INFORMAL INSTITUTIONS AND

DEVELOPMENT

Chapter FOUR
Outline
This chapter covers

1. Informal institutions in Development

 Informal institutions and how they matter for development

 Primary roles of Informal institutions

2. Informal Institutions in Ethiopia

3. Empirical evidence
 Institutions
 ‘Institutions are a set of rules, compliance procedures and
moral and ethical behavioural norms designed to constrain the
behaviour of individuals in the interests of maximising the
wealth or utility of the principals’ (North, 1981).

 “Institutions are the rules of the game in a society or,

more formally, are the humanly devised constraints that shape
human interaction.” (North, 1990)
 “In consequence they structure incentives in human exchange,
whether political, social, or economic.” (North, 1990)
 Institutions
 Lin and Nugent (1995) "a set of humanly devised behavioural
rules that govern and shape the interactions of human
beings, in part by helping them to form expectations of what
other people will do.

 North’s ‘moral and ethical behavioural norms’ are often

embodied in informal institutions like religion and caste
that determine the quality and sustainability of formal
institutions like schools, labour markets and the rules and
regulations governing economic activity.
Institutions…
 Historically institutions emerged through a social contract
between citizens and the state which delegated the use of
violence to the latter in exchange for protection and social
order.

 Over time, these institutions were supplemented by economic

institutions like private property rights and markets, all of
which stimulate economic growth (see Rodrik (2000, 2005)
and Savoia et al (2010)).

 For development, we need growth igniting institutions but

also growth sustaining institutions which will reinforce long
term economic development (as opposed to growth alone)
and conflict management institutions, which will relieve social
conflict.
Formation of Institutions
 How are formal institutions formed?
 informal institutions (gender, class, caste and social capital)
shape formal ones (e.g. the law).
 informal institutions (customs) gradually change the actions
and interactions of agents in all sorts of social organisations
(households, groups, villages, as well as firms and
governments).

 North’s theory of institutional change explains that formal

institutions are a crystallisation of informal ones
(North, 1990), and that both co-evolve through the operation
of organisations (informal and formal social groups, from
households and villages to networks, firms, parties and
governments).
 Formation of Institutions
 Institutions affect economic outcomes but will society
choose those institutions that maximise social surplus
(North and Thomas, Demsetz)?

 Institutions are not always chosen by all of society but

instead by the few, hence not efficient, i.e. the winners do not
fully compensate the losers.

 North (1981) argues that institutions act to constrain the

individual in order to enhance the welfare of the ‘principals’.
 Formation of Institutions
 Informal institutions in developing countries play a very
significant role in shaping formal institutions and the
operation of markets, and can emerge as the preeminent
rules of interaction when formal institutions and markets fail.
 E.g. caste, religion or tribe can influence access to schools,
credit etc.

 They can influence the outcomes of elections and

therefore the benefits derived from them.
Formation of Institutions
 Johnson and Robinson (AJR, 2004) provide the following
framework for understanding the formation of institutions.
1. Economic institutions influence growth because they shape
incentives and affect investment in physical and human
capital
 Institutions  incentives investment  growth

2. Economic institutions are endogenous – determined as

collective choices of society – mostly for their economic
consequences.

3. Distribution of power in society is also endogenous. It is

determined by political institutions.
Informal institutions in Development

Informal institutions and how do they matter for

development?
Informal institutions in Development
 The proposition that ‘institutions matter’ for economic
growth and development has received intense attention.

 But, we are still some way away from knowing exactly which
institutions in exactly which forms are necessary, or at least
useful, for economic development in which contexts.

 Are they formal or informal, and at what quality? It becomes

immediate clear that the search for “high quality institutions”
such as “good governance”, “conflict resolution mechanisms”
and “effective property rights” is a very tricky task and the
result depends heavily on context and external factors
Informal institutions in Development
 Organizational economists have focused on formal
institutions (Coase, 1937; Williamson, 1985; Barzel, 1982;
Holmstrom & Milgrom, 1994 etc...)

 Grass-roots institutions, which are more likely to exist in a

high-trust environment, can also facilitate the accumulation of
factors of production and raise the level of productivity.

 Collectiveaction problems may well be resolved either by

norms, or grass-roots institutions, leading to efficiency gains

 Externalities
are more likely to be internalised, and public
goods provided, in societies where cooperative norms exist
Informal institutions in Development
 Itis suggested that the presence of informal institutions can
potentially lead to higher levels of investment in physical and
human capital and higher levels of total factor productivity.

