LECTURE-1

INSTITUTIONAL ECONOMICIS

Institution

All human interactional requires a degree of predictability. Individual actions

become more predictable when rules or institutions bind people. Institutions are needed
to facilitate economic life: economic exchanges cannot function in a social vacuum. Indeed,
the type and quality of institutions make a great difference to how well the members of a
community are able to satisfy their economic aspirations and how fast the economy grows. In
short, economic practices are embedded in rules, routines and conventions.

Institutions are structures and mechanisms of social order and cooperation

governing the behaviour of a set of individuals. Institutions are identified with a social
purpose and permanence, transcending individual human lives and intentions, and with the
making and enforcing of rules governing cooperative human behavior. The term, institution,
is commonly applied to customs and behavioural patterns important to a society, as well
as to particular formal organizations of government and public service.

As structures and mechanisms of social order among humans, institutions are one of
the principal objects of study in the social sciences. Although unindividual, formal
organizations, commonly identified as “institutions”, may be deliberately and intentionally
created by people, the development and functioning of institutions in society in general may
be regarded as in instance of emergence; that is, institutions arise, develop and function in a
pattern of social self-organization, which goes beyond the conscious intentions of the
individual humans involved.

Institutions are the rules of game: the humanly devised constraints that structure
human interaction. They are made up of formal constraints (such as rules, laws,
constitutions), informal constraints (such as norms of behaviour, conventions self-
imposed codes of conduct), and their enforcement characteristics.

Institutions are rules of human interaction that constrain possibly opportunistic

and erratic individual behaviour, thereby making human behaviour more predictable
and thus facilitating the division of labour and wealth creation. Importantly, institutions
constitute the individual: shaping and moulding social objectives, means of behaviour and
social relationships. Institutions, to be effective, always imply some kind of sanction for rule
violations.

Institutional economics

Institutional economics focuses on understanding the role of

the evolutionary process and the role of institutions in shaping economic behavior. Its
original focus lay in Thorstein Veblen's instinct-oriented dichotomy between technology on
the one side and the "ceremonial" sphere of society on the other. Its name and core
elements trace back to a 1919 American Economic Review article by Walton H.
Hamilton. Institutional economics emphasizes a broader study of institutions and views
markets as a result of the complex interaction of these various institutions (e.g.
individuals, firms, states, social norms). The earlier tradition continues today as a
leading heterodox approach to economics.

The difficulty in defining and field for the so-called institutional economics is the
uncertainty of meaning of an institution. Sometimes an institution seems to mean a
framework of laws or natural rights within which individuals act like inmates. Sometimes it
seems to mean the behaviour of the inmates themselves. Sometime anything that is
“economic behaviour” is institutional. Sometimes anything that is “dynamic” instead of
“static” or a “process” instead of commodities, or activity instead of feelings, or mass
action instead of individual action, or management instead of equilibrium, or control
instead of laissez faire, seems to be institutional economics.

Institutional economics, known by some as institutionalist political economy, focuses

on understanding the role of human-made institutions in shaping economic behaviour. The
institutional economist were typically focuses their attention on the role of institutions in
reducing transaction costs.

Institutional Economics examines the two-way relationship between institutions

and individuals. It is concerned with the effect of institutions on individuals, as well as the
transformation of institutions through individual practices. In addition, institutional
economics is inter-disciplinary: it engages, borrows and draws on other social sciences such
as sociology and political economy. In many ways, the approach of institutional economic
contrasts with neoclassical economics: orthodox economics assumes that institutions are
fixed, and are taken as given; and remains confined within its disciplinary boundary.
 There are two types of institutions: First, Internal institutions evolve from human
experience and incorporate solutions that have tended to serve people best in the past.
Examples include customs, ethical norms, goods manners and conventions in trade, as
well as natural laws. Violations of internal institutions are normally sanctioned informally;
e.g. social exclusion from parties and meetings. But there are also formal sanctioning
processes to enforce internal institutions; e.g. barred from professional and trade associations.
In many respects, institutional economics engages with sociology, psychology and
anthropology.

Second, external institutions are imposed and enforced from above, having been
designed and established by political and administrative agents. An example is
legislation. External institutions are enforced by explicit formal sanctions (through the
law courts and legitimated use of force — the police). Here, institutional economics
borrows from political and legal sciences.

INSTITUTIONAL ECONOMICS FOCUSES ON LEARNING, BOUNDED

RATIONALITY, AND EVOLUTION (RATHER THAN ASSUME STABLE
PREFERENCES, RATIONALITY AND EQUILIBRIUM). It was once the main school
of economics in the United States, including such famous but diverse economists as
Thorstein Veblen, Wesley Mitchell, and John R. Commons. Some institutionalists see
Karl Marx as belonging to the institutionalist tradition because he described capitalism as e
historically bounded social system; other institutionalist economists disagree with Marx's
definition of capitalism, instead seeing defining features such as markets, money and the
private ownership of production as indeed evolving over time, but as a result of the purposive
actions of individuals.

"Traditional" institutionalism rejects the reduction of institutions to simply

tastes, technology, and nature. Tastes, along with expectations of the future, habits, and
motivations, not only determine the nature of institutions but are limited and shaped by them.
If people live and work in institutions on a regular basis, it shapes their world- views.
Fundamentally, this traditional institutionalism (and its modern counter-part
institutionalise political economy) emphasizes the legal foundations of an economy and
the evolutionary, habituated, and volitional processes by which institutions are erected
and then changed. Some of the authors associated with this school include
Thorsten Veblen

Thorsten Veblen (1857-1929) wrote his first and most influential book while he was at the
University of Chicago, on The Theory of' the Leisure Class (1899). In it he criticised
materialistic culture and wealthy people who conspicuously consumed their riches as a way
of demonstrating success. Conspicuous leisure was another focus of Veblen’s critique. In The
Theory of Business Enterprise (1904) Veblen distinguished production for people to use
things and production for pure profit, arguing that the former is often hindered because
business pursue the latter. Output and technological advance are restricted by business
practices and the creation of monopolies. Businesses protect their existing capital investments
and employ excessive credit, leading to depressions and increasing military expenditure and
war through business control of political power. These two books, focusing on criticism
first of consumerism, and second of, profiteering, did not advocate change.

John R. Commons

John. R. Commons (1862-1945) also came from mid-Western America. Underlying

his ideas, consolidated in Institutional Econoics (1934) was the concept that the economy is a
web of relationships between people with diverging interests. There are monopolies,
large corporations, labour disputes and fluctuating business cycles. They do however
have an interest in resolving these disputes. Government, Thought Commons, ought to be
the mediator between the conflicting groups. Commons himself devoted much of his time
to advisory and mediation work on government boards and industrial commissions.

Wesley Mitchell

Wesley Clair Mitchell (1874–1948) was an American economist known for his empirical
work on business cycles and for guiding the National Bureau of Economic Research in its
first decades. Mitchell's teachers included economists Thorstein Veblen and J. L. Laughlin
and philosopher John Dewey.

Clarence Ayres

Clarence Ayres (1891–1972) was the principal thinker of what some have called the Texas
school of institutional economics. Ayres developed on the ideas of Thorstein Veblen with a
dichotomy of "technology" and "institutions" to separate the inventive from the inherited
aspects of economic structures. He claimed that technology was always one step ahead of the
socio-cultural institutions.
Ayres was heavily influenced by the philosophy of John Dewey. Dewey and Ayres both
utilized the instrumental theory of value to analyze problems and propose solutions.
According to this theory, something has value if it enhances or furthers the life process of
mankind. Therefore, this should become the criterion to be utilized in determining the future
courses of action.

Adolf Berle

Adolf A. Berle (1895–1971) was one of the first authors to combine legal and economic
analysis, and his work stands as a founding pillar of thought in modern corporate governance.
Like Keynes, Berle was at the Paris Peace Conference, 1919, but subsequently resigned from
his diplomatic job dissatisfied with the Versailles Treaty terms. In his book with Gardiner C.
Means, The Modern Corporation and Private Property (1932), he detailed the evolution in
the contemporary economy of big business, and argued that those who controlled big
firms should be better held to account.

Directors of companies are held to account to the shareholders of companies, or not, by the
rules found in company law statutes. This might include rights to elect and fire the
management, require for regular general meetings, accounting standards, and so on. In 1930s
America, the typical company laws (e.g. in Delaware) did not clearly mandate such rights.
Berle argued that the unaccountable directors of companies were therefore apt to funnel the
fruits of enterprise profits into their own pockets, as well as manage in their own interests.
The ability to do this was supported by the fact that the majority of shareholders in big public
companies were single individuals, with scant means of communication, in short, divided and
conquered.

John Kenneth Galbraith

John Kenneth Galbraith (1908-2006) worked in the New Deal administration of

Franklin Delano Roosevelt. Galbraith shared a critical of orthodox economics throughout the
late twentieth century. In The Affluent Society (1958), Galbraith argues voters reaching a
certain material wealth begin to vote against the common good. He coins the term
"conventional wisdom" to refer to the orthodox ideas that underpin the resulting
conservative consensus. In Economics and the Public Purpose (1973) Galbraith advocates a
“new socialism" as the solution, nationalising military production and public services
such as health care, introducing disciplined salary and price controls to reduce
inequality.
New Institutional Economics

It incorporates a theory of institutions into economics. It builds on, modifies, and

extends neoclassical theory. It retains and builds on the fundamental assumption of
scarcity and hence competition. It has developed as a movement within the social
sciences, especially economics and political science that unites theoretical and empirical
research examining the role of institutions in furthering or preventing economic growth.
It includes work in transaction costs, political economy, property rights, hierarchy and
organization, and public choice. Most scholars view the work of Ronald Coase as a
central inspiration for the field.

With the development of theories of asymmetric and distributed information an

attempt was made to integrate institutionalism into mainstream neoclassical economics, under
the title new institutional economics. However, this latter variant of institutionalism failed to
supersede the classical school, because heterodox economists argue it was heir to what they
perceive as the flaws of neoclassical economics. Specifically, new institutional economics
failed to avoid criticisms of reductionism and lack of realism: these were leveled at
neoclassical economics for effectively ignoring institutions, and at new institutional
economics for attempting to reduce institutions to 'rational' and 'efficient' resolutions to
the problem of transaction costs.

New Institutional Economics (NIE) is an economic perspective that attempts to

extend economics by focusing on the social and legal norms and rules that underly
economic activity. Although NIE has its roots in Ronald Coase’s fundamental insights about
the critical role of institutional frameworks and transaction costs for economic performance,
at present NIE analyses are built on a more complex set of methodological principles and
criteria. They now depart from both mainstream Neoclassical economics and “old”
institutional economics, though authors often care about both efficiency and distribution
issues. The term “New Institutional Economics’ was coined by Oliver Williamson in
1975.

Major scholars associated with this school include Ronald Coase, Douglass North,
Oliver Williamson, Avner Greif and Claude Menard. In 1997 they founded the
International Society for New Institutional Economics.

Mainstream economics refers to the various schools of economics predominantly

taught in prominent universities and is used to distinguish certain approaches and schools of
thought in economics from heterodox approaches and schools such as the feminist economics
and Marxian economics.

