Notes on the Institutional Context

Notes on the Institutional Context

For the second half of the course on Macroeconomics

& the Institutional Context, we use notes to provide
more insight in the institutional context of firms. Each
week has a note, which becomes available in the
Content folder on Blackboard. Since we cover quite a
lot of material in class, the notes also are meant to
free up some class time and discuss some topics that
may require a bit extra attention. So, it is important to
stress that notes complement, rather than summarize,
the lectures. Make sure to consider notes, in addition
to presentation slides in preparation for your case and
final examination.

The weeks cover a variety of topics, and have a

number of specific objectives. To help you navigate
through these topics and objectives, we have a guiding
framework, which will be introduced in Week 6. To
give you a sneak preview of the topics we will be
discussing, please consider the key objectives of the
weeks ahead.

If you have questions about the material do not

hesitate to ask me. You can do this in the Discussion
folder of Blackboard or by email (treus@rsm.nl). I
appreciate comments and questions concerning the
notes as it can help us identify content that would
benefit from further clarification and update these
notes.

Prof. Dr. Taco Reus

Professor of Global Strategy
Department of Strategic Management & Entrepreneurship
Rotterdam School of Management
Erasmus University
Notes on the Institutional Context

CONTENTS AND KEY OBJECTIVES FOR THE 2nd HALF OF THE COURSE

Week 6 Objectives - Introduction

1. Defining “institution” and “the institutional context”
2. Introducing core typologies of institutions
3. Gaining an understanding why we have institutions
4. Recognizing why managers would need to know about institutions
5. Introducing overarching institutional framework
6. Distinguishing institutional from macro-economic explanations

Week 7 Objectives – Institutions at different levels

1. Understanding institutions as multi-level contextual features
2. Recognizing the roles of the State, Market and Civil Society as
important institutional spheres that influence national institutions
3. Gaining insight in important (inter)national organizations as
institutional drivers
4. Recognizing sources and effects of regional integration

Week 8 Objectives – Institutional development & change

1. Illustrating the different stages of institutional development
2. Considering accelerators and decelerators of institutional
development
3. Understanding concepts, such as path dependency, institutional
voids
4. Gaining insights in the institutional context of less developed,
transitional and emerging economies
5. Recognizing the institutional causes and consequences of the
financial crisis
6. Understanding institutional constraints in crisis responses

Week 9 Objectives – Institutional proximity and distance

1. Understanding the notion of organizational fields and clusters
2. Recognizing the notion of institutional logics
3. Illustrating core benefits and core rigidities of institutional fields
4. Understanding varieties of distance and the effects of institutional
differences

Week 10 Objectives – Institutional strategy & institutional

entrepreneurship
1. Recognizing the importance of organizational legitimacy.
2. Identifying stakeholders and what their role is in institutional
pressures.
3. Learning the institutional strategies that are available to
organizations.
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Notes on the Institutional Context
4. Understanding when to
implement which strategy
5. Gaining insight into what institutional entrepreneurship is, and
what is required to make it successful.

Introduction to Institutions
- Week 6 Note -
Taco Reus

Week 6 Objectives - Introduction

1. Defining “institution” and “the institutional context”
2. Introducing core typologies of institutions
3. Gaining an understanding why we have institutions
4. Recognizing why managers would need to know about institutions
5. Introducing overarching institutional framework
6. Distinguishing institutional from macro-economic explanations

Week 6 introduces four core questions related to the institutional context of firms:
(1) What are institutions?
(2) Where do institutions come from?
(3) Why do we have institutions, and how do they affect firms?
(4) Why is it important for (strategic) managers need to know about institutions?

These core questions also are core to the guiding framework that will be introduced
toward the end of this note, and will continue to guide the focus of our attention
throughout the second half of the course; each question receives more detailed answers in
the weeks ahead. We also add a fifth question here to clarify how the focus on the
institutional context continues, and departs from, the topics discussed in the first half of
the course:
(5) How does an institutional perspective relate to macroeconomics?

