares of state and private ownership, in
reality it mainly shapes the system of incentives of the society.
Property rights define what external effects deriving from the exclusive use of certain goods or resources
have to be tolerated by others and what uses require an explicit consent from the state.
The definition of property rights involves the imposition of several prohibitions
- For instance, the protection of intellectual property or trademarks requires the prohibition of any
reproduction or copy of the goods involved
The system of rules
- requires several contractual mechanisms for the transmission of property rights.
The crucial aspect of these contracts is the freedom to transfer the goods on the basis of
prices decided exclusively by the contracting parties without any external constraint or
interference.
The definition of market prices requires in fact a clear set of rules.
- Prices efficiently transmit the relevant information if and only if they result from transaction
freely undertaken that have not been pushed from third parties.
The system of rules must therefore guarantee that market transactions are not conducted under power
relationships or external pressures. And the rules must protect third parties that may be affected by
external effects that the contract may impose on them.
- For instance, the transfer of property rights on real estate requires the registration on a public land
registry, while contracts involving cars or firearms have to be made public by other registers.
The hereditary transmission of property across generations is subject to complicated system of rules that
are peculiar to each country and system, to protect the interests of both individuals and the collectivity.
The system of market rules requires the presence of a number of state organizations that are necessary to
protect property rights and promote free trade. The system requires the presence of an efficient judiciary
system to manage any controversy arising among private parties . The market system of rules requires the
existence of an efficient state and cannot exist in the absence of a state. Such a system is not “natural”,
since it is not a system of simple and primitive interactions
The market is a complex system that generates substantial benefits for all of the community, but also
substantial costs for specific individuals or groups of individuals that are harmed by some of the rules.
- the evolution of the system is very slow
- the development of the rules complicated, because the system is a mixture of legal rules rationally
studied and defined and of a set of contracts, traditions and habits that have evolved from private
transaction and have become customary laws.
- The spontaneous evolution of customary rules is a very important feature of the system, but does
not guarantee that the outcomes are efficient or fair.
Several customary practices may in fact benefit a small subsection of the population that
have more power in society.
- Legislation is necessary to improve on inefficient outcomes in many different instances
Whenever some firms constrain the access to market because they can influence
legislation or the judiciary system.
- The system of rules can never be entirely rewritten abstracting from the existing set of rules.
- Rationally defined laws and regulation have to be integrated in the system of traditional rules and
accepted by the shared culture of the country to become effective.
- Market rules promote innovation and social mobility.
Innovations, however, can often generate conflicts, because many members of the
community are not willing to accept an tolerate new ideas, habits and life styles.
- The system besides generates very different outcomes for different groups of agents, since
entrepreneurial success depends on a mixture of individual qualities and purely random external
dynamics.
- The market does not reward merit
Market rewards the capability to satisfy the needs and wills of other members of the
community. Success in a market system is not necessarily associated with any ethical value or
virtue
- Market outcomes depend on:
1. individual talents and skills,
2. from the a very specific knowledge and understanding of particular market conditions and
prices,
3. a nearly infinite number of choices of others that become near random processes.
- the capabilities and skills that produce successful market outcomes are associated with values that
a large number of members of the community do not share.
- the distribution of property rights reflects:
1. the outcome of past market transactions,
2. a large number of historical accidents and arbitrary or violent acquisitions of resources.
- The systems of rules therefore need a set of rules that help to make market outcomes acceptable
to the members of the community that are hurt or get limited benefits from the system, in order to
prevent conflicts and violence.
- The fundamental principles and values behind the system have to ultimately be shared by a large
enough share of the population, for the system to be viable and sustainable over time
 Economic growth

1. The Stability of Growth Rates

 Long-term Trends: Growth rates in many developed economies have maintained a stable path
over the years. For instance, the U.S. economy has grown at an average per capita rate of around
2% annually since the late 19th century. This stability shows that even significant events, like the
Great Depression or post-World War II changes, didn’t alter the long-term growth trajectory.
 Short-Term Cycles vs. Long-Term Growth: Business cycles, such as recessions and booms,
may cause temporary dips or spikes in economic output, but these are generally short-lived. The
presentation emphasizes that even major downturns like the 1930s recession were offset by
growth in later years. This demonstrates resilience in growth trends, which could be attributed to
factors like technological progress, institutional stability, and consistent policy frameworks.
2. Growth Theory and Production Function

 Production Function Basics: The production function Y=A ⋅ f (K, L) encapsulates the idea that
output (GDP) is driven by capital (K), labor (L), and a productivity factor (A). This factor, total
factor productivity (TFP), measures efficiency or technological advancement that enhances how
well capital and labor produce goods and services.