Mainstream economics includes theories of market and government failure and

private and public goods. These developments suggest a range of views on the
desirability or otherwise of government intervention. Mainstream economists do not, in
general, identify themselves as members of a particular school; they may, however, be
associated with approaches within a field such as the rational-expectations approach to
macroeconomics. Currently mainstream economics is dominated by the neoclassical
synthesis, which combines neoclassical approach to microeconomics with Keynesian
approach to macroeconomics. The term came into common use in the late 20th century.
The term neoclassical synthesis itself also appears in Samuelson's influencial 1955 textbook.

Mainstream economics may employ axioms (In traditional logic, an axiom or

postulate is a proposition that is not proved or demonstrated but considered to be either self-
evident, or subject to necessary decision. Therefore, its truth is taken for granted, and serves
as a starting point for deducing and inferring other truths) or postulates in stating a theory.
Testing the theoretical and empirical implications of those postulates is a standard method of
mainstream economics.

Orthodox economics, also known as mainstream economics, largely consists of the

neoclassical synthesis, which combines a neoclassical approach on microeconomics and
Keynsian approach to macroeconomics

Heterodox economics refers to the approaches, or schools of economic thought, that

are considered outside of orthodox economics. Heterodox Economics is an umbrella term
used to cover various separate unorthodox approaches, schools, or traditions. These include
post Keynesianism, Technocratic, (old) institutionalism, feminist, social, Marxian and
Austrian economics, among others.

Heterodox institutional economics emphasizes a broader study of institutions and

views markets as a result of the complex interaction of various institutions (e.g. individuals,
firms, states, social norms). Law and economics has been a major theme since the
publication of the Legal Foundation of Capitalism by John R. Commons in 1924.

Behavioural economics is another hallmark of institutional economics based on what

is known about psychology and cognitive science (It is most simply defined as the scientific
study either of mind or of intelligence), rather than simple assumptions of economic
behaviour.

Organization

It is a group of individuals bound by some common purpose to achieve

objectives. Organizations include political bodies (political parties, regulatory agencies),
economic bodies (firms, trade unions), social bodies (temples, clubs), and educational
bodies (schools, universities). (Note: the term "institution" refers to the rules of the
game, whereas "organization" refers to players of the game).

Transaction

A transaction occurs when a good or service is transferred across a

technologically separable interface.
Transaction costs

The costs of resources utilized for the creation, maintenance, use, and change of
institutions and organizations. They include the costs of defining and measuring
resources or claims, the costs of utilizing and enforcing the right specified, and the costs
of information, negotiation, and enforcement.

Transaction costs arise from the costliness of information needed for measurement and
enforcement of the exchange. Institutions provide the structure for exchange that (together
with technology) determines the cost of transacting and the cost of production. How well
institutions solve the problems of coordination and production is determined by the
motivation of players, the complexity of the environment, and the ability of players to
decipher and order the environment (measurement and enforcement) The three general
types of exchange are personal, impersonal, and impersonal with third-party
enforcement. Institutions determine transaction (defining property rights, enforcing
contracts) and transformation (type of technology employed, efficiency of factor and
product markets) costs. Because markets are imperfect, institutions are a mixed bag of rules
that lower costs and those that raise them.

Property rights

There are two distinct meanings: i. economic property rights and ii. Legal property rights.
The economic property rights of an individual over a commodity or an asset are the
individual's ability in expected terms, to consume the good or the services of the asset
directly or to consume it indirectly through exchange. These can include (1) the right to use
an asset, (2) the right to earn income from an asset and contract over the terms with
other individuals, and (3) the right to transfer ownership rights permanently to another
party. The legal property rights are the property rights that are recognized and
enforced by the government.

Governance structure

It is a system of rules plus the instruments that serve to enforce the rules. It is the
explicit or implicit contractual framework (including markets, firms, and mixed modes)
within which a transaction is located.
Contract

It is a legally enforceable agreement. It is a formal legal commitment to which each

party gives / express (though not necessarily written) approval and to which a particular body
of law applies.

Social cost

An actor viz., business firm, individual, etc. initiating an action does not necessarily
bear all the costs or reap all the benefits of that action. Those that the actor does bear are
the private costs; those that the actor does not bear are the external costs. The sum of
these two is the social cost.

Collective action

It is the actions taken by two or more people, comprising a group or

organization, in pursuit of the some collective good (a good such that, if any member of
the group consumes it, it cannot possibly be withheld from the others in the group). The
economic theory of collective action is concerned with the provision of public goods (and
other collective consumption) through the collaboration of two or more individuals, and the
impact of externalities on group behavior. It is more commonly referred to as public
choice. The foundational work in collective action in the economic sense was Ronald
Coase’s, “The Nature of the Firm" 1937), which introduced the concept of transaction
costs to explain the size of firms, and "The Problem of Social Cost" (1960)

Commons

A scarce resource used in common, from which it is not feasible to exclude potential
beneficiaries from using or consuming it, and for which each actor's use or consumption
of it subtracts from its availability to others.

Social capital

Features of social organizations, such as trust, norms and networks, which can improve
the efficiency of society by facilitating coordinated actions are social capital. It is an
attribute of an individual in a social context. Social capital is determined by a) the
individual‘s connections - whom he/she knows, and common group memberships, b) the
strength of these ties, and c) the resources available to these various groups. It can be
acquired partly through purposeful actions and can be transformed into conventional
economic gains. Otherwise, social capital is a concept in business, economics, organizational
behaviour, political science, public health, sociology and natural resources management that
refers to connections within and between social networks. Though there are a variety of
related definitions, which have been described as "something of' a cure-al for the problems of
modern society, they tend to share the core idea "that social networks have value. Just as a
screwdriver (physical capital) or a college education (human capital) can increase
productivity (both individual and collective), so too social contacts influence the productivity
of individuals and groups.

Informal economy

Economic actions and activities conducted outside the legal framework of a society. The
activities or products may in themselves may be legal but they are conducted in a way which
disobeys specific legal provisions, such as registration with the government, payment of
taxes, and so on.

Rent- seeking

The outlay of resources by individuals and organizations in the pursuit of rents

created by government. In economics, rent seeking occurs when an individual,
organization or firm seeks to make money by manipulating the economic and/or legal
environment rather than by trade and production of wealth. The term comes from the
notion of economic rent, but in modern use of the term, rent seeking is more often associated
with government regulation and misuse of governmental authority than with land rents as
defined by David Ricardo.

Rent seeking generally implies the extraction of uncompensated value from

others without making any contribution to productivity, such as by gaining control of
land and other pre-existing natural resources, or by imposing burdensome regulations
or other government decisions that may affect consumers or businesses. While there may
be few people in modem industrialized countries who do not gain something, directly or
indirectly, through some form or another of rent seeking, rent seeking in the aggregate may
impose substantial losses on society.

Most studies of rent seeking focus on efforts to capture special monopoly privileges,
such as government regulation of free enterprise competition, though the term itself is derived
from the far older and more established practice of appropriating a portion of production by
gaining ownership or control of land,. The term “monopoly privilege rent seeking” is an
often-used label for the former type of rent seeking. Often-cited examples include a
farm lobby (hat seeks tariff protection or an entertainment lobby that seeks expansion
of the scope of copyright. Other rent seeking is held to be associated with efforts to
cause a redistribution of health by, for example, shifting the government tax burden or
government spending allocation.

WHEN A COMPANY, ORGANIZATION OR INDIVIDUAL USES THEIR

RESOURCES TO OBTAIN AN ECONOMIC GAIN FROM OTHER WITHOUT
RECIPROCATING ANY BENEFITS BACK TO SOCIETY THROUGH WEALTH
CREATION, IT IS RENT SEEKING. An example of rent-seeking is when a company
lobbies the government for loan subsidies, grants or tariff protection. These activities
don’t create any benefit for society; they just redistribute resources from the taxpayers
to the special-interest group.

Opportunity Cost

The evaluation placed on the most highly valued of the rejected alternatives or
opportunities when a choice is made. It is the value that is given up in order to secure
the higher value that selection of the chosen object embodies.

Path dependence A condition that exists when the outcome of a sequence of economic
changes can be significantly influenced by temporally remote events, including
happenings dominated by chance elements rather than systematic forces.

Feminist economics

It broadly refers to a developing branch of economics that applies feminist lenses to

economics. Research under this heading is often interdisciplinary or heterodox. It
encompasses debates about the relationship between feminism and economics on many
levels: from applying mainstream economic methods to what feminist economists claim are
under-researched "women‘s" areas, to questioning how mainstream economics values the
reproductive sector, to examinations of economic epistemology and methodology.

One prominent claim that feminist economists make is that the Gross Domestic
Product (GDP) does not adequately measure unpaid labour predominantly performed
by women, such as housework, childcare, and eldercare. Since a large part of women's
work is rendered invisible, they argue that policies meant to boost the GDP can, in many
instances, actually worsen the impoverishment of women, even if the intention is to increase
prosperity. For example, opening up a state-owned forest in the Himalayas to commercial
logging may increase India’s GDP, but women who collect fuel from the forest to cook with
may face substantially more hardships.
 NEW INSTITUTIONAL ECONOMICS
New institutional economics

New Institutional Economics (NIE) is an economic perspective that attempts to extend

economics by focusing on the institutions (that is to say the social and legal norms and
rules) that underlie economic activity and with analysis beyond earlier institutional
economics and neoclassical economics. Unlike neoclassical economics, it also considers the
role of culture and classical political economy in economic development.[2]

The NIE assume that individuals are rational and that they seek to maximize their
preferences, but that they also have cognitive limitations, lack complete information and
have difficulties monitoring and enforcing agreements. As a result, institutions form in
large part as an effective way to deal with transaction costs.

NIE rejects that the state is a neutral actor (rather, it can hinder or facilitate effective
institutions), that there are zero transaction costs, and that actors have fixed
preferences.

Overview

It has its roots in two articles by Ronald Coase, "The Nature of the Firm" (1937)
and "The Problem of Social Cost" (1960). In the latter, the Coase theorem (as it was
subsequently termed) maintains that without transaction costs, alternative property
right assignments can equivalently internalize conflicts and externalities. Thus,
comparative institutional analysis arising from such assignments is required to make
recommendations about efficient internalization of externalities and institutional design,
including Law and Economics.

Analyses are now built on a more complex set of methodological principles and criteria. They
work within a modified neoclassical framework in considering both efficiency and
distribution issues, in contrast to "traditional", "old" or "original" institutional economics,
which is critical of mainstream neoclassical economics.[6]

The term 'new institutional economics' was coined by Oliver Williamson in 1975.

Among the many aspects in current analyses are organizational arrangements (such as
the boundary of the firm), property rights, transaction costs, credible commitments,
modes of governance, persuasive abilities, social norms, ideological values, decisive
perceptions, gained control, enforcement mechanism, asset specificity, human
assets, social capital, asymmetric information, strategic behavior, bounded
rationality, opportunism, adverse selection, moral hazard, contractual safeguards,
surrounding uncertainty, monitoring costs, incentives to collude, hierarchical
structures, and bargaining strength.

