INFO-LINK UNIVERSITY COLLEGE

Institutional Economics

By: Feleke Ph.(Msc)

UNIT ONE: THE ORIGIN AND CONCEPTS OF
INSTITUTIONAL ECONOMICS
 After completing this unit, you should be able to:
 Define Institutional Economics
 Identify interdependence that exist between institution and
Institutional economics ;
 Identify Definition and Concept of institution ;
 Explain institutions and organizations;
 Explain types of institutions in economics;
 Differentiate neoclassical and institutional economics
 Elaborate why institutions matter? And
 Explain origin and evolution of new institutional economics
 Introduction to Institutional Economics

• What is institutions?
• Definitions of institutions from the perspective of Old
Institutionalists:
• Institutions are "settled habits of thought common to the generality of
men." (Veblen 1919)
• Institutions are understood as essentially ―collective action in control
of individual action‖ (Commons 1934, 69).
• Institution are "way of thought or action of some prevalence and
permanence, which is embedded in the habits of a group or the
customs of a people." (Hamilton 1934).

• Notably, in the "old" institutionalism, the concept of habit plays a

central role both in its definition of an institution, as in its picture of
human agency.
 Cont…
• Institutions from the perspective of New Institutionalists:
• Institutions are ―the humanly devised constraints that shape human
interaction‖ (North 1990).
• This definition seems to exclude conventions, habits and even some
norms that are not the product of human design but that just arise
autonomously.
• To include norms and conventions, North provide an alternative
definition:
• Institutions are ―the rules of the game‖ (North 1994).
 Cont…
• According to Douglas North, the rules provide a framework of
incentives that shape economic, political, and social
organizations.
• Institutions are composed of:
• 1. Formal rules (for example, laws and constitutions),
• 2. informal constraints (conventions, codes of conduct, and norms
of behavior), and
• 3. their enforcement.

• Rules need to be enforceable. Enforcement can be carried out by

third parties (law enforcement, social ostracism), second parties
(retaliation), or by the first party (self-imposed codes of conduct).
Rules also affect beliefs and preferences and provide signal for
agents to uncalculated action.
 Cont…
• Ostrom (1990) provides a similar definition:
Institutions refers to the rules, norms, and
strategies used by humans in repetitive
interactions.
• According to World Bank (2002), institutions are
‗rules, enforcement mechanisms and
organizations‘
 Cont…
• Two key terms in the above definitions need to be clarified: rules and
norms. Rules refer to shared prescriptions (must, must not, or may) that
are mutually understood and enforced in particular situations in a
predictable way by agents responsible for monitoring conduct and for
imposing sanctions. Norms are considered to be shared prescriptions
known and accepted by most of the participants themselves.

• They involve intrinsic costs and benefits rather than material sanctions or
inducements. Social norms such as ―customary law‖ can in some cases be
superior to administrative or judicial dispute resolution among people
with close social ties. Since social norms effectively work among member
of a closed social group, they inherently lack universality.

• The adherence of rules is largely due to explicit enforcement while

adherence of norms is largely due to acceptance. Rules and norms thus
differ by virtue of the different ways they influence behavioral patterns.
 Cont..
• Generally, institutions enable ordered thought,
expectation, and action by imposing form and
consistency on human activities.
• Institutions both constrain and enable behavior.
• The existence of rules implies constraints.However, such
a constraint can open up possibilities: it may enable
choices and actions that otherwise would not exist.
 Cont…
• The other point is that distinctions about rules are made as
formal and informal.
 Formal rules are consciously designed by humans and often codified in
written form – examples are constitutions, laws and regulations. They are
also often enforced by some external authority. The police and the courts,
for instance, enforce the rule of law. Enforcement requires enforcing
organizations. The rules, the enforcement mechanisms, the organizations
and the way these influence behavioral patterns together are considered
as formal institutions.

 Informal rules evolve spontaneously and unintentionally over time

through human interaction, and take the form of unwritten conventions,
routines, customs, codes of conduct and behavioral norms (Menger
1963). For instance the norms to honor promises, to protect private
property, or to speak Somali in Somalia can be considered as informal
rules. The ways these informal rules are adhered to and their effect on
behavioral patterns can be considered as informal institution. Generally,
non-compliance with informal rules is sanctioned through decentralized,
spontaneous social feedback.
 Cont…
• Key features of institutions
• Perhaps the following key features of institutions help you to
understand what institutions are:
 All institutions involve the interaction of agents, with crucial
information feedbacks.
 All institutions have a number of characteristic and common
conceptions and routines.
 Institutions sustain, and are sustained by, shared conceptions and
expectations.
 Institutions have distinct social boundaries in which they
effectively work.
 Unenforced rules are not component of institutions.
 Cont…
• Institutions generally are thought to serve collectively
valued purposes but sometimes institutions may exist
without collective intentionality e.g. merely by virtue of
shared conventions and habits or by virtue of sustained
enforcement by certain groups;

• Although they are neither immutable nor immortal,

institutions have relatively durable, self-reinforcing, and
persistent qualities.