Together, the answers to these questions should provide a good introduction to the
content of the second half of the course.

(1) What are institutions?

While there are many definitions of the term, we follow most directly Douglas North’s
definition – “Institutions are the humanly devised constraints that structure political,
economic and social interaction.” It is important to note that the term “constraint” does
not mean that institutions only limit interaction, but rather facilitate some and restrict
other behaviors, practices, even attitudes and viewpoints. They are the “rules of the
game,” which determine what is, or is not, allowed, accepted, valued.
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Notes on the Institutional Context

Clearly, there are many kinds of institutions we, and

the firms and organizations we work for, follow. Just to illustrate, consider the roles of
traffic lights that facilitates the flow of traffic – it facilitates certain driving behaviors by
moving more safely from A to B, while they also constrain us by limiting how fast we can
go. And, think about the role of our habit of cycling through town that seems to surprise
foreigners when they visit. Or, consider the role of the “meter” that helps us understand
and communicate what the geographic distance between two points. These are rules we
accept but others may not – they might use inches, yards and miles to determine distance.
Together, these rules (and of course many others) determine, the way we make sense of
traffic, the way we behave in it, and how we can maneuver through it most successfully or
fail to do so.

Institutions are distinct from institutes or organizations, though their existence and their
meaning may often depend on the actions and expectations of organizations. Institutions
are the rules of the game, but their existence relies on the support, use, or more general
involvement of involve many organizations. For example, the institution of money – as our
primary means of buying and selling – relies on a variety of organizations, such as banks,
government treasury departments, stock exchanges, and people’s trust in and willingness
to use it.

To understand what we mean by institutions, several scholars have identified types, or

categories of institutions. Douglas North distinguished formal from informal institutions.
Formal institutions are the more explicit rules, such as laws, regulations, formal
agreements that can be written down, while informal institutions relate to more tacit
understandings, habits, cultural norms, routines, broadly shared expectations. Some
situations or countries have more formalized institutions, while other situations rely more
on informal institutions.

Another institutional scholar, Richard Scot, was also influential in the way we can
categorize institutions. Scott distinguished three types, and labeled these the three
institutional pillars: regulatory institutions, normative institutions and cognitive
institutions.

Regulatory institutions are put in place with the explicit purpose to regulate behavior. You
have to stop for a red light in order to facilitate traffic to run smoothly, or a company has to
report their intend to acquire another company in order to determine whether it is
following anti-trust laws to make sure competition remains healthy.

The informal institutions – normative and cognitive - are commonly not explicitly enforced
but are implicitly imposed. As such they also regulate behavior but do so in more subtle
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Notes on the Institutional Context
ways. They are shared by groups of people, and
widely accepted.
Degree of Institution Examples Potential
formality al pillars consequences of
(North) (Scott) violations
Formal Regulatory Laws, regulations, explicit rules Facing prosecution

Informal Normative Shared expectations, informal Falling in discredit

obligations, principles

Cognitive Deeply ingrained worldviews, Being viewed as

confusing,
taken-for-granted,“frames-of-
reference”, how we look at the world

Normative institutions are shared expectations that may be experienced as obligations

toward others, or governing principles about how to act and behave. Such institutions are
about how people and the companies they work for “should” behave. For example,
people often would wait to enter a train before others have exited, because they feel this
is what you should do, even though there may not be an explicit regulatory institution for
it. Or, a company might adopt a certain incentive plan (bonus system) for employees
because that is the system that they, and their competitors, believe they should implement
in their industry.