Major scholars associated with the subject include Masahiko Aoki, Armen Alchian, Harold
Demsetz, Steven N. S. Cheung, Avner Greif, Yoram Barzel, Claude Ménard
(economist), Daron Acemoglu, and four Nobel laureates—Ronald Coase, Douglass
North, Elinor Ostrom, and Oliver Williamson. A convergence of such researchers resulted
in founding the Society for Institutional & Organizational Economics (formerly the
International Society for New Institutional Economics) in 1997.

Herbert A. Simon criticized NIE for solely explaining organizations through

market mechanisms and concepts drawn from neoclassical economics. He argued that
this led to "seriously incomplete" understandings of organizations. Jack Knight and Terry
Moe have criticized the functionalist components of NIE, arguing that NIE misses the
coercion and power politics involved in establishing and maintaining institutions.

Institutional levels

Although no single, universally accepted set of definitions has been developed, most scholars
doing research under the methodological principles and criteria follow Douglass North's
demarcation between institutions and organizations. Institutions are the "rules of the
game", both the formal legal rules and the informal social norms that govern individual
behavior and structure social interactions (institutional frameworks).

Organizations, by contrast, are those groups of people and the governance arrangements that
they create to co-ordinate their team action against other teams performing also as
organizations. To enhance their chance of survival, actions taken by organizations attempt to
acquire skill sets that offer the highest return on objective goals, such as profit
maximization or voter turnout. Firms, universities, clubs, medical associations, and unions
are some examples.

Oliver Williamson characterizes four levels of social analysis. The first concerns itself with
social theory, specifically the level of embeddedness and informal rules. The second is
focused on the institutional environment and formal rules. It uses the economics of
property rights and positive political theory. The third focuses on governance and the
interactions of actors within transaction cost economics, "the play of the game".
Williamson gives the example of contracts between groups to explain it. Finally, the fourth is
governed by neoclassical economics, it is the allocation of resources and employment. New
Institutional Economics is focused on levels two and three.

Because some institutional frameworks are realities always "nested" inside other broader
institutional frameworks, the clear demarcation is always blurred. A case in point is a
university. When the average quality of its teaching services must be evaluated, for example,
a university may be approached as an organization with its people, physical capital, the
general governing rules common to all that were passed by its governing bodies etc.
However, if the task consists of evaluating people's performance in a specific teaching
department, for example, along with their own internal formal and informal rules, it, as a
whole, enters the picture as an institution. General rules, then, form part of the broader
institutional framework influencing the people's performance at the said teaching department.

New institutional economics has become well established. This trend in economics
deals with the origin of (mainly capitalist) institutions within the mainstream
tradition. Many of the catchphrases articulated within the new institutional
economics, such as “institutions”, “organizations”, “transaction costs”, “property
rights” and “contracts”, have become very common in orthodox economics
discourse. This development is intellectually stimulating and interesting because it
raises some fundamental issues with regard to the role and functioning of institutions.

In November 2009, Oliver Williamson was awarded the Swedish Central Bank

'Nobel' prize in economics.2 This follows the award to Ronald Coase in 1991 and to
Douglass North in 1993. Between them, Coase, Williamson and North, are the
founders and most important representatives of the new institutional economics. This
third Nobel prize is symbolic of the continuing vitality of the new institutionalist
research program within, and around the borders of, the mainstream economics

reflecting the idiosyncratic nature of the so called ‘Nobel Prize in Economics’.3

NEW INSTITUTIONAL ECONOMICS: DEFINITIONS AND CONCEPTS

The new institutional economics as a body of theory emerged in the 1970’s and
1980’s, although its roots lie further back in time. It seeks to incorporate the theory
of institutions into economics by internalizing their study in a manner
compatible with the core tenets of the neoclassical economics. In this way, new
institutionalism seeks to fill a gap in the mainstream (neoclassical) economic
theorizing, where institutions, even when implicitly present, play virtually no
role as exemplified by the examples of welfare economics and the Walrasian general
equilibrium model. The common denominator of all institutionalists, old and new, is
that institutions matter for economic performance, and that institutional

structures exert an important influence on economic behavior. According to the new

institutionalists, the determinants of institutions can be analyzed with the aid of the
neoclassical economic theory. In particular, their aim is to explain what institutions are,
how they emerge, what purposes they serve, how they evolve and how—if at all—they
should be reformed.

The new institutional economics is a research program which includes various theoretical
trends, such as transaction cost economics (Ronald Coase, Oliver Williamson), property
rights theory (Ronald Coase, Armen Alchian, Harold Demsetz), new institutional
economic history (Douglass North, Robert Thomas), and the economic analysis of law
(Ronald Coase, Richard Posner) to name but a few. Other theoretical approaches close
to the new institutional economics, and sometimes defined as being within this research
program, include public choice theory, constitutional economics, the theory of collective
action and the principal–agent approach (Furubotn&Richter, 1998; Schotter, 1981;
Richter, 2005; Menard & Shirley, 2008).

The term “new institutional economics” was coined by Williamson (1975), however, its
origins can be traced back to Coase’s classic 1937 article on the “Nature of the Firm”.
In his seminal analysis of the firm, through the introduction of the concept of (but not
the term) transaction costs which a few decades later became the foundation of the new
institutional economics, Coase attempted to answer the question “Why do firms
exist?”. Until then, within the neoclassical theory, the firm was merely treated as a
production function which transforms inputs into outputs, thus representing what
came to be known as the “black box” of the neoclassical theory—the firm.

All institutionalists see institutions as governing social interactions, or in North's terms,

“by providing a structure to everyday life” (North, 1990). North (1990) went on to say
that “institutions are the rules of the game in society or, more formally, are the
humanly devised constraints that shape human interaction (…) in the jargon of the
economist, institutions define and limit the set of choices of individuals. Institutional
constraints include both what individuals are prohibited from doing and sometimes under
what conditions some individuals are permitted to undertake certain activities”, otherwise,
“in the absence of constraints, we exist in a Hobbesian jungle and civilization is impossible”
(North, 1990). For the new institutionalism, much more simply, institutions are formed to
reduce uncertainty in human exchange.

Further, according to North (1990), there is a clear demarcation between the “institutional
environment” and “institutional arrangements”, and between “formal rules” and
“informal constraints”. For North (1990), the institutional environment or
framework provides the “rules of the game” affecting and shaping behavior, while
institutional arrangements include the “players of the game” or organizations—what
Williamson calls “governance structures”. “What must be clearly differentiated,” North
(1990) says, “are the rules from the players”. “If the institutions are the rules of the game,
organizations and theirentrepreneurs are the players. Organizations are made up of
groups of individuals bound together by some common purpose to achieve certain
objectives” (North, 1994). Thus, for North, the institutional framework represents the
“constitutive rules” of the game where various organisations interact. Williamson (2000)
appeals to this distinction and argues that the transaction costs economics is
predominantly concerned with institutional arrangements, or governance structures.

There are, however, some major stumbling blocks in trying to sustain such a clear–
cut distinction between the institutional environment and organizations. For one
thing, the institutional environment of organizations includes other
organizations, such as the state. Moreover, organizations themselves are made
 up of rules. Organizations and institutions are interlinked or vested within one
another. They are not entirely separable species. Hodgson (2006) has argued that
treating organizations simply as individual actors is problematic to the extent that
organizations are defined as actors. If, however, it simply represents an abstraction
from the internal relationships and mechanisms within organizations, he considers
the treatment of organizations as individual players a legitimate analytical exercise.
This abstraction, according to Hodgson, is legitimized by North’s “primary interest in
economic systems” and “on interactions at the national and other higher levels”
(Hodgson, 2006).

Concerning the second demarcation, North (1994) exemplifies that “formal

rules” are “(property) rules, laws, constitutions”, and that “informal
constraints” refer mainly to “norms of behavior, conventions, self–imposed
codes of contact”. This suggests that an alternative is to view the formal–informal
distinction as similar to the distinction between explicit and tacit rules.

Hodgson (2006) has tried to clarify this distinction further through a comprehensive
discussion of the different definitions and the problems involved in defining terms,
such as rules (formal and informal), institutions, organizations conventions, habits,
etc., and attempts to provide some tentative definitions himself. He defines
institutions as “systems of established and embedded social rules that structure
social interactions”, and rules as “socially transmitted and customary normative
injunctions or immanently normative dispositions, that in circumstance X do
Y”. Organizations, in turn, “are special institutions that involve a) criteria to
establish their boundaries and distinguish their members from non–members,
b) principles of sovereignty concerning who is in charge, and c) chains of
command delineating responsibilities within an organization.” Formal
institutions are generally meant as institutions that are explicit, written or legal,
whereas by informal institutions we generally mean non formal, non–legal or
inexplicit.

Old Institutional Economics (OIE) and New Institutional Economics (NIE)

 In institutional economics, it is appropriate to analyse values: institutions
influence how people attain their own personal objectives and are able to realise their
fundamental values (such as freedom, justice, security and prosperity). Shared fundamental
values in the community support cohesion and motivate people to act within the institutional
framework. In that sense, institutional economics draws upon moral philosophy.

Differences within institutional economics

While discussing the ways to understand institutions, we shall outline the strength and
weaknesses of Old Institutional Economics (OIE) and New Institutional Economics (NIE).
While both approaches include institutions within economics, they differ significantly in
philosophical (problems concerning the issues related to existence, knowledge, truth, justice,
validity etc.) And methodological (explaining and understanding broad society-wide
developments as the aggregation of decisions by individuals) orientation as well as in the
theoretical direction (concerned primarily with theories or hypotheses rather than practical
considerations) and normative content. Furthermore, there are significant differences within
each school.

OIE does not represent a single well-defined or unified body of thought,

methodology or program of research.

1. The first research program is focused on the effects of new technology and
institutional schemes, and the ways in which established social conventions and
vested interests resist such change.

2. The second major program concentrates on law, property rights and

organisations, their evolution and impact on legal and economic power,
economic transactions and the distribution of income.

3. Institutions are outcomes of formal and informal processes of conflict resolution and
ability to generate 'reasonable value'.

The important elements of NIE

i. Property rights.
 ii. Public choice processes.

iii. Organisations.

Some NI economists criticize those who take the purely rent-seeking approach to
government activity, and want to emphasize notions of fairness and ideology in institutional
change. Some NI economists argue that more research should be done on spontaneous,
invisible-hand processes, rather than deliberation and calculation.

Often, the differences between OIE and NIE are dichotomized into:

 Formalism (the activity or its product which rigorously follows a set/system of rules
previously defined and usually known) versus anti-formalism.

 Individualism versus holism (methodological issues)

 Rational choice (a framework for understanding and often formally modelling social
and economic behaviour) versus behaviourism (a philosophy of psychology based on
the proposition that all things which organisms do and can and should be regarded as
behaviours)

 Evolutionary or invisible hand orders versus collectivism (describe any moral,

political, or social outlook that stresses human interdependence and the importance of
a collective, rather than the importance of separate individuals- designed orders)

 Non-interventionist versus interventionist (distribution of income and regulation)

Among the many concepts/aspects that are often taken into account in current NIE
analyses these can be mentioned: organizational arrangements, transaction costs, credible
commitments, modes of governance, persuasive abilities, social norms, ideological values,
decisive perceptions, gained control, enforcement mechanism, asset specificity, human
assets, social capital, asymmetric information, strategic behaviour, bounded rationality,
opportunism, adverse selection, moral hazard, contractual safeguards, surrounding
uncertainty, monitoring costs, incentives to collude, hierarchical structures, bargaining
strength, etc.