expressed as Y=A⋅Kα⋅Lβ, where α\alphaα and β\beta represent the output elasticities of capital and
 Cobb-Douglas Function: A specific form of the production function, the Cobb-Douglas, is

labor, respectively. These values indicate the percentage increase in output due to a 1% increase
in capital or labor, helping explain the balance between capital accumulation and labor
contributions to growth.
 Decreasing Marginal Returns: The concept here is that increasing one input, like capital, will
lead to progressively smaller gains in output. This is crucial in explaining why countries can’t
rely solely on capital accumulation for long-term growth—at a certain point, productivity and
technological innovation must take over as key drivers.
3. Growth Accounting and the Solow Model
 Understanding Growth Contributions: Growth accounting, introduced by Robert Solow,
breaks down the sources of economic growth into contributions from capital, labor, and
productivity. The model is particularly useful for distinguishing between growth due to factor
accumulation (capital and labor) and that due to productivity improvements.
 Formula Interpretation: Solow’s model decomposes growth with a formula:
Here, changes in YYY (output) over
time are partially explained by
changes in productivity (A) and the
 contributions from capital and labor. The productivity term is often calculated residually (as
what’s left after accounting for capital and labor growth), emphasizing that productivity boosts
(from innovations, for instance) are pivotal for long-term growth.
4. Convergence vs. Divergence
 Economic Convergence: The theory of convergence suggests that poorer countries should grow
faster than rich ones, leading them to “catch up” in terms of GDP per capita. This happens when
nations adopt advanced technologies, improve institutions, and accumulate human capital.
Convergence has occurred in parts of Europe and Asia, where growth rates in countries like South
Korea and Japan led them to narrow the gap with Western economies.
 Divergence Examples: Not all regions or countries converge. Argentina, for example, started
converging early in the 20th century but then diverged due to political instability and economic
challenges. This shows how institutional and policy differences can impact the growth trajectory,
making convergence conditional on more than just starting levels of income or capital.
5. The Asian Tigers’ Growth Experience
 Factor Accumulation: The rapid post-war growth in Hong Kong, South Korea, Singapore, and
Taiwan is often called the "economic miracle." This wasn’t just a result of technological
innovations; rather, it was driven by significant investments in capital and the expansion of the
labor force, including the entry of more women into the workforce. This factor accumulation
underpins their high GDP growth rates.
 Education and Human Capital: An increase in average education levels among the workforce
also played a significant role. By building a more educated and skilled workforce, these nations
were able to increase productivity and attract foreign investments in advanced industries. This
emphasis on human capital aligns with growth theories that highlight education and skills as
essential for sustainable economic expansion.
 Challenging the Neoclassical Model: Initially, this growth appeared to challenge the Solow
model (which emphasizes exogenous technological progress). However, Alwyn Young’s analysis
showed that much of this growth was still in line with the neoclassical model, driven by factor
inputs rather than purely by technological advances.
6. China’s Growth Path
 Market Reforms and Investment: China’s growth began accelerating after it introduced market-
oriented reforms and opened its economy to global trade and investment. This growth has been
powered by large-scale investments in infrastructure and industry, alongside significant
improvements in productivity.
 Current Position and Global Influence: Despite recent slower growth, China’s economy has a
massive influence on global markets due to its size and demand, particularly for commodities.
China’s GDP per capita still lags behind the U.S., indicating room for further growth, but its
population size means it wields substantial global economic power.
7. The Role of Capital Accumulation
 Importance of Initial Capital Levels: Countries with lower initial capital stocks tend to benefit
more from new investments, as they experience higher growth rates from capital accumulation.
 This is because additional investments generate more substantial returns in these economies due
to their lower starting base.
 Shifts in Capital-Labor Ratio: Technological advances have lowered the costs of machinery
relative to structures, allowing economies to increase machinery investments without a
proportional cost increase. This shift impacts productivity, as machinery often enables more
efficient production compared to physical structures.
8. Labor’s Role and Urbanization Effects
 Human Capital Growth: Labor productivity has increased as more people acquire higher
education and specialized skills. This has led to a premium on skilled labor and increased wages
for educated workers, as their productivity outpaces the overall labor force growth.
 Urbanization as a Growth Driver: The shift from agriculture to industry and services has
spurred urbanization, leading to agglomeration economies where people and firms benefit from
being close together. Cities promote knowledge exchange and support large-scale services,
enhancing productivity.
9. Examining the Relative Stability of Factor Shares
 Labor vs. Capital Shares: Traditionally, labor and capital shares in income have remained
relatively stable. However, in recent decades, the capital share has risen while the labor share has
declined, especially in advanced economies. This shift may reflect the rising importance of
technology and automation, which substitute capital for labor in production processes.
This detailed overview should help clarify and expand on concepts in the presentation. For exam
preparation, focus on understanding the relationships among these factors, especially how they
collectively influence long-term growth and development patterns across different countries.