Cognitive institutions are deeply ingrained worldviews, which are taken-for granted by
people. This is the deepest level of a cultural belief – people view the world in ways that is
often shared by others in their group, country or region. It’s what psychologists call
“schemata” that are shared by members of a culture. These cognitive institutions form a
mental structure of fixed ideas, representing some feature of the world. Or you might think
of it as a system of organizing and perceiving information. They influence the way we view
the world, and selectively direct attention to certain aspects of the world, and what bits of
new information to absorb. That is, people are more likely to notice things that fit with the
prevailing cognitive institutions, while they will attempt re-interpret contradictions as
exceptions or distortions to reassure the validation of the cognitive institutions. Because
the world is so complex, this structuring of ideas is also a manner of reducing uncertainty
(resolving the inherent lack of information) and ambiguity (resolving the multiple
meanings that exist about information). It allows people to make sense of situations
automatically (by running on their schemata), without having to make much effort to
understand the situation. And, people can adapt new impressions or new tasks quickly to
the ruling cognitive institutions. As a result, cognitive institutions tend to stay unchanged,
even in the face of much contradictory information.

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Notes on the Institutional Context
Institutions may often act on the background during
daily activities. We follow the rules blindly, and
hardly spend time thinking of their existence. Yet, at times they may suddenly come to the
forefront, making their relevance and influence seamlessly clear. Often, there tend to be
four underlying reasons for bringing institutions more to the forefront. First, institutions
come to forefront when people or firms commit violations to the institutions, which can
often be consequential. It can lead violators to being prosecuted, being discredited, or
being viewed as incomprehensible or even absurd. Second, institutions come to the
forefront when people or firms enter an institutional context in which they have litle or
no experience. For example, when a firm has expansion plans to move into a foreign
market, the institutions in the foreign market may be different from home country
institutions. Third, institutions tend to come to the forefront particularly in times of
change. For example, when the telecom and mail delivery sectors in Europe and the US
opened up for competition, the regulatory institutions were brought into stark relief.
Interestingly, these types of change moments also provide ample opportunity for debate,
struggles, and fights for new regulatory, normative and at times even cognitive institutions;
not only changing the way activities and behaviors are regulated, but also changing the
principles of competition and cooperation, and even changing the way we view the world.
Finally, institutions come to the forefront through analysis when we study them more
carefully. Since institutions and the institutional context have important bearing on critical
outcomes that affect how firms behave and can succeed in business, such analysis can be
extremely important.

(2) Where do institutions come from?

An important characteristic of institutions is that they are “humanly devised.” Institutions
are always designed, upheld, enforced by people. At times, this becomes very clear. For
example, when a new political coalition gets in power and decides to change the speeding
limit, or when G20 countries come to an understanding about how to respond to the
financial crisis. But since institutions often play their role in the background, we may
forget why we have them, where they came from, or that they are actually humanly
devised. Yet, the existence of institutions depends completely on the extent to which they
are supported and enforced by people. As such, they are very much social instruments to
order our lives and the firms we work for.

When we consider the origins of institutions, one catchphrase – history matters – is spot
on. Many of the institutions we follow today were created a long time ago. Because of the
deep historical roots, we experience institutions as long-held givens, making it difficult to
view the origins of institutions, and giving them an almost transcendent, beyond human,
status.
Often only through considerable historical analyses can the origins of the institutions we
follow today become clear.
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Notes on the Institutional Context

For example, the United

States
Constitution was created on
September 17, 1787 by a group of
delegates from various American
states. There were quite a lot
interests to be dealt with through
different sections and clauses but
eventually the Constitution was a
fact, and became the supreme
law of the United States. This
historical document was itself influenced by the
historical European roots of the delegates, and the national and regional conditions of the
United States in the 18th century. Now, nearly 230 years later, the supreme law still exist
and is often viewed as a given. However, it still requires people to uphold, enforce and
adapt it. Because institutions can have deep historical roots in local markets, it is very
important for firms to understand the institutions, particularly when entering foreign
markets.

Moreover, the notion of path dependency explains why institutional contexts, and
institutions, once created and “institutionalized,” tend to limit the subsequent choices for
adaptation, and development of new institutions. Path dependency refers to the tendency
that the choice options for a particular decision people or organizations encounter are
limited by the decisions made in the past, even though past circumstances may no longer
apply. We will return to this important concept in Week 8 when discussing institutional
development.