2 NEW VERSUS OLD INSTITUTIONAL ECONOMICS

The new institutional economics is contrasted with the “original” (or “old” or
“American”) institutional economics. The first explicit attempt to integrate
institutions into economics can be found in Veblen’s (1898, 1899, 1919, 1932)
writings. He set out to turn economics into an evolutionary science and was
highly critical of the static and mechanistic approach of the neoclassical

economics.9 Veblen is now widely acknowledged as the father of the “old

institutional economics”. This tradition was influential in the USA in the 1920’s and
30’s headed by Veblen, Commons (1931, 1934), Mitchell (1913, 1914), and Ayres (1927,

1936, 1944).11 Following this tradition, Galbraith (1952) uses the notion of power
to explain the evolution of large firms in advanced economies. It was then
seriously weakened and has slowly begun a recovery from the 1960’s onwards when
the Association for Evolutionary Economics was founded as a platform. The first
attempt to revive the Old Institutional Economics was made by Grunchy (1987),
however, Hodgson (1998, 1999a, 1999b, 2001, 2004) has been a prominent figure
in the recent revival of the old institutional economics, mainly in the tradition of
Veblen.

Old institutionalism rejects the mechanistic notion of individual agents as

utility– maximizing in the pursuit of given preferences. To the contrary, it
does not take the individual as given in the orthodox version of the “economic
man”.
For Veblen (1919), this is the basis for a fundamental critique of the
mainstream economics which he describes as “the wants and desires, the end and
the aim, the ways and the means, the amplitude and drift of the individual’s
conduct are functions of an institutional variable that is of a highly complex and
wholly unstable character”. The economy (and the market) is viewed by
institutionalists as an open and dynamic system, affected by technological
changes and embedded in a structural context comprising of social, cultural,
political and power relationships. Old institutionalism emphasizes the
importance of institutions in the economy and attempts to understand their role
and their evolution. In doing so, it develops a theory of institutions and of
human behavior by combining and developing methodological and analytical
 tools from psychology, sociology and anthropology (Hodgson, 2000).

New institutionalists do not see their work as a continuation of the endeavors of old

institutionalists, but as a distinct effort to apply economic approaches to institutions. As

Coase (1984, p. 230) characteristically argues, “the phrase, ‘the new institutional economics’ was
coined by Oliver Williamson. It was intended to differentiate the subject from the ‘old
institutional economics’. John R.Commons, Wesley Mitchell, and those associated with
them were men of great intellectual stature, but they were anti–theoretical, and
without a theory to bind together their collection of facts, they had very little that they
were able to pass on”. Williamson (1996), arguing in similar vein, points out that
“where they differ is that older style institutional economics was content with
description, whereas newer style institutional economics holds that institutions are
susceptible to analysis”.

Furubotn and Richter (1998) describe the division of the two approaches as follows: “At first
glance, it might seem that exponents of the new institutional economics would show some
interest in the work of the old institutionalists (…). Such concern with past work, however,
is not found in the attitudes of neoinstitutionalists. While there may be some exceptions to
the rule, most neoinstitutionalist scholars have been at pains to disassociate themselves from
the central ideas put forward by the old institutionalists. What gave the original NIE
advocates such confidence that they could disregard the older work on institutions was the
belief that the standard neoclassical analysis could be readily generalized or ‘extended’ to treat
institutional problems”. In other words, as already mentioned, new institutionalists analyze
institutions within the framework of the neoclassical economics, given the assumption
of self–interest seeking individuals, attempting to maximize an objective function
subject to constraints. In this light, institutions are incorporated as an additional
constraint under the new institutionalist framework. AS LANGLOIS (1986) PUTS IT,
“THE PROBLEM WITH MANY OF THE EARLY INSTITUTIONALISTS IS THAT
THEY WANTED AN ECONOMICS WITH INSTITUTIONS BUT WITHOUT

THEORY; THE PROBLEM WITH MANY NEO–CLASSICISTS IS THAT

THEY WANT ECONOMIC THEORY WITHOUT INSTITUTIONS; WHAT
THE NEW INSTITUTIONAL ECONOMICS TRIES TO DO IS PROVIDE AN
ECONOMICS WITH BOTH THEORY AND INSTITUTIONS”.
In short, the main differences between old and new institutionalists rest on the

methodological and analytical grounds.13 Old institutional economics underlines the

role of habits, norms, culture and institutions in directing human behavior,
without totally discarding rationality in individual behavior which is, however,
constrained by the social and economic environment. On the other hand, the point of
departure of new institutional economics is the individual itself. In the new
institutional analysis, institutions are derived from an individual action, through
interaction among individuals, hence remaining faithful to the neoclassical
theoretical premises. As Hodgson (1993a) puts it, “the individual, along with his or
her assumed behavioral characteristics, is taken as the elemental building block in the
theory of the social or economic system (…) it is thus possible to distinguish the new
institutionalism from the ‘old’ by means of this criterion”. In this vein, new
institutionalists use basically the deductive method as does the neoclassical
economics. Their point of departure is always the individual together with some
behavioral assumptions from which they go on to build a theory of institutions,
property rights, the state, and so on.

Although both approaches recognize the role of institutions and agree that institutions
matter, they nevertheless have distinct conceptualizations of institutions. As already
mentioned (section 3), for new institutionalism, institutions are viewed as an
additional constraint on human behavior, based on the standard neoclassical
maximization subject to the constraints principle. According to Veblen’s (1919)
definition, however, institutions are “settled habits of thought common to the
generality of men”. Ayres (1962), on the other hand, underlines the role of culture in
shaping institutions, while Commons (1990) proposes his definition of institutions as
“collective action in control, liberation, and expansion of individual action”. Thus,
within the old institutional economics, institutions are viewed first and foremost
on social and collective entities without, however, totally neglecting the role of
individual action, as Commons underlined, while emphasizsing collective
processes. On the other hand, the coordination of different individuals is explained
not simply through reference to institutional structure, but also through the agent–
 level properties of shared habits (Spong, 2019).

The new institutionalist perspective on institutions has been developed on the

basis of the transaction costs theory, where institutions are explained in terms of
themaximizing behavior of individual agents, as outcomes of a conscious design.
Institutional arrangements, in this view, are deliberately chosen by individuals on
the grounds of their efficiency properties, and the basic source of institutional
change is the substantial and persistent changes in relative prices. Hence, the
emergence and change of institutions is viewed as the result of rational responses to
changes in the underlying economic conditions.

In this way, the dynamics of the emergence and evolution of institutions are traced back
to the cost–benefit calculations of rationally acting individuals. Generally speaking,
new institutionalists adopt, explicitly or implicitly, a contractarian approach, explaining
institutions as the intentional product of free and voluntary exchange. Contracts reflect
the rules produced by social actors to facilitate the achievement of socially beneficial
outcomes. The key point is that the resulting institutions are the product of voluntary
agreement. Individuals create these institutions because they can benefit more than they
would in their absence. The underlying motivation of institutional formation is individual
utility and the concomitant pursuit of self–interest and, as such, the new institutionalist
approach is heavily based on the principle of methodological individualism.

On the other hand, old institutional economics is based chiefly on the Veblenian

evolutionary approach drawing upon the Darwinian analogy in biology. Economics,

Veblen (1898) argues, should focus on explaining evolution and change, rather than
remaining stuck to a static equilibrium framework. Veblen, then, utilizes a Darwinian
analogy in economics, arguing that institutional evolution is a process governed by natural
selection. In his classic book, The Theory of Leisure Class, Veblen (1994) states in typical
Darwinian fashion that “the life of man in society, just as the life of other species, is a
struggle for existence, and therefore it is a process of selective adaptation. The
evolution of social structure has been a process of natural selection of institutions”. In
this vein, institutions are seen as the unintended result of individual actions, and institutional
evolution proceeds according to a logic paralleling the logic of biological evolution. Hence,
institutions are not explained by recourse to some economizing mechanism, such as the new

institutionalist transaction cost minimization mechanism. On the contrary, more

contemporary ideas search the basis for the evolution of institutions in the evolution and
competition of ideas in the public sphere (Markey–Towler, 2019).

Given their methodological and analytical differences, it becomes apparent that the old
and new institutional economics constitute two distinct approaches to the analysis of
institutions, stemming from different paradigmatic viewpoints that produce and
nurture contrasting perspectives on how to theoretically tackle institutions
 LECTURE-2

New Institutional Economics (NIE) and Neo-classical Economics

New Institutional Economics (NIE) focuses on the interaction between legal (formal
and informal) institutions and economic behaviour. Both directions of causality concern
researchers in the field: how institutions influence economic behaviour and how economic
factors affect institutional change.

As such, the NIE abandons standard neoclassical economics assumptions that

individuals have perfect information about the market and important current or future
events, as well as the assumption that transaction costs of exchange are zero. As a result,
NIE introduces observed organization and information costs to neoclassical analysis, thereby
providing more analytical richness and power for examining empirical activities.

Institutions, such as written contracts, charters, constitutions, laws, and even

unwritten norms and codes of behaviour are devised to reduce information uncertainty and
transaction costs. If effective, these institutions can promote efficiency by encouraging
investment, production, and trade.

Institutions, especially laws and regulatory arrangements, may also be used to

redistribute income, or be part of rent-seeking activities. If ineffective, these institutions
may result in inefficiencies and reduced investment, production, and trade. At the same time,
individuals engage in collective action (as a response to exogenous changes in relative prices)
make institutions more effective in promoting economical activities.

The Fundamentals of New Institutional Economics

The emphasis of the theory of property rights on institutional arrangements for the
economic process is not new. They had already formed the core of the approaches to
economics by the German historical school and American institutional economics.

However, while these approaches rejected the fundamental idea of neoclassical

economics, namely, that of taking individuals and their preference functions as given, new
institutional economics does not challenge this assumption. What it attempts is rather to
extend the neoclassical model of barter exchanges by forcefully considering the
neglected institution of property rights.
 New institutional economics claims that only an appropriate analysis of these rights
will &low transforming neoclassical economics into a mature theory of market economy,
suitable for making the conditions for economic development understood.

New institutional economists regard property rights as an eternal and universal

instrument of society to help its members deal with each other in economic exchanges.
"This implies that it is impossible not to have a property rights system".

Property rights are defined as an exclusive, transferable, and legal right to the physical
use of scarce resources, the returns thereon, and alienation thereof. If this right is designated
to a specific person, it is termed a private, or individual, property right, and a common, or
state, property right if it is assigned to all members of "society." The latter right is defined as
a right without exclusivity of use. A resource to which a private property right applies is
referred to as private property and, correspondingly, the application of common property
right turns the resource into common property.

Unlike the neoclassical model, new institutional economics regards the way by which
property rights are allocated and enforced as determined by transaction costs. There are
inherent difficulties, frictions in economic exchanges, and, therefore, substantial costs in any
attempt to allocate property rights. In the absence of an appropriate specification of rights,
external effects result which need to be internalized by incentives. To economize transaction
costs, wealth-maximizing individuals, therefore, substitute private property rights for
common property rights as soon as they realize that the private rights leave room for
unexploited gains of exchanges or benefits, that is, that the rights are not used efficiently
because individuals cannot be excluded from an inefficient use.