 Informal institutions, therefore, affect the level of income

per capita, via their effect on the proximate determinants
of development

 Hence, informal institutions, like formal institutions, can

be thought of as a deep- determinant of economic
development.
Informal institutions in Development
 Informal institutions (morals, customs, traditions, norms,
ideologies, and religion) will be economically productive in so
far as they encourage cooperation and reduce transactions
costs North (1990)

 “[e]ffective
traditions of hard work, honesty and integrity
simply lower the cost of transacting and make possible
complex, productive exchange.”

 Iftransactions costs can be minimised, this will increase

productivity as more time and resources can be devoted
to production.

 High levels of trust will also increase the number of trades

and increase the incentive for firms and individuals.
Informal institutions in Development

Primary roles of Informal institutions….

Informal institutions in Development
 Indeveloping country context informal institutions all have
about three primary roles…

1. Institutions provide guidance

2. Institutions allow for routines

3. Institutions reduce uncertainty

Informal institutions in Development
 Informal institutions provide guidance

 Institutions through institutional outcomes affect the

behaviour of individuals by providing incentives or placing
restrictions

 The role of formal and informal institutions in many

respects is about managing social relations, and therefore
the management of conflict
Informal institutions in Development
 Informal institutions allow for routines

 By guiding actions, institutions facilitate social interaction in

our daily lives

 For instance, driving on the right-hand side of the street

is a rule which guides motorists in ways that permit the
coordination of cars

 As North explains, it is the existence of an embedded set

of institutions in our daily lives which removes many
difficult choices that, in the absence of institutions, would
have to be made in order to obtain social interaction
Informal institutions in Development
 Informal institutions reduce uncertainty

 Itfollows that institutions reduce the uncertainty of

social interaction by providing a structure within which
everyone can act.

 Thisfunction is very important because it allows for the

coordination of plans.
Informal institutions in Development

Relationship between formal and informal

institutions…..
Informal institutions in Development
 Informal institutions interact with formal institutions as they
affect outcomes in four stylized ways (Helmke and Levitsky
2004):

1. Complementary
2. Accommodating
3. Competing
4. Substituting
Informal institutions in Development
Complementary

 Informalinstitutions are complementary with formal ones

when they converge and the formal institutions are effective.

 Suppose that a new state decides to adopt better anti-

corruption laws

 The content of the specific laws may matter very little if in fact
pre-existing norms already form informal checks and balances
on public officials. In this scenario, knowing what about anti-
corruption law matters requires that one understand how the
norm and law interacts to form the beneficial outcome. Both
might reinforce the check on corruption, or the formal laws (due
to some fluke) may hinder the informal checks in place.
Informal institutions in Development
Accommodating

 The informal institutions may accommodate the formal ones

when they diverge and formal institutions are effective by not
violating the letter of the law but violating its spirit.

 In other words, it coexists with the formal institution and

drives the outcome that is not entirely intended by the
formal rules.

 Even if the informal institution may be identified as corrupt, it

might be more efficient. The desirability of the rules depends
on the criteria for judging (efficiency versus fairness).
Informal institutions in Development
Competing

 Informal institutions compete with formal ones when formal

institutions are ineffective and the two diverge.

 This is true where formal law is poorly enforced, or simply

ignored by authorities.

 This situation exists because states do not feel the need to

enforce the laws (they ignore it) or they do not necessarily
have the capacity to enforce (costs are too high).

 While many laws protecting women and human rights in poor

countries may exist on the books, customary laws contravene
these rights in practice.
Informal institutions in Development
Substituting

 Informal institutions can substitute for the lack of effectiveness of

formal institutions.

 Like complementary institutions, these informal institutions are

designed to achieve what formal institutions should be doing but
is ineffective or ignored by official sources.

 Informal credit markets and insurance schemes might very well

be thought of as substitutions for formalized market or state
organs that usually provide such services.

 Informal neighbourhood associations that form to prevent crime

or collect garbage off streets may be substituting a city gov’t
function.
Informal Institutions in Ethiopia
 Ithas been argued that informal institutions and institutional
mechanisms (governance structures) contribute a lot for
development and explain differences in growth rates and
development paths in developing countries

 But what are these informal institutions in Ethiopia?