(3) Why do we have institutions, and how do they affect firms?

Clearly, institutions affect firms in many different ways, and there are quite a few
perspectives on how this influence takes shape. A more fundamental question we can ask
is why do we have institutions to begin with? Different perspectives on this question
illustrate scholars’ focus on a variety of key outcomes.

It is important to note that the role of institutions is very much a multi-disciplinary topic –
economists, sociologists, political scientists, psychologists, and organizational theorists are
all interested in the rules of the game. While all these disciplines consider the roles of
institutions, they tend to take different perspectives, and emphasize different purposes of
institutions. The functional perspective, held particularly by institutional economists, such
as Douglas North, stresses that institutions create order, and reduce uncertainty to help
stabilize transactions. Neoinstitutionalism – most popular among sociologists –
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Notes on the Institutional Context
emphasizes that institutions define social legitimacy,
explain why people and firms behave the way they
do, and help to simplify a complex world. The power perspective – popular among
political scientists – emphasizes that institutions define the political landscape – they
determine who is in power, and who owns what.

Functional Perspective
The functional perspective of institutions can be explained by considering how game
theory explains the likelihood of cooperation among players in a game. It assumes that
people generally prefer to cooperate to make transactions possible. In simple game-
theoretic explanations, theorists have stressed that cooperation among players is likely (a)
when the game is frequently played – referred to as repeated games, (b) when information
about the game and the other players is complete – referred to as complete information,
and (c) when there are only a few players, referred to as small numbers. Game theorists
predict that cooperation becomes less likely when games are not repeated – so-called
endgames – and when there are many players about whom we have only incomplete
information (or no information at all).

In lab tests, these predictions often hold. However, in reality we are faced with many
potential endgames when we make large purchases, such as buying a house or a car, or
when making less expensive purchases, such as a new pair of pants. We often do not
know much about the other players (the realtor, the seller, potential other sellers, makers
of half products, suppliers, etc.), and many players are involved. Quickly, such endgames
become highly complex and cooperation, according to game theory, would be highly
constrained. Yet, we all are happy to take part in these games. We often do not
experience these games as complex and we often are more than happy to cooperate. This
is because a multitude of formal and informal constraints are in place to facilitate these
exchanges. Players stick to the law, expectations, business standards, etc. So, from a
functional perspective institutions have a clear function – i.e., to make complex
transactions possible.

The principle of bounded rationality is core to explanations of this functional perspective

and many other perspectives on institutions. This is where institutional theorists most
directly depart from the rational macroeconomic models. Bounded rationality is a
principle developed by Nobel laureate Herbert Simon, which argues that people intend to
make rational decisions but are limited in their capacity to do so. Decision-makers strive to
make decisions that best help to reach their goals (pursue their self-interest) but they are
limited in their ability to do so. This is because they have incomplete information and
limited mental capacity and time to process information – i.e., rationality is bounded by
capacity – and people therefore use heuristics (mental shortcuts) and biases to simplify a
complex world.

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Notes on the Institutional Context
Because of bounded rationality, people impose rules
(institutions) on interactions to structure
transactions. When we take this worldview, ideas and ideologies become very important
in choices – they direct people’s attention toward certain preferences and perceptions that
may not necessary lead to the most efficient choice model. Some would even say that we
cannot define “the most efficient choice model” because what is efficient and effective is
also in the eye of the beholder.

Thus, from a functional perspective, institutions have specific functions that influence
firms. A first important function of institutions is that they reduce uncertainty. The rules
determine how we transact, and release us from having to negotiate many terms and
practices each time we make a transaction (or play a game). Without institutions
transactions on the modern marketplace would be nearly impossible, just like it would be
nearly impossible to play a game of football without any rules.