Neoclassical economics refers to a general approach in economics focusing on the

determination of prices, outputs, and income distributions in markets through supply and
demand. Neoclassical economics basically rests on three assumptions, although certain
branches of neoclassical theory may have different approaches:

 People have rational preferences among outcomes that can be identified and
associated with a value.

 Individuals maximize utility and firms maximize profits.

 People act independently on the basis of full and relevant information.

 From these three assumptions, neoclassical economists have built a structure to
understand the allocation of scarce resources among alternative ends in fact understanding
such allocation is often considered the definition of economics to neoclassical theorists.
2.NEW INSTITUTIONAL VERSUS NEOCLASSICAL ECONOMICS

On the first page of his 1975 book Markets and Hierarchies, Williamson argues that the new
institutional economics is based on the view “that received micro theory (…) operates at a
too high level of abstraction”, that “the study of ‘transactions’ (...) is really a core matter”,
and that “what they (i.e. new institutionalists are doing is complementary to, rather than a
substitute for, conventional analysis”.
One obvious idea delivered above is that the neoclassical theory is too abstract
and does not encompass the reality and efficacy of transaction costs. The traditional
microeconomic theory does not consider the set of activities that normally precede,
accompany and follow market transactions and the associated transaction costs. Within the
new institutional economics, the concept of transaction costs has become the center of
Coase’s and Williamson’s analysis of the firm and is the basis of an approach to the theory
of institutions and property rights linked mainly with the works of Alchian (1965), Demsetz
(1967), Alchian and Demsetz (1973), and North (1981, 1990). Williamson (1985) argues that the
neoclassical theory is similar to physics which studies a frictionless world, with friction
being the analogue to transaction costs. By excluding transaction costs, the neoclassical
theory also excludes institutions from its theoretical corpus. On the other hand, the
inclusion of transaction costs in the theory makes it capable of dealing with institutions
and reduces its level of “abstraction”.
However, the new institutional economics does not attempt to overturn or replace the
neoclassical theory, but instead serves as “complementary to (…) the conventional analysis”
(Williamson, 1975). The new institutional economics builds on, modifies and extends the
neoclassical theory to permit it to come to grips and deal with institutions heretofore beyond
its scope (North, 1995). In particular, the new institutional economics adds institutions
as a critical constraint and analyses the role of transaction costs in the emergence and
development of institutions and property rights.
In this direction, the new institutionalists take a step away from the neoclassical
economics by modifying the instrumental rationality assumption of the neoclassical
theory through the adoption of Simon’s (1961) concept of bounded rationality and
Williamson’s (1975, 1985) concept of opportunism. This is how Williamson (1975)
delineates the principal differences between the neoclassical theory and his approach: “I
expressly introduce the notion of opportunism and am interested in the ways that
opportunistic behavior is influenced by economic organization and (…) I emphasize that it
is not uncertainty or small numbers, individually and together, that occasion market failure
but it is rather the joining of these factors with bounded rationality on the one hand and
opportunism on the other that gives rise to exchange difficulties”.

Bounded rationality, for Simon (quoted in Williamson, 1985) denotes that “human
behavior is intendedly rational but only limitedly so”. Individuals are not omniscient and
have real difficulties in processing information, in addition, they have restricted ability
to handle data and formulate plans. Hence, Williamson (1975, 1985) assumes
individuals to be only bounded rational, while North (1995) suggests that “the place to
begin a theory of institutions (…) is with a modification of the instrumental rationality
assumptions”. Coase (1984), on the other hand, regards the assumption of “a (perfectly)
rational utility maximizer” as both “unnecessary and misleading”. Note that bounded
rationality does not replace the assumption of instrumental rationality, but instead only
relaxes the heroic assumption of perfect information. This means that being confronted
with limited calculatory power, costly provision of information and a complex and
uncertain world, the individual is not capable of acquiring perfect information, but
nevertheless behaves in a rational manner, maximizing his/her utility.

Williamson (1985) defines opportunism as “self–interest seeking with a guile”.

What sets opportunism apart from the standard economic assumption of self–interest seeking
behavior is the notion of guile, which includes individuals’ inclination to “lying, stealing,
cheating, and calculated efforts to mislead, distort, disguise, obfuscate, or otherwise
confuse”. The existence of such behavior is important because, while bounded rationality
prevents the writing of complete contracts, opportunism raises the transaction costs of
negotiating and enforcing a contract even further.

Thus, Furubotn and Richter (1998) conclude that the new institutional economics is an
amalgam of a critique of the standard neoclassical economics based on the absence of
transactions costs, and an apparent move towards greater realism through a shift to a more
empirically relevant model. This is achieved primarily by mellowing the concept of a
fully rational “economic man”, acting with full knowledge and certainty, into a concept
of a “boundedly rational” individual acting upon limited knowledge.
 However, the new institutional economics does not break fundamentally from the
neoclassical economics. To the contrary, the new institutional economics is a
research program which is developed within and around the dominant
neoclassical paradigm. Although new institutionalists start by acknowledging the
deficiency of the neoclassical economics in recognizing the effect of positive
transaction costs and the role of institutions in economic development, they end up
erecting a theory that tries to accommodate institutions within a neoclassical
framework. While new institutionalists feel uncomfortable with the theory that
seems to ignore institutions, they restrict themselves to a neoclassical attempt to
deal theoretically with the fact that institutions matter. Institutional
arrangements in this view are the result of rational responses to changes in the
underlying economic conditions on the basis of the efficiency criterion.
Consequently, the framework is built on the orthodox microeconomic theory,
using the marginalist analysis, general equilibrium theory and the principles of
methodological individualism, individual self–interested rationality and
economic efficiency.

More specifically, according to North (1995), the new institutionalist approach

“begins with the scarcity and hence competition postulate, it views economics as a theory of
choice subject to constraints, it employs price theory as an essential part of the analysis of
institutions, and it sees changes in relative prices as a major force inducing change in

institutions”. These are the basic ingredients of the MARGINALIST CHOICE–

THEORETIC APPROACH AND THE STATIC EQUILIBRIUM THEORY OF
PRICE (Coase, 1988).

Thus, the new institutional economics retains the neoclassical principle of

methodological individualism, always couching its explanations in terms of the goals,
plans and actions of individuals, and proposes an instrumental view of the emergence and
change of institutions,
i.e. all institutions have been consciously created in order to reduce the transaction
costs of economic exchange and production. The result is that “the foundation stones of
the NIE (New Institutional Economics) are the same as those of the neoclassical
economics: methodological individualism and individual rational choice given as a set
of constraints” (Richter, 2005). Similarly, “... (T)he exponents of modern institutional
economics apply the analytical apparatus of the neoclassical theory (and newer
techniques) to explain the workings and evolution of institutional arrangements, and
thus expand the scope and predictive power of microeconomics (Furubotn & Richter,
1998).

Using the Lakatosian (1970) terminology of “hard core” and “protective belt” as the essential

parts of research programs,6 Fine and Milonakis (2009) argue that the new institutional
economics retains the “hard core” of the neoclassical economics, i.e. maximizing
behavior, market equilibrium, and stable preferences. On the other hand, there is a
modification in the “protective belt” in the form of information and transaction costs,
making property rights indispensable for the analysis of economic organizations.

To sum up, the new institutional economics is not a development away from the neoclassical
theory. Rather, it is best viewed as a demonstration of the use of the neoclassical

conceptualtion of institutions.8 In this vein, the new institutional economics aims to fill a
vacuum in the neoclassical theory without denouncing its theoretical basis, especially the
model of (bounded) rational maximizing individuals, acting within given constraints
(Furubotn & Richter, 1991). Thus, the analysis of institutions, as well as the impact of
institutions on the behavior of economic actors are reduced to a cost–benefit
calculation of (more or less) rationally acting individuals. Institutional arrangements
are deliberately chosen by individuals on the basis of efficiency criteria. Hence, the
emergence and evolution of institutions is viewed as the result of rational responses to
changes in the underlying economic conditions. It can thus be suggested that the new
institutional economics has grown mainly out of developments at the heart of the
modern orthodox theory itself. As Simon (1991) remarks, “the new institutional
economics is wholly compatible with and conservative of the neoclassical theory”.
 LECTURE-3

Institutions and Organizations

Institutions

‘Institutions keep society from falling apart, provided that there is something to keep
institutions from falling apart’
 Institutions are structures and mechanisms of social order and cooperation
governing the behaviour of a set of individuals and institutions are identified with a social
purpose and permanence, transcending individual human lives and intentions, and with the
making and enforcing of rules governing cooperative human behaviour. The term, institution,
is commonly applied to customs and behaviour patterns important to a society, as well as to
particular formal organizations of government and public service.

As structures and mechanisms of social order among humans, institutions are one of
the principal objects of study in the social sciences, including sociology, political science and
economics. Institutions are a central concern for law, the formal regime for political rule-
making and enforcement. Although unindividual, formal organizations, commonly identified
as "institutions," may be deliberately and intentionally created by people, the development
and functioning of institutions in society in general may be regarded as an instance of
emergence; that is, institutions arise, develop and function in a pattern of social self-
organization, which goes beyond the conscious intentions of the individuals.

As mechanisms of social cooperation, institutions are manifest in both objectively

real, forma/organizations, such as the U.S. Congress, or the Roman Catholic Church or
Indian temple trust, and, also, in informal social order and organization, reflecting human
psychology, culture, habits and customs. Most important institutions, considered
abstractly, have both objective and subjective aspects: examples include money and
marriage. The institution of money encompasses many formal organizations, including banks
and government treasury departments and stock exchanges, which may be termed,
''institutions," as well as subjective experiences, which guide people in their pursuit of
personal well-being. Marriage and family, as a set of institutions, also encompass formal
and informal, objective and subjective aspects. Both governments and religious institutions
make and enforce rules and laws regarding marriage and family, create and regulate various
concepts of how people relate to one another and what their rights, obligations and duties
may be as a consequence. Culture and custom permeate marriage and family.

