See discussions, stats, and author profiles for this publication at: https://www.researchgate.

net/publication/228179880

Institutions, Institutional Change, and Economic Performance

Article · June 2009

CITATIONS READS

26 1,256

2 authors, including:

Wei Li
Cheung Kong Graduate School of Business
28 PUBLICATIONS   502 CITATIONS   

SEE PROFILE

All content following this page was uploaded by Wei Li on 18 December 2013.

The user has requested enhancement of the downloaded file.

 SSRN Inspection

UVA-BP-0475
Institutions, Institutional Change, and Economic Performance

Username:
TO ACCESS THIS DOCUMENT
This is a protected document. The first two pages are available for everyone to see, but only faculty members
who have verified faculty status with Darden Business Publishing are able to view this entire inspection copy.
Submit
VERIFIED FACULTY
If you have verified faculty status with Darden Business Publishing, simply enter the same username that
you use on the Darden Business Publishing Web site, and then click “Submit.” Please note that this is an
inspection copy and is not for classroom use. Faculty Register
UNVERIFIED FACULTY
If you are teaching faculty and do not yet have verified faculty access with Darden Business Publishing,
please click on the “Faculty Register” link and submit your information requesting verified faculty access.
Buy Case Now
OTHER USERS
If you would like to read the full document, click on “Buy Case Now” to be redirected to the Darden Business
Publishing Web site where you can purchase this and other Darden cases.

Document Id 0000-1402-8E9C-00008FD1
If you have any questions or need technical help, please contact Darden Business
Publishing at 1-800-246-3367 or email sales@dardenbusinesspublishing.com

2009-5-20 (Version 3.0 R2)

The protectedpdf technology is © Copyright 2006 Vitrium Systems Inc. All Rights Reserved. Patents Pending.
 UVA-BP-0475

INSTITUTIONS, INSTITUTIONAL CHANGE,

AND ECONOMIC PERFORMANCE

Why are some countries much richer than others? This technical note proposes a
framework to begin answering this question. The first part identifies inefficient institutions as the
root cause of the economic differences between societies. The second part analyzes how these
institutions change. And the final part suggests how lessons from this institutional framework
can be applied.

Institutions and Economic Performance

Economic theory implies that over time the economies of different countries will attain similar
levels of wealth. When there is competition between organizations (be they tribes, companies, or
countries), the less effective organizations die out and are replaced by more effective organizations.

It is hard to deny that the world’s organizations are not in competition with each other.
Competition is most dramatically manifested in open warfare between countries. But the more
important form of competition is expressed in the daily economic contests waged between
countries and companies in world markets.

Given open competition we should see the surviving societies converge over time in
terms of economic development. Why then do countries continue to show large disparities in
terms of wealth? What causes some societies to flourish and others to stagnate and decline? The
simple answer is differences in the effectiveness of a country’s institutions.

Institutions Are Rules That Structure How People Interact

Institutions are the rules of the game. They shape how humans interact with each other.
They structure the incentives that shape how society evolves.

Institutions can be thought of as a continuum. Formal rules are on one end and informal
rules on the other.

This note was prepared by Victor Abiad under the supervision of Wei Li, Professor of Business Administration.
Copyright © 2003 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights
reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part of this publication may be
reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording, or otherwise – without the permission of the Darden School
Foundation. ◊
 -2- UVA-BP-0475

Formal rules are rules that are created and are often set down in writing. These often
complement and increase the effectiveness of the informal rules of a society. Examples of formal
institutions include political rules (the US constitution, government laws), economic rules
(property rights, money as storage of value), and contracts between two parties.

On the other end of the continuum are informal rules. These are rules that evolve. They
often aren’t written down, yet they influence actions more pervasively than formal rules.

Many informal rules come from a society’s culture. Culture can be defined as knowledge,
values, and beliefs that are passed along from one generation to another. Examples of cultural
informal rules are siestas in the afternoons, women not working outside the home, and business
agreements completed on handshakes rather than contracts.

Economic Theories Ignore the Effects of Inefficient Institutions

Economic theory cannot explain the disparity between the rich and the poor because for
the most part these theories assume efficient institutions. One assumption is that efficient
institutions mean costless transactions. In reality transaction costs are significant. Even the
simplest currency conversions carry transaction fees that can be easily measured. Other
transaction costs are harder to measure. For example how does one account for delays and
possible bribes as goods go through customs? Or for costs for gathering information?

A second assumption is that efficient institutions lead to correct mental models. Mental
models are ways people analyze data to make decisions. Those organizations that utilize accurate
models make correct decisions and are economically rewarded. Those that utilize wrong models
are penalized. If institutions are efficient, there will be effective feedback to help organizations
correct wrong models. In reality this does not happen and many organizations continue to make
decisions based on models that are wrong.

A third assumption is that efficient institutions effectively collect and share information. In
reality many situations are very complex which makes it difficult and expensive to gather information.
Those parties that do devote resources collecting the information are often reluctant to share it.

A fourth assumption about efficient institutions is that the goal organizations is to maximize
profits. Though profits can account for a substantial portion of people’s motivation, it cannot account
for all of it. Other things that motivate people and organizations include ideology, values, and religion.

Inefficient institutions result in costly transactions, subjective models, poor information,

and non-profit maximizing goals. These inefficiencies lead organizations to make decisions that
do not maximize economic benefits.

The root cause of economic divergence between rich and poor countries is that their
institutions vary in their levels of efficiency. These differences lead to different decisions being
made and ultimately lead to the different economic results.
View publication stats