A second important function of institutions is that they give purpose and meaning.
Decision-makers make their choices and set their strategies, given the institutions that are
in place – i.e., in their institutional context. As such, the institutions have direct bearing on
the outcomes of interactions. They determine where and how to transact, and even
determine the size of transactions and production costs. For example, a middle man might
double the price of a half product when he sells it to a retailer, not because it is
determined by the market or because that reflects the costs he makes but because of the
formal and informal institutions of the market. Consequently, institutions influence the
feasibility of transactions and even the profits that these transactions can achieve.

Neoinstitutionalism (behavioral perspective)

Institutional economists and historical institutionalists tend to stress this functional
perspective on institutions. On the other hand, sociologists stress much more how
institutions affect society, and the idea that firms comply to institutions for the sake of
attaining organizational legitimacy. In sociology this view is referred to as
neoinstitutionalism to emphasize its departure from the traditional views of institutions by
the economists. It emphasizes that institutions are followed not because they have some
economic function, but rather because they give legitimacy to people and firms, and to
their actions and activities. From that perspective institutions define what is legitimate –
what is accepted and expected organizational behavior. So, we could also label this the
behavioral perspective.

There are different ways in which firms live by institutions to gain or retain legitimacy. The
concept of institutional isomorphism is important in this regard. This refers to the
processes that force a unit (e.g., a firm) within a population to become more similar to
other units with a similar institutional context. There are three types of institutional
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Notes on the Institutional Context
isomorphism. Coercive isomorphism refers to the
pressures organizations receive from the state and
government mandate. For example, all public firms have to stick to financial reporting
requirements, and restaurants have to comply to specific health and safety regulations.
Firms become increasingly homogeneous (i.e., adopting more similar practices, forms,
shapes) when they all have to stick to prescribed laws, and conform to local societal rules
and regulations. For example, while universities in the Netherlands clearly have their
unique features, they also are alike in many ways. An important reason for this is that the
Dutch government has numerous regulations that universities have to comply to, and
universities are closely monitored to make sure these regulations are followed.

Another form of institutional isomorphism refers to normative isomorphism. This

happens when firms become more homogeneous because they experience the same
normative professional pressures. For example, as students you share certain experiences
and expectations with your classmates about work and live. Once you then complete your
studies and start to work, you bring along these experiences and expectations to a wide
variety of organizations. As a result, the diverse companies that you will be working for
begin to look a little bit more alike. For some industries, that require much professional
development, normative isomorphism can be stronger, such as the law firms that rely on
the inflow of strong students from select universities, and continuous professionalization
throughout the careers of lawyers. Similarly, certain accreditation agencies, professional
certification boards, training qualifications may set the standards for all firms (e.g., AACSB
for business schools, CPA for accountants, long-term medical training for hospital staff). In
addition, firms may become very similar because they use the same “experts” (who set
the norm), such as consultants or management gurus.

A third form of institutional isomorphism is called mimetic isomorphism. This refers to

processes by which organizations imitate each other often because of uncertainty about
what could be effective ways to complete tasks. There are quite some ways in which this
occurs, such as frequency imitation, trait imitation, and outcome imitation.
Frequency imitation occurs when organizations copy practices that are very common.
When a large number of firms use a particular practice it gains legitimacy – it becomes
taken-for-granted, or common practice. For example, decision-makers might adopt an
Mform organizational structure not because it is the proven best or most efficient
structure but because most of the other firms in the industry have adopted this structure.
Firms that are new to the field then assume they will need to follow suit, and adopt the
same practice, not necessarily because it is the best or most efficient way to do the task,
but because they assume it is the way work has to be done.

Trait imitation refers to firms that imitate those firms that have certain features that they
admire (e.g., a large size or success). This may happen because the practice becomes
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Notes on the Institutional Context
“legitimate” when the successful company has
adopted it, or when lower-status firms want to be
associated with higher-status firms.