Organization
An organization is a social arrangement which pursues collective goals, which controls
its own performance, and which has a boundary separating it from its environment. The word
itself is derived from the Greek word opyavov (organon) meaning tool. The term is
used in multiple ways.
 In the social sciences, organizations are studied by researchers from several disciplines,
the most common of which are sociology, economics, political science, psychology,
management, and organizational communication. The broad area is commonly referred to as
organizational studies, organizational behaviour or organization analysis. Therefore, a
number of different theories and perspectives exist, some of which are compatible, and others
that are competing.
Organization (process-related): An entity is being (re-)organized (organization as task or
action).
Organization (functional): An organization as a function of how entities like businesses or
state authorities are used (organization as a permanent structure).
Organization (institutional): An entity is an organization (organization as an actual
purposeful structure within a social context)
In sociology "organization" is understood as planned, coordinated and purposeful
action of human beings to construct or compile a common tangible or intangible product.
This action is usually framed by formal membership and form (institutional rules).
An organization is defined by the elements that are part of it (who belongs to the
organization and who does not?), its communication (which elements communicate and how
do they communicate?), its autonomy (changes are executed autonomously by the
organization or its elements?) and its rules of action compared to outside events (what causes
an organization to act as a collective actor?).
Organizations are purposeful entities designed by their creators to maximize their
objectives defined by the opportunities afforded by the institutional structure. The
institutional context determines the incentives for the kinds of knowledge and skills that pay
off; this knowledge has implications for the long-run development of society. Organizations
will (a) change institutions at the margins whenever this is more profitable than investing in
existing constraints; and (b) encourage society to invest in skills and knowledge that
contribute to profitability. Adaptive efficiency provides the incentives to encourage the
development of decentralized decision-making processes that will allow societies to
maximize efforts required to explore alternative ways of solving problems.
Organizations vs. Institutions
The term organization is sometimes used interchangeably with the term institution,
as when referring to a formal organization like a government, panchayat, hospital or a prison.
In the sociology of organizations and especially new institutionalism' (also new institutional
economics in economics and historical institutionalism in political science), 'organization'
and 'institution' refer to two different phenomena. Organizations are a group of
individuals pursuing a set of collective goals with established roles, methods of coordination,
procedures, culture and space.
Organizations can include political bodies (political parties, Congress, Department of
Corrections), social groups (churches, clubs, athletic associations), economic bodies ‘/
(unions, cooperatives, corporations), and educational bodies (schools, training centers,
colleges) (Refer North, 1990 for details).
Institutions are ideas about how something should be done, looked at or be constituted in
order to be viewed as legitimate. Institutions can be defined as a "stable collection of social
practices consisting of easily recognized roles coupled with underlying norms and a set of
rules or conventions defining appropriate behaviour for and governing relations among,
occupants of these roles.” (Jonsson, 2007, p5.) Institutions provide structure, guidelines for
behaviour and shape human interaction (Martin, 2004; North, 1990; Scott, 1995). Institutions
are also characterized by social practices that reoccur or are repeated over time by members
of a group (Martin). Institutions may or may not involve organizations. The issue is
complicated by the fact that one may talk of institutions that govern organizations and the
organization as an institution.
 Difference Between Organization and Institution

Organization means a systematically organized collection of people, with a common goal

and identity associated with an external environment, like a business entity or a government
department. It is often misconstrued with the institution, which encompasses an entity, with
a high degree of sustainability, that can be seen as an indispensable part of the large society
or community.

The term institution is commonly used for the place of knowledge, i.e. an entity which
delivers information or imparts education to those who need it. On the other hand, an
organization can be any entity established to fulfil the commercial, social, political or some
other purpose.

Definition of Organization

An organization is used to mean a group of people, engaged in chasing the predetermined

goals or set of goals. Indeed, it is a social system that ascertains all formal relations between
the activities and the members.

An organization is owned and controlled by one person or a group, who are the members, of
the organization itself. The head of the organization is chosen either on a permanent or
temporary basis, through voting at the annual general meeting, in which all the members of
the organization participate.
It incorporates specialization and coordination of activities of the workers, wherein the roles,
responsibilities and authority are assigned to the members, to undertake tasks efficiently. It
includes both profit and non-profit undertaking. There are two types of organization
structure:

1. Formal Organization Structure

 Line Organization
 Functional Organization
 Line and Staff Organization
 Project Management Organization
 Matrix Organization.
2. Informal Organization Structure

Definition of Institution

The term institution can be defined as a receptive organization, which comes into being as a
result of social needs and pressures. It is a portion of a large society or community, which is
forward looking in nature.

It performs those functions and activities that add value to the public at large. It has a high
degree of endurance that leads to constant growth, ability to survive and adapt various
pressures and pulls in order to move towards the future along with the effect on the
environment to which the institution belongs.

The internal structures of the institution exhibit and protects the frequently held norms and
values of the society. It plays the role of change inducing and change protecting agent, that
protects positive values and create new ones that are required for the sustenance of the
society.

Comparison Chart
 BASIS FOR
ORGANIZATION INSTITUTION
COMPARISON

Meaning An organization is an assemblage of An institution is described a form

people who unite to undertake a of organization, which is set up for
common goal, led by a person or a an educational, religious, social or
group thereon. professional cause.

Administration Centralized or Decentralized Decentralized

Governing factor Rules and Regulations Customs and Values

Existence It has a life cycle. It is long lasting.

Purpose To earn money, or provide service to To deliver knowledge to the

the members etc. people.

Conclusion

All the institutions are organizations first, as it is the initial step of the institution building
process. There are only a handful of organizations, that survive, grow and adapt themselves
to reach the status of the institution. The basic objective of an organization is to maintain the
internal order of the organization along with the effectiveness in the achievement of desired
ends. However, when it comes to the institution, it goes beyond the goals of the organization.
 LECTURE-4

THE BEHAVIOURAL ASSUMPTIONS IN A THEORY OF INSTITUTIONS

Behavioural assumptions of economics accurately reflect human behaviour, they

do (mostly) believe that such assumptions are useful for building models of market
behaviour in economics and, though less useful, are still the best game in town for studying
politics and the other social sciences.

Modification of these assumptions is essential to further progress in the social

sciences. More controversial (and less understood) among the behavioural assumptions,
usually, is the implicit one that the actors possess cognitive systems that provide true
models of the world about which they make choices or, at the very least, that the actors
receive information that leads to convergence of divergent initial models. Individuals make
choices based on subjectively derived models that diverge among individuals and the
information the actors receive is so incomplete that in most cases these divergent
subjective model show no tendency to converge. Only when we understand these
modifications in the behaviour of the actors can we make sense out of the existence and
structure of institutions and explain the direction of institutional change.

EXPECTED UTILITY THEORY, which is the underlying behavioural assumption

of neoclassical economics. As a theory of individual behaviour, the expected utility model
shares may of the underlying assumption of standard consumer theory. In each case we
assume that the objects of choice, either commodity bundles or lotteries, can be
unambiguously and objectively described, and that situations, which ultimately imply the
same set of availabilities (e.g the same budget set) will lead to the same choice. In each case
we also assume that the individual is able to perform the mathematical operations
necessary to actually determine the set of availabilities, e.g. to add up the quantities in
different size containers or calculate the probabilities of compound or conditional
events. Finally, in each case we assume that preferences are TRANSITIVE, so that if an
individual prefers one object (either a commodity bundle or a risky prospect) to a second, and
prefers this second object to a third, he or she will prefer the first object to the third.
(Machina, 1987)
 This approach has come under severe attack and also has found strong defenders. The
severe attack has come from experimental economic methods, research by psychologists.
Briefly, these fall into the following categories; violations of the transitivity assumptions;
framing effects, where alternative means of representing the same choice problem can yield
different choices; preference reversals, where the ordering of objects on the basis of their
reported valuations contradicts the ordering implied indirect choice situations; and problems
in the formulation, manipulation, and processing of subjective probabilities in uncertain
choices.

Sidney Winter. He argues that there are seven steps to what he calls the classic defense of
neoclassical behavioural assumptions. They are;

1. The economic world is reasonably viewed as being in equilibrium.

2. Individual economic actors repeatedly face the same choice situations or a sequence
of very similar choices.
3. The actors have stable preference and thus evaluate the outcomes of individual
choices according to stable criteria.
4. Given repeated exposure, any individual actor could identify and would seize any
available opportunity for improving outcomes and, in the case of business firms,
would do so on the pain of being eliminated by competition.
5. Hence no equilibrium can arise in which individual actors fail to maximize their
preferences.
6. Because the world is in approximate equilibrium, it exhibits at least approximately
the patterns employed by the assumptions that the actors are maximizing.
7. The details of the adaptive process are complex and probably actor and situation
specific. By contrast, the regularities associated with optimization equilibrium are
comparatively simply; considerations of parsimony, therefore, dictate that the way of
progress in economic understanding is to explore these regularities theoretically and
to compare the results with other observations.

To explore the deficiencies of the rational choice approach as it relates to institutions,

we must delve into two particular aspects of human behaviour (1) motivation and (2)
deciphering the environment. Human behaviour appears to be more complex than that
embodied in the individual utility function of economist’s models. Many cases are ones not
simply of wealth – maximising behaviour but of altruism and of self-imposed constraints,
which radically change the outcomes with respect to the choices that people actually make.
Similarly, we find that people decipher the environment by processing information
through pre-existing mental constructs through which they understand the environment
and solve the problems they confront. Both the computational abilities of the players and the
complexity of the problems to be solved must be taken into account in understanding the
issues.

In recent years the work of sociobiologists and economists has been combined to
explore the many parallels between the underlying features of genetic survival and
evolutionary development among animals and similar patterns of behaviour among
human beings. Many economists have found that this approach is not only congenital, but
that it also reveals a great deal about human behaviour.

Socioeconomic evolution mainly concerns the differential growth and survival of

patterns of social organization. The main inheritance element is the deadweight of social
inertia supported by intentionally taught tradition. As for variation, there are analogues to
mutations (copying errors as we learn traditions). Also, natural selection is still effective.
Finally, imitation and rational thought constitute additional non-genetic sources of
socioeconomic variation.

Reputation, trust and other aspects of human behaviour that on the surface
appear to be altruistic and not consistent with individual wealth-maximization turn out
to be superior survival traits under certain circumstances.

Thus, we can build more elaborate models of complex human behaviour within the
individual expected- utility model, incorporating certain aspects of altruism. Free-riding,
fairness, and justice enter the utility function and do not necessarily fit neatly with the
maximising postulates in the narrow sense just described.

The evidence we have with respect to ideologies, altruism, and self-imposed

standards of conduct suggests that the trade-off between wealth and these other values
is a negatively sloped function. That is, where the price to individuals of being able to
express their own values and interests is low, they will loom large in the choice made; but
where the price one pays for expressing one’s own ideology, or norms, or preferences is
extremely high, they will account much less for human behaviour (Nelson and Silberberg,
1987)
 The second crucial element in our understanding human behaviour is
deciphering the environment. The issue plays little or no role in the standard economists’
repertoire, although Lucas (1986) acknowledges that one does not get the consequences of
rational expectation models without learning on the part of the players and indeed without
the implication of stable equilibria and competition (the implication Winter derives), so that
the choices and the alternatives become clearly known.

It is the existence of an imbedded set of institutions that has made it possible for us not to
have to think about problems or to make such choices. We take them for granted, because the
structure of exchange has been institutionalized in such a way as to reduce uncertainty. As
soon as we move away from choices involving personal and repetitive actions to making
choices involving impersonal and non-repetitive exchanges the uncertainty about outcomes
increases. The more complex and unique the issues we confront, the more uncertain the
outcome.

Simon’s statement captures the essence of why, in my view, the subjective and incomplete
processing of information plays a critical role in decision making. It accounts for ideology,
based upon subjective perceptions of reality, playing a major part in human beings choices.

It brings into play the complexity and incompleteness of our information and the fumbling
efforts we make to decipher it. It focuses on the need to develop regularized patterns of
human interaction in the face of such complexities, and it suggests that these regularized
interactions we call institutions may be very inadequate or very far from optimal in any sense
of the term. In short, such a way of looking at how human beings proceed is consistent with
the arguments about the formation of institutions.