 Iddir, Mahber, Eqqub, Elder’s

Group, Gadaa/Cheffe Kore,
Debo/Wobera/Wonfel/ Oxen sharing (labour sharing) etc.
Informal Institutions in Ethiopia
 These informal institutions or governance structures engaged
in different economic and social activities.

 The major benefits include risk coping, provision of credit,

common property regulation, manpower and traction force,
conflict resolution and information.

 Some of these institutions played a significant role in

various activities
 Informal institutions in Development
Empirical evidence
 Relationship between institutions and economic growth
widely studied (AJR, 2001, 2004; Hall and Jones, 1999; Knack
and Keefer, 1995;)…see some recent empirical evidence
 Findings of this literature suggest that institutional quality is a
significant determinant of a country’s growth performance.
 The findings argue that ‘of fundamental importance for
development economists and policy practitioners suggest that
institutional quality may cause poor countries and
people to stay poor,’ (Pande and Udry, 2005)
 Informal institutions in Development
Empirical evidence
 Glaeser et al (2004) argue that measures of institutional quality
such as risk of expropriation, government effectiveness and
constraints on the executive are ‘outcomes’ and do not
represent ‘deep’ institutions.
 They estimate the following equation:
Informal institutions in Development
Common proxies variables used for institutions are:
 Voice and accountability
 Political Stability/No violence
 Government Effectiveness
 Regulatory Quality
 Rule of Law
 Control of Corruption
 Corporate Ethics
 Corporate Corruption
 Judicial Effectiveness
 Corporate Governance etc.
 Informal institutions in Development
Common proxies variables used for institutions are:

 Problem is that all of these variables are related to the

level of development. So, more developed economies are
likely to have better institutions. How then can we identify
whether these institutions influence the level of growth or
development?

 Also, these variables are not ‘deep’ institutions. Instead,

they denote ‘outcome’ institutions (or quality of secondary
institutions) and the question is what determined these
institutions.
Institutions and Growth
Interpretation of results

 Coefficient on Initial level of schooling is always +ve and

significant.

 So also the coefficients on Initial GDP per capita (-ve and

significant) and Share of Population living in Temperate Zone
(+ve and significant).

 The beta coefficients are only significant when the

institutional proxies stand for outcomes (expropriation
risk (82-90) or government effectiveness (98-2000).

 Other proxies for institutions such as judicial independence

or constitutional review are insignificant.
Institutions and Growth – Empirical
Estimation Problems
Problems:
 Endogeneity: Institutions affect growth but the latter in turn
influences the kind of institutions that exist.
 The solution is for us to try and find a variable or a
factor that meaningfully can affect institutions but
does not directly affect economic growth.
 Most institutional variables that are available in datasets
tend to be outcome variables rather than deep institutional
variables.
 Measuring institutions is difficult because popular measures
are (i) ‘outcomes’ rather than anything ‘deep’ (ii) they are
mostly subjective (iii) when non-outcome proxies for
institutions are used they are insignificant.
 Institutions influencing Schooling
Crost & Kambhampati, 2010
 Analyse the factors that influence the availability of schools in India.
 Include a range of formal (political) and informal (caste, religion, ethnicity)
institutions.

 The political variables include:

 extent of political competition in the district (as reflected in the margin of victory of the
incumbent party,
 the extent of party fractionalization,
 the probability that an incumbent party loses an election;
 political awareness of inhabitants of the village (as reflected in turnout at elections)
 empowerment of minority communities (as reflected in reservation of seats for such
communities in assembly elections).

 Ethnic diversity: caste fractionalization index constructed using upper caste,

middle caste, SC, backward agricultural & other castes, Muslims.
 When seats are reserved for certain minority groups (political reservation),
then the number of primary schools decreases.
 Implying that minority politicians are less bothered about getting schools built?

 When there are a large number of small parties (party fractionalisation) and
when parties are often overthrown at elections (party turnover), then more
primary schools built.

 Number of middle schools is not affected by any political variable except the
margin of victory – higher this is, smaller the number of middle schools.
 If schools are to be used as election winners, then primary schools easier to set
up……also see that they are very tangible. Less likely to see quality of schools
being improved.

 Informal institutions eg. caste, religion etc.

 Upper caste villages have more primary schools and also more teachers per school.
 SC districts have fewer primary schools.