Outcome imitation occurs when firms imitate practices of other firms because of the
perceived effects of adopting the practice. Then, it is not about the number of other
companies that use the practice, or the traits of those that use the practice, but rather
about the apparent outcome that occurs after other firms adopted the practice. If the
apparent outcomes are positive, they’re more likely to be adopted; if the apparent
outcomes are negative, they’re less likely to be adopted. For example, in certain industries
the few most successful companies may have pursued innovation strategies. This, then
may lead other firms to imitate the firms by also pursuing innovation strategies, even
though the firms that do not innovate may be performing better on average.

The outcomes of the firms that are being imitated may actually be less than completely
clear, particularly in highly uncertain situations. For example, when firms make large
mergers or acquisitions, the determination of what price to pay for such a large purchase
can be very uncertain – the buyers may do thorough due diligence (analyze the company’s
assets and performance of the company they wish to acquire) but because of the inherent
secrecy and complexity of these purchases, a certain degree of uncertainty remains.
Under these conditions, acquirers may consciously or unconsciously consider the actions
and outcomes of other firms that faced a similar situation. For this reason, the price firms
pay become similar to the price other firms paid for comparable, albeit often quite
different, acquisitions. This notion of imitating the practices of others in similar situations
provides a form of social proof – conforming to the actions of others provides a way to
show what is believed to be correct behavior for the uncertain task.

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Notes on the Institutional Context

Key strategic choices of McDonalds and Burger King, such as the menus and
architecture of companies, seem to be quite similar. What may be the cause of this?

Power perspective
Sociologists as well as political scientists also take a power perspective on the role of
institutions. Power refers to the ability of one person or group to exercise influence and
control over others. Power plays a multi-faceted role in the institutional context in (a)
creating new institutions, (b) maintaining a status quo, and (c) monitoring people’s
compliance to the institutions.

Power is reflected in the different typologies of institutions we discussed before. For

example, institutions that regulate behavior make clear who has the power to create new
regulations, monitor whether others live by these regulations. When this power is
perceived by others as legitimate we call it authority, and when achieved through force,
against the will of the people being forced, we called coercive power. Normative
institutions also embody power relationships, and may reflect people’s influence over
other through peer pressure or social proof. And cognitive institutions may influence
people by giving preferential treatment to people’s own group members (who hold similar
worldviews), while outsiders’ opinions are not heard or are valued much less.

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Notes on the Institutional Context

In this power perspective, scholars have considered the role of the state, and institutional
spheres. We will discuss this in more detail in Week 7.

(4) Why do (strategic) managers need to know about institutions?

An important reason for why managers need to know about institutions is because they
have an important influence on market exchanges. Clearly, the normal economic
constraints emphasized in the first half of this course influence market choice sets - for
example, consumers stop spending because of a recession. The second half of the course
stresses that institutions also define the choice set of market decisions. Formal legal rules,
broadly accepted and expected norms, and cultural values determine transaction and
production costs. Ultimately, institutions therefore influence the profitability and
feasibility of economic activity, as well as the expected behaviors and practices to conduct
business.

In the field of global strategy,

Macroeconomic & Institutional Context scholars have emphasized a
resource-based , industry-
based,andinstitution-based
Market Context view. We can be brief
regarding the former two
Organizational
because these are discussed in
Resources
more detail in strategic
management and market context courses. Instead we focus on the institutional context.
However, it’s important to keep in mind that this context has implications for these other
views on the firm. Throughout the second half of the course we more or less explicitly
come back to these links to the other views. For now, it’s important to note that the
institutional context influences both the market context and the resources available to
firms, and ultimately are consequential for firms’ strategies, performance, and survival.
For example, American superstore Wal-Mart’s slogan “Everyday Low Prices” may be a
display of an effective low-cost leader in some markets, but may be viewed as suspiciously
cheap, unethical, or even illegal in other markets.

A famous business scholar, Rosabeth Moss Kanter, emphasized the importance of taking
an institutional perspective most eloquently: “It focuses leaders on understanding, taking
advantage of, and influencing the wider system in which the organization operates.”1 A
view on the institutional context stresses firms’ interdependence with the broader societal
environment, and how they can effectively deal with the environment and possibly create

1 From Moss Kanter, R. 1997. The institutional perspective on management.

Harvard Business School Note.