In “The Origins of Predictable Behaviour” (1983), Ronald Heiner makes many of the
same points. He argues that the gap between the competence of the agent in deciphering
problems and the difficulty in selecting the most preferred alternatives, what he calls of
CD gap, is a major key to the way in which human beings behave. His essay is based upon
the simple notion that the greater that gap, the more likely the agents will impose
regularized and very limited patterns of response to be able to deal with the complexities
and uncertainties associated with that gap. Heiner argues, indeed, that this uncertainty not
only products predictable behaviour but is the underlying source of institutions.

1. For some purposes the concept of equilibrium is a valuable tool of analysis, but for
most of the issues that we are concerned with there is not one equilibrium, but
 multiple equilibria that arise because “there is a continuum of theories that agents
can hold and act on without ever encountering events which lead them to change their
theories” (Hahn, 1987)
2. Although individual actors face many repetitious situations and, as noted above, can
act rationally in such situations, they also are confronted with many unique and
non-repetitive choices where the information is incomplete and where outcomes
are uncertain.
3. Although becker and Stigler have made an impressive case (1977) for relative price
changes accounting for may apparent changes in preferences, the stability issue is not
so easily dismissed. Not only do anomalies show up at the disaggregated level at
which psychological research has been conducted, but certainly historical evidence
suggests that preferences over time change. I know of no way to explain the demise
of slavery in the nineteenth century that does not take into account be changing
perception of the legitimacy of one person owning another.
4. Actors would certainly like to improve outcomes, but the information feedback
may be so poor that the actor cannot identify better alternatives
5. Competition may be so muted and the signals so confused that adjustment may
be slow or misguided and the classic evolutionary consequences may not obtain for
very long periods of time
6. The condition of the world throughout history provides over whelming evidence of
much more than simple rational non cooperative behaviour
7. The behavioural assumptions of economists are useful for solving certain
problems. They are inadequate to deal with many issues confronting social
scientists and are the fundamental stumbling block preventing an understanding
of the existence, formation, and evolution of institutions.

A precise and tidy behavioural model that no only explained why institutions are a
necessary extension of the way human beings process information, but also predicted the
complex mix of motivations that shape choices. We have made progress toward doing so;
indeed enough to explain the existence of institutions and (less precisely) the motivation
of the actors that helps to shape institutions and provides the means by which altruism
and other non-wealth-maximising values enter the choice set.

Institutions exist to reduce the uncertainties involved in human interaction. These

uncertainties arise as a consequence of both the complexity of the problems to be solved and
the problem solving software (to use a computer analogy) possessed by the individual. There
is nothing in the above statement that implies that the institutions are efficient.

Uncertainties arise from incomplete information with respect to the behaviour of other
individuals in the process of human interaction. The computational limitations of the
individual are determined by the capacity of the mind to process, organize, and utilize
information. From this capacity taken in conjunction with the uncertainties involved in
deciphering the environment, rules and procedures evolve to simplify the process. The
consequence institutional framework, by structuring human interaction, limit the choice set of
the actors.

In a strict sociobiological model, maximising survival potential motivates the actor. Such
motivation sometimes, but no always, coincides with wealth-maximising behaviour. The
complexity of the environment, given the limited processing ability of the actor, can explain
the subjective perceptions of reality that characterize human understanding and even the
sense of fairness or unfairness that the individual feels about the institutional environment

The broad range of human actions characterized by such activities as the anonymous
free donation of blood, the dedication to ideological causes such as communism, the deep
commitment to religious precepts, or even the sacrificing of one’ s life for abstract causes
could all be dismissed (as many neoclassical economists dismiss them) if they were isolated
events. But obviously they are not and they must be taken into account if we are to advance
our understanding of human behaviour.
 INFORMAL CONSTRAINTS

In all societies from the most primitive to the most advanced, people impose constraints
upon themselves to give a structure to their relations with others. Under conditions of
limited information and limited computational ability, constraints reduce the costs of
human interaction as compared to a world of no institutions. However, it is much easier
to describe and be precise about the formal rules that societies devise than to describe and
be precise about the informal ways by which human beings have structured human
interaction.

Formal rules, in even the most developed economy, make up a small (although very
important) part of the sum of constraints that shape choices. In our daily interaction with
others, whether within the family, in external social relations, or in business activities, the
governing structure is overwhelmingly defined by codes of conduct, norms of behavior,
and conventions. Underlying these informal constraints are formal rules, but these are
seldom the obvious and immediate source of choice in daily interactions.

Informal constraints come from? They come from socially transmitted information
and are a part of the heritage that we call culture. Culture can be defined as the
"transmission from one generation to the next, via teaching and imitation, of knowledge,
values, and other factors that influence behavior" (Boyd and Richerson, 1985, p. z). Culture
provides a language-based conceptual framework for encoding and interpreting the
information that the senses are presenting to the brain.

Cultural filter provides continuity so that the informal solution to exchange problems in
the past carries over into the present and makes those informal constraints important sources
of continuity in long-run societal change.

Bates then describes the deterring effects that both compensation among the tribe and the
threat of feud posed for preserving order. He shows how this cooperative solution makes
sense in game theoretic terms. A one-shot prisoner's dilemma problem, where it would
appear that the players must arrive at a violent solution with the result that each family is
worse off, is avoided. Instead an iterated game is played, and with the threat of feud it is
in the interests of the parties to preserve order and hence not to pursue interfamily
cattle raiding. The critical point here is that it is the members of the family themselves who
prevent other family members from engaging in raiding, because a feud, once started, would
be harmful to all member.
 The extensive literature that anthropologists have produced on primitive societies makes
clear that exchange in tribal societies is not simple. In the absence of the state and formal
rules, a dense social network lead to the development of informal structures with
substantial stability.

Several implications are clear from this review of work by Colson and other
anthropologists. Order in the societies they describe is the result of a dense social network
where people have an intimate understanding of each other and the threat of violence is a
continuous force for preserving order because of its implications for other members of
society. Deviant behavior cannot be tolerated in such a situation, because it is a
fundamental threat to the stability and insurance features of the tribal group

Richard Posner's model of primitive society (1980), which generates an explanation of

many institutional features of such societies, is similar to the one I develop here (although
mine has none of the maximizing social wealth or efficiency implications that are explicit in
Posner's work. In Posner's model, high information costs, the absence of effective govern-
ment, limited numbers of goods and limited trade, limited food preservation, and
negligible gains from innovation produce a set of common characteristics:

Arising to coordinate repeated human interaction, they are (1) extensions, elaborations,
and modifications of formal rules, (2) socially sanctioned norms of behavior, and (3)
internally enforced standards of conduct.

1. In a study of the institutional foundations of committee power Shepsle and Weingast

(1987) demonstrate that the power of congressional committees that is not explained
by the formal rules is a result of a set of informal unwritten constraints that have
evolved in the context of repeated interaction (exchange) among the players.
2. Robert Axelrod (1986) provides a vivid illustration of a socially sanctioned norm of
behavior. The night before he was to engage in a duel with Aaron Burr, Alexander
Hamilton sat down and wrote out all the reasons why he should not accept this
challenge; a crucial one, of course, was that he was likely to get killed. Yet, in spite of
the overwhelming rational bases for not dueling, he felt that his effectiveness in tile
public arena would be significantly diminished by such a decision because dueling
was the accepted way to settle disputes among gentlemen. Social norms dictated the
choice, not formal rules.
 3. Both of the first two types of informal constraints can be modeled in the context of
wealth-maximizing models and therefore lend themselves to treatment in neoclassical
(and game theory) frameworks. But internally enforced codes of conduct only have
meaning in terms of informal constraints, altering choices when the individual gives
up wealth or income for some other value in his or her utility function. Numerous
essays explore voting behavior by legislators and conclude that one- cannot ex-
plain legislative voting behavior by an interest group model (in which the
legislator faithfully mirrors the interests of his or her constituents), but must
take into account the subjective, personal preferences of the legislator (Kali and
Zupan, i984).)

Conventions that solve coordination problem: “These are rules that have never been
consciously designed and that is in everyone’s interest to keep. The important characteristic
of conventions is that, given the costs of exchange (Chapter 4), both parties have a stake in
minimizing the costliness of measurement and the exchanges are self-enforcing. In terms of
the total resources that go into transacting in an economy, conventions that solve coordination
probably account for a larger proportion of the costs of transacting than the other informal
constraints

Informal constraints can take the form of agreed upon lower cost forms of measurement
(standardized weights and measures, for example) and make second- and third-party
enforcement effective by specific sanctioning devices or information networks that acquaint
third parties with exchange performance (credit ratings, better business bureaus, etc.). Such
organizations and instruments that make norms of cooperative behavior (informal constraints)
effective are not only a major part of the story of more complex exchange through history,
but are strikingly paralleled by the game theoretic models that produce cooperative
outcomes through features that alter discount rates and increase information.

Much more difficult to deal with in theoretical terms than wealth maximizing informal
constraints are internally enforced codes of conduct that modify behavior. It is difficult
because one must devise a model that predicts choices in the context of the trade-off
between wealth and other values. But strong religious beliefs or commitment to
communism, for example, provide us with historical accounts of the sacrifices individuals
have made for beliefs. As noted earlier, experimental economics provides evidence that
individuals do not always free-ride and a study by Frank (1988) provides both a large body of
evidence and a model of such behavior)

The literature cited above and the earlier chapter of this book dealing with" human
behavior make clear that motivation is more complicated than the simple expected utility
model. Chapter 3 also emphasized that under certain conditions traits like honesty, integrity,
and living up to a reputation pay off in strictly wealth-maximizing terms. Still
unexplained is a very large residual. We simply do not have any convincing theory of the
sociology of knowledge that accounts for the effectiveness (or ineffectiveness) of organized
ideologies or accounts for choices made when the payoffs to honesty, integrity, working hard,
or voting are negative

Margolis's argument is that individuals possess not one but two utility functions: S
preferences are governed by the usual self-interest preference function, whereas G
preferences are purely social (group interested)

In the short run, culture defines the way individuals process and utilize information and
hence may affect the way informal constrains is get specified. Conventions are culture
specific, as indeed are norms.

Even if we do not possess a good explanation for social norms, we can model wealth-
maximizing norms in a game theoretic context. That is, we can explore and test, empirically,
what sorts of informal constraints are most likely to produce cooperative behavior or how
incremental changes in such informal constraints will alter the game to increase (or decrease)
cooperative outcomes

The importance of self-imposed codes of behavior in constraining maximizing behavior

in many contexts also is evident. Our understanding of the source of such behavior is
deficient, but we can frequently measure its significance in choices by empirically
examining marginal changes in the cost of expressing convictions. Such analysis opens
the door to explaining the power of subjective perceptions in affecting choices. If the
demand function is negatively sloped (i.e., the lower the cost of expressing one's
convictions the more important will the convictions be as a determinant of choice) and
formal institutions make it possible for individuals to express preferences at little cost to
themselves, then indeed the subjective preferences that individuals hold play a big part
in determining choices. Voting, hierarchies that produce slack in the principal/agent
relationship in legislatures, and lifetime tenure for judges are formal institutional constraints
that lower the cost of acting on one's convictions.

We seldom know much about the elasticity of the function or shifts in the function, but
we do have abundant evidence that the function in negatively sloped and that the price
incurred for acting on one’s convictions is frequently very low (and hence convictions are
significant) in many institutional settings.