• Institutions incorporate values, and processes of

normative evaluation. In particular, institutions reinforce
their own moral legitimation: that which endures is often-
rightly or wrongly-seen as morally just.
 Cont….
• Economics
• Economics is the study of scarcity and how it
affects the use of resources, the production of goods
and services, the growth of production and well-
being over time, and many other important and
complicated issues that affect society.
 Cont…
Institutional economics
• Institutional economics, or institutionalism, is a school
of thought that studies how institutional rules influence the
economy and its behavior.
• It focuses on the role of different institutions in shaping
the economy.
• It guides developing countries to learn from developed
countries and make appropriate policies.
Cont….
 Cont…
• Institutional economics theory determines the
factors that influence the economy.
• It describes how developed countries and their
institutions grew to become large and successful. In
addition, it also explains the effect of different
institutions on the daily transactions of the economy.
• However, it also criticizes how every part of society
is accountable for economic development.
 Cont..
• Example #1
• Suppose Africa aims to target 4-4.2% GDP (gross
domestic product) by the end of this year. However, they
face certain flaws in their economy.
• So, the ministers and other governing bodies decide to
install institutions within the country. Every business has
to adhere to certain guidelines to achieve growth.
• Likewise, every individual has to incorporate institutions
and norms. At the end of the year, Africa was successful
in at least reaching 4.1% of GDP. Thus, developing
countries could change their status if they try to install
proper institutions and laws within the economy.
 Cont…
• Example #2
• Douglass North, a pioneer of the Institutional economics
journal, stated that developing countries should refrain
from copying the institutions of the developed ones. The
main reason to state this was that developed countries
like Europe, the U.S, and Japan have different
institutions.
• Thus, replicating them will be a bad idea. A transfer of
Western institutions to the Eastern world would not result
in enough growth. Because highly developed countries
tend to follow proper rules, norms, and institutions. Thus,
it leads to potentially increasing growth.
 Institutional Economics vs Neoclassical Economics

 From the discussion of neoclassical economics (Standard

economics),
 Economics is the theory of choice……..
 But how do we make choices- Neoclassical Economists say we
use the rationality assumption.

 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
 Cont….

• Although institutional and neoclassical

economics had similar pioneers, they differed
hugely.
• The former aims at understanding how institutions
influence the economy. At the same time, the latter
focuses on creating wealth through the optimum use
of resources.
• However, both theories had the same economists
working on them.
Cont…
 Institutions vs. Organizations
 These two terms are often used interchangeably in everyday
language. In the context of institutional analysis, however,
institutions are complexes of rules, norms and behavioral patterns.
 Organizations are made up of groups of individuals bound together
by some common purpose to achieve certain objectives.
 Examples of organizations include political bodies (political parties,
a city council, a regulatory agency), economic bodies (firms, trade
unions, family farms, cooperatives), social bodies (churches, clubs,
athletic associations), and educational bodies (schools, universities).

 The complex of formal rules, regulations, code of conducts, norms,

conventions, etc. that determine the behavioral pattern of actors in
these organizations could be thought as institution. But institution
go beyond the boundary of the organization.
 Cont…
• Although there is a great deal of overlap between institutions and
organizations, many cultural and market institutions do not have a
corresponding organization, and certain organizations may exist ―on paper‖
only and have not been fully institutionalized through the creation of
accepted rules.

• If institutions are the rules of the game, organizations and their

entrepreneurs can be thought as the players of the game.