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Notes on the Institutional Context

change in it. Institutions become most apparent when firms enter an unfamiliar terrain,
such as a foreign market, or when substantial change occurs in a market. When markets
are stable and certain, institutions remain largely on the background. However, even then
it is important for managers to understand the role of institutions to anticipate and shape
institutional change. Understanding institutions can then also facilitate entrepreneurial
activity.

Managers and firms tend to vary in their institutional capabilities – their ability to
perceive, understand, navigate, and influence the institutional context, and their ability to
deal with institutional differences (differences between institutional contexts) or
institutional complexity (the multiplicity of institutions that that at times may be
contradictory or even conflicting). We will come back to this in Week 9 and 10.

Guiding Framework for the 2nd Half of the Course

Now that we discussed some initial answers to the four fundamental questions to help
make sense of the meaning, views and relevance of the institutional context, we can
introduce the guiding institutional framework that we consider in the 2nd half of the
course.
The framework has four connected focus points.

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Notes on the Institutional Context

Central in the framework is the Institutional

Context. We have started to consider this box by describing what institutions are. In
subsequent sessions, we will also consider different levels of institutions, institutional
fields, institutional logics (Week 7), institutional development (Week 8), and institutional
differences (Week 9).

Institutional Drivers are those factors that shape the institutional context. As we
discussed in this first note, an important factor is that history matters. In the sessions that
follow, we will examine institutional drivers in more detail – such as the roles of
institutional spheres (Week 7), and when we discuss institutional development and
change (Week 8), as well institutional work and institutional entrepreneurship (Week 10).

Institutional Outcomes are the key consequences or effects of institutions on firms and
the people that work in firms. As we discussed this week, key outcomes are firm behavior
and the practices they follow, organizational performance, and organizational legitimacy.
In the subsequent sessions, we will continue to consider these critical outcomes for firms,
and specify them more carefully where needed. For example, Week 10 distinguishes
between a multinational company’s internal and external legitimacy, which may at times
present conflicting demands on the decision-makers involved. Important is also that these
outcomes have their subsequent influence on institutional drivers. Positive feedback
loops may reinforce the institutions and strengthen their role in transactions. As we will
discuss in Week 8 on the topic of institutional development, this feedback loop pushed by
the power holders, can explain why moving from one stage to the next can be extremely
difficult and why underperforming economies persist.

The box labeled Institutional Capabilities completes the framework. As mentioned above,
this refers to the strategies and abilities of firms (and their decision-makers) to deal with
institutions, institutional differences and institutional complexity. This is an important
construct because it influences the extent to which the institutional context has its effect
on the firm’s behavior and other critical outcomes (such as making or avoiding legitimacy
mishaps), and because it allows a firm to shape the institutional context through
institutional drivers. In part these capabilities of firms are influenced by the institutional
context itself, as they are embedded in this context. Yet, we will discuss important tools,
qualities, and mechanisms that may explain why firms vary in their institutional
capabilities.
We will do this most directly in Week 10.

We will use this framework throughout the second half, adding meaning to the boxes and
clarifying the relationships between them.

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(5) How does an institutional perspective relate to macroeconomics?

An important side-question you may ask yourself is how this half of the course relates to
the first half – macroeconomics. Macroeconomics and institutional theory are both
about the broader context of firms. And they are both about how scarcity (competition)
influences choices of people and firms.

Where this second half is different is that it abandons the notion of instrumental
rationality. The instrumental rationality assumption holds that while actors may initially
have diverse and erroneous choice models, information feedback processes and
arbitraging actors will correct incorrect models, punish deviant behaviors, and direct
surviving actors to correct models. In the end, under this assumption, only the most
efficient model persists. This instrumental rationality assumption of neo-classical
economics makes it an institutions-free theory - ideas and ideology do not matter
because efficient markets are characterized by complete information and unlimited
mental capacity to process information. With such a theory, institutions do not have to be
taken into the equation. Yet, once we depart from this assumption and replace it with the
assumption of bounded rationality, institutions become an important part of business and
markets.

Rather than having a single most efficient model of the way economic transactions are
made, institutional theory suggests that many models may coexist. An institutional view
emphasizes the role of ideas and ideologies on which rules are founded. People’s “mental
models” of the world are influenced by many sources. For example, the institutional
context emphasizes the role of people’s cultural background. We see the world how it is
not because it necessarily is the most efficient model of the world but because we have
adopted an interpretation of the world that is dominant in our culture. Consequently,
models can vary quite a bit among ethnic groups and societies. Or, mental models
emerge through “local” experiences in a particular environment. For example, Japan’s
many experiences with earthquakes determine Japanese people’s mental models of the
world, how they go about their lives and work. Because most experiences are local, there
are many different perceptions of the world and the way it is supposed to “work.” Some
mental models are also formally learned through textbooks and training, which are less
locally dependent. But even these lead to conflicting models through which we interpret
the world around us.2

2 Douglas North discusses these sources of mental models in his book “Institutions, Institutional Change and
Economic Performance”

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Notes on the Institutional Context

While the role of choice remains central to institutional perspectives, existence of a great
variety of models (that provide many different perceptions of the world) also breeds
variety in choice. The theory holds that individuals typically act on incomplete
information and with subjectively derived models that are often erroneous, and
information feedback loops are often incapable to correct these subjective models; but
rather may reinforce the subjective models through heuristics and biases.

Finally, institutional views bring in the role of power and politics. Institutions are not
necessarily created to be socially efficient. Rather, they tend to serve the interests of
those with the highest bargaining power.

So in considering the institutional context of firms in this second half of the course, we
a) exchange instrumental rationality with bounded rationality
b) emphasize that institutions influence transaction and even production costs
c) incorporate ideas and ideologies into the analysis
d) model power and political processes as a critical factor in the performance of
economies and explanation for persisting “inefficient” markets
e) emphasize path dependency
f) but most importantly add institutions as critical constraints and facilitators in
economic transactions

Interesting Sources for Week 6

If there were no rules…

A nice illustration of football in a world where the institutions would not yet be so clear
can be found here:
https://www.youtube.com/watch?v=ur5fGSBsfq8

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Notes on the Institutional Context

Slippery slope to violating the rules…

There are plenty of examples where people or firms violate the formal and informal
institutions. When it concerns violations of formal institutions this involves breaking the
law. A fascinating example of this is the price-fixing activities by Archer Daniels Midland.
“This American Life” aired a documentary radio show on it. You can find it here:
http://www.thisamericanlife.org/radio-archives/episode/168/the-fix-is-in
Here you find a Discovery Channel documentary on it:
http://www.youtube.com/watch?v=DNLrR0qkMR8
Based on the radio show, Steven Soderbergh made the movie “The Informant” with Matt
Damon:
http://trailers.apple.com/trailers/wb/theinformant/
The main character, Mark Whitacre, was sent to prison for a 10.5 year sentence but got
out a bit earlier and is now back in business… as a speaker on ethics…
http://www.markwhitacre.com/businessethics.html

Background readings
Meyer JW, Rowan B. 1977. Institutionalized organizations: Formal structure as myth and
ceremony. American Journal of Sociology 83(2): 340-363.

North DC. 1990. Institutions, Institutional Change and Economic Performance. Cambridge
University Press.
This article provides a very nice summary of the book:
North DC. 1991. Institutions. Journal of Economic Perspectives 5(1): 97-112.

Peng MW, Sun SL, Pinkham B, Chen H. 2009. The institution-based view as a third leg for a
strategy tripod. Academy of Management Perspectives 23(3): 63-81.

Scott WR. 2008. Institutions and organizations (3 ed.). Sage Publications: California.

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