• Institutional framework determine the type of organizations that come into

existence. That is if the institutional framework rewards piracy then
piratical organizations will come into existence; and if the institutional
framework rewards productive activities then organizations—firms—will
come in to existence to engage in productive activities. If the institutional
framework incentivize distributive activities, then organizations that
perform that distributive activities will come into existence.
 Institutional environment
 Institutional environment is a broader concept that shows how the complex
interaction of institutions (formal and informal) describe property rights,
enforcement mechanisms, human behaviors, and power relations in an
economy.
 It also include includes beliefs, such as religions; norms, such as trust and
lawfulness; constitutionally determined government structures; and legal
systems.
 Three evolving structures can be identified:
 i. Formal economic institutions and rules (the political dimension);
 ii. Culture, values, and conventions (that give sense to economic actions,
define what is good and great, the determine preferences and value systems,
and supply common knowledge for facing the uncertainty of economic
behavior); and
 iii. social networks (density and forms of the networks, and the relative
position of each economic agent in the network).
 Institutions matter?
• Effective institutions of economic exchange play the
following role: coordinate exchange, facilitate low cost
exchange (transaction costs) and provide the necessary
incentives for agents.
• 1. Coordination roles – institutions coordinate exchange at
several levels. At its most basic level, coordinated exchange
involves the reliable bringing together of buyers and sellers.
•
• 2. Facilitative roles – institutions facilitate efficient
exchange by reducing information problems and by limiting
opportunistic actions. The idea is as transaction costs
increases, the potential gains from economic exchanges
declines and hence economic activities decline.
 Cont…
• 3. Allocative roles – institutions providing the incentive
structure affect the pattern of allocation of economic resources.

 If the institutions provide incentive to piracy, more resources

will be devoted to capture the economic gains from piracy.
 On the other hand institutions make production a profitable
activity, then it provides agents to invest their resources on
productive activities.

 If institution (the rules system, the belief, culture, etc.) enforce

and protect private property rights, then agents will have the
incentive to accumulate private property which affects the
extent of economic activity, saving, investment and so many
other economic variables.
 Cont…
• Activity
• Suppose the institution of property rights in Ethiopia is such
that it provides strong protection to intellectual property rights
by granting an inventor exclusive rights to prevent others from
commercially making, using, selling, importing, or distributing
a patented or copy-righted invention or original work without
the permission of the inventor or the creator.

• Similarly the institution grant a similar exclusive copyrights to

creator of original work. What implications these would give on
resource allocations and economic activities.
• Explain its implications by taking a movie production as a case.
 Cont…
 In the past, development was conceived as a matter of
investment on infrastructure, education, and technology
dissemination.

 Though these investments are necessary, cannot bring the

intended effect on economic development if institutions fail
to provide the necessary incentives structure, if they fail to
protect and enforce property rights and if they fail to reduce
transaction costs.

 The question to most developing countries is then ‘how to

get institutions right’. Unfortunately, getting institutions
right is now an easy task.
 Cont…
• It is not something that can be achieved in an overnight
campaign. Rather it requires continuous efforts and results
of evolutionary process.

• It is not something that can be achieved just by government

intervention. It rather require the commitments of all
actors.

• It is not something achieved by through intervention on a

given organization or sector. Rather it require overall
organizational, social and cultural transformation.

• In a nut shell, there is no short cut to get institutions right.

But the good news is, once institutional change begins, the
change is then incremental.
 Origin and Evolution of New Institutional Economics:
Overview
• In the past, neoclassical economics was the dominant economic
theory. This theory assumes that markets provide the necessary
incentives through the forces of demand and supply. This theory
implicitly assume as institutions to have no role or as they play
only frictional roles.

• However many influential papers showed the role of institutional

aspects to economic issues, the concept of institutions had not
taken root in the field of economics until recently.

• The concept of institutions in the field of economics in particular

has long history, at least since Velben (1910). But it has not found a
theoretical foundation until the influential works of Coase ―The
Nature of the Firm‖ (1937) and ―The Problem of Social Cost‖
(1960).
 Cont…
• The concept of transaction costs is the foundation of New
Institutional Economics.
• The idea is costs of transactions determines what goods and
services are produced and the capacity of any economy to
take advantage of the division of labor and specialization –
the two key concepts of economic theory since Adam Smith.

• Thus, transaction costs profoundly influence not just

individual firms but the size and activities of the entire
economy.
• But in addition to the concept of transaction costs, two
other concepts are also central to NIE: the concepts of
property rights and contracts.
 The main contribution of NIE to the field of economics are:
o Its stress on rules and norms,
o Its explicit consideration of socio-cultural
elements in the explanation of economic
evolution, and
o Its openness towards interdisciplinary
approaches and towards case studies and other
less mathematical methodologies
 Cont…
• It is also important to note that NIE is not a substitute for other fields of
neoclassical economics. These economic theories are still important.
Institutional economics incorporate empirical, comparative and historical
elements to make neoclassical economic theories more relevant to real
world economic problems.

• But NIE, when compared to other economic theories, it has special

features. One of the special feature of NIE is it encourage
multidisciplinary approach as it recognize the relevance of social,
historical, political and cultural aspects in explaining economic problems.

• It thus attempt to use theories from other fields of studies such as sociology,
history and political sciences in understanding economics.
• Yet theories from these fields of studies have not been well-integrated to
form a clearly structured theory.
• NIE is in many ways a still decentralized field of inquiry. Indeed in some
ways new institutional economics is still more of a movement than a field.