Cultural traits have tenacious survival ability and that most cultural changes are
incremental. Equally important is the fact that the informal constraints that are
culturally derived will not change immediately in reaction to changes in the formal
rules. As a result the tension between altered formal rules and the persisting informal
constraints produces outcomes that have important implications for the way economics
change.
 Formal Constraints

Envision a continuum from taboos, customs, and traditions at one end to written
constitutions at the other. The move, lengthy and uneven, from unwritten traditions and
customs to written laws has been unidirectional as we have moved from less to more
complex societies and is clearly related to the increasing specialization and division of
labour associated with more complex societies

The increasing complexity of societies would naturally raise the rate of return to the
formalization of constraints (which became possible with the development of writing), and
technological change tended to lower measurement costs and encourage precise,
standardized weights and measures. The creation of formal legal systems to handle more
complex disputes entails formal rules; hierarchies that evolve with more complex

Formal rules can complement and increase the effectiveness of informal constraints.
They may lower information, monitoring, and enforcement costs and hence make informal
constraints possible solutions to more complex exchange (see Milgrom, North, and Weingast,
1990, and Chapter 7 for elaboration). Formal rules also ‘may be enacted to modify, revise,
or replace informal constraints.

Formal rules include political (and judicial) rules, economic rules and contracts. The
hierarchy of such rules, from constitutions, to statute and common laws, to specific bylaws,
and finally to individual contracts defines constraints, from general rules to particular
specifications. And typically constitutions are designed to be more costly to alter than statute
laws, just as a statute law is more costly to alter than individual contracts. Political rules
broadly define the hierarchical structure of the polity, its basic decision structure, and the
explicit characteristics of agenda control. Economic rules define property rights that is the
bundle of rights over the use and the income to be derived from property and the ability to
alienate an asset or a resource. Contracts contain the provisions specific to a particular
agreement in exchange.

Given the initial bargaining strength of the decision-making parties, the function of rules
is to facilitate exchange, political or economic. Exchange involves bargains made within
the existing set of institution, but equally the players at times find it worthwhile to devote
resources to altering the more basic structure of the polity to reassign rights.
 Rules that implies efficiency. As stressed above, rules are, at least in good part, devised
in the interests of private wellbeing rather than social well-being. Hence, rules that deny
franchise, restrict entry, or prevent factor mobility are everywhere evident.

Rules are generally devised with compliance costs in mind, which means that methods
must be devised to ascertain that a rule has been violated, to measure the extent of the
violation (and consequent damages to the party to exchange), and to apprehend the violator.
The costs of compliance include measuring the multiple attributes of the goods or
services being exchanged and measuring the performance of agents. In many cases, the
costs of measurement, given the technology of the time, exceed the gains, and rules are not
worth devising and ownership rights are not delineated. Changes in technology or relative
prices will alter the relative gains from devising rules.

In equilibrium, a given structure of property rights (and their enforcement) will be

consistent with a particular set of political rules (and their enforcement). Changes in
one will induce changes in the other.

We start with a simplified model of a polity made up of a ruler and constituents. In such a
simple setting, the ruler acts like a discriminating monopolist, offering to different
groups of constituent’s protection and justice or at least the reduction of internal
disorder and the protection of property rights in return for tax revenue. Because
different constituent groups have different opportunity costs and bargaining power
with the ruler, different bargains result. But there are also economies of scale in the
provision of these (semipublic) goods of law and enforcement. Hence, total revenue is
increased, but the division of incremental gains between ruler and constituents depends
on their relative bargaining power; changes at the margin, either the violence potential
of the ruler or the opportunity costs of the constituent, will result in redivisions of the
incremental revenue. Moreover the ruler's gross and net revenue differ significantly as a
result of the necessity of developing agents (a bureaucracy) to monitor, meter, and collect the
revenue. All the consequences inherent to agency theory obtain here.

This model of the polity becomes one step more complicated when we introduce the
concept of a representative body reflecting the interests of constituent groups and their role
in bargaining with the ruler. This concept, consistent with the origin of parliaments, estates
general, and tortes in early modern Europe, reflects the needs of the ruler to get more
revenue in exchange for which he or she agrees to provide certain services to constituent
groups. The representative body facilitates exchange between the parties. On the ruler's
side, this leads to the development of a hierarchical structure of agents, which is a major
transformation from the simple (if extensive) management of the king's household and estates
to a bureaucracy monitoring the wealth and/or income of the king's constituents.

When we move from the historical character of representation in early modern Europe
to modern representative democracy, our story is complicated by the development of multiple
interest groups and by a much more complicated institutional structure devised to facilitate
(again given relative bargaining strength) the exchange between interest groups. This
political transaction cost analysis is built on the recognition of the multiplicity of
interest groups reflecting concentrations of voters in particular locations.

Vote-trading or logrolling. This approach was a step forward in recognizing the way
by which legislators can strike bargains that facilitate exchange; however, it is too simple to
solve fundamental problems involved in legislative exchange. It assumes that all bills and
payoffs were known in advance, and it has a timeless dimension to it. In fact, a variety of
exchanges arise in which today's legislation can only be enacted by commitments made for a
future date. To lower the costs of exchange, it was necessary to devise a set of institutional
arrangements that would allow for exchange over space and time.

How does credible commitment evolve to enable agreements to be reached when the
payoffs are in the future and on completely different issues? Self-enforcement is important
in such exchange, and in repeat dealings a reputation is a valuable asset. But as in economic
exchange, the costs of measurement and enforcement, discovering who is cheating
whom, when free-riding will occur, and who should bear the cost of punishing defectors
make self-enforcement ineffective in many situations. Hence political institutions
constitute ex ante agreements about cooperation among politicians. They reduce uncertainty
by creating a stable structure of exchange. The result is a complicated system of
committee structure, consisting of both formal rules and informal methods of orga-
nization.

The existence of efficient economic markets entails competition so strong that, via ar-
bitrage and information feedback, one approximates the Coase zero transaction cost
conditions. Such markets are scarce enough in the economic world and even scarcer in the
political world). It is true that the move toward a democratic polity will reduce legislative
transaction costs per exchange (as elaborated by Weingast and Marshall, 1988), but only
will the number of exchanges increase so that the size of the total political transaction
sector will grow, the agency costs between constituent and legislator and legislator and
bureaucrat will be substantial. Moreover, rational ignorance on the part of constituents
is going to increase the role, in many situations, of incomplete subjective perceptions
playing an important part in choice.

As a first approximation we can say that property rights will be developed over resources
and assets as a simple cost-benefit calculus of the costs of devising and enforcing such rights,
as compared to the alternatives under the status quo. Changes in relative prices or relative
scarcities of any kind lead to the creation of property rights when it becomes worthwhile to
incur the costs of devising such rights

In North (1981), I revised the 1973 argument to account for the obvious persistence of
inefficient property rights. These inefficiencies existed because rulers would not antagonize
powerful constituents by enacting efficient rules that were opposed to their interests or
because the costs of monitoring, metering, and collecting taxes might very well lead to a
situation in which less efficient property rights yielded more tax revenue than efficient
property rights. This argument is an improvement over the efficiency argument but needs
amplification.

The efficiency of the political market is the key to this issue. If political transaction costs
are low and the political actors have accurate models to guide them, then efficient property
rights will result. But the high transaction costs of political markets and subjective
perceptions of the actors more often have resulted in property rights that do not induce
economic growth, and the consequent organizations may have no incentive to create
more productive economic rules. At issue is not only the incremental character of
institutional change, but also the problem of devising institutions that can provide credible
commitment so that more efficient bargains can be struck.

The rules descend from polities to property rights to individual contracts. Contracts
will reflect the incentive-disincentive structure imbedded in the property rights
structure (and the enforcement characteristics); thus the opportunity set of the players
and the forms of organization they devise in specific contracts will be derived from the
property rights structure.

The contract in modern complex economies both is multidimensional and extends over
time. Because there are multiple dimensions, with respect both to the physical
characteristics and to the property rights characteristics of the exchange, of necessity the
result is that one must spell out many of the provisions. Moreover, the contract will typically
be incomplete, in the sense that there are so many unknowns over the life of contracts
extending over time that the parties will (deliberately) leave to the courts or to some third
party the settlement of disputes that arise over the life of the contract.

The contracts will reflect different ways to facilitate exchange, whether through
firms, franchising, or other more complex forms of agreement that extend in a
continuum from straightforward market exchange to vertically integrated exchange.

Explicit rules provide us with a basic source of empirical materials by which to test
the performance of economies under varying conditions, the degree to which these rules
have unique relationships to performance is limited. That is, a mixture of informal
norms, rules, and enforcement characteristics together defines the choice set and results
in outcomes. Looking on!), at the formal rules themselves, therefore, gives us an
inadequate and frequently misleading notion about the relationship between formal
constraints and performance.
 LECTURE-5

INSTITUTIONS, ECONOMIC THEORY AND ECONOMIC PERFORMANCE

Do institutions matter? Do tariffs, regulations, and rules matter? Does government

make a difference?

(i) Specify what changes must be made in neoclassical theory to incorporate

institutional analysis into that theory,
(ii) Outline the implications for the static analysis of economic performance, and
(iii) Explore the implications of institutional analysis for the construction of a dynamic
theory of long-run economic change.

The instrumental rationality postulate of neoclassical theory assumes the actors

possess information necessary to evaluate correctly the alternatives and in consequence make
choices that will achieve the desired ends. In fact, such a postulate has implicitly assumed the
existence of a particular set of institutions and information. If institutions play a purely
passive role so that they do not constrain the choices of the actors and the actors are in
possession of the information necessary to make correct choices, then the instrumental
rationality postulate is the correct building block. If, on the other hand, the actors are
incompletely informed, devise subjective models as guides to choices, and can only very
imperfectly correct their models with information feedback, then a procedural rationality
postulate is the essential building block to theorizing.

The former postulate evolved in the context of the highly developed, efficient
markets of the Western world and has served as a useful tool of analysis in such a context.
But those markets are characterized by the exceptional condition of low or negligible
transaction costs. I know of no way to analyse most markets in the contemporary world and
throughout history with such a behavioral postulate. A procedural rationality postulate, on
their hand, not only can account for the incomplete and imperfect markets that characterize
much of the present and the past world, but also leads the researcher to the key issues of just
what it is that makes markets imperfect. That leads us to the costs of transacting.

The costs of transacting arise because information is costly and asymmetrically

held by the parties to exchange and also because any way that the actors develop
institutions to structure human interaction results in some degree of imperfection of the
markets. In effect the incentive consequences of institutions provide mixed signals to
the participants, so that even in those cases where the institutional framework is
conducive to capturing more of the gains from trade as compared to an earlier institu-
tional framework, there will still be incentives to cheat, free ride, and so forth that
will contribute to market imperfections. Given the behavioural characteristics of-
human beings, there is simply no way to devise institutions that solve the complex
exchange problems and at the same time are free of some incompatible incentives. As
a result, much of the recent literature of industrial organization and political economy
has attempted to come to grips with incentive incompatibility in economic and
political organization. The success stories of economic history describe the
institutional innovations that have lowered the costs of transacting and permitted
capturing more of the gains from trade and hence permitted the expansion of markets.
But such innovations, for the most part, have not created the conditions necessary
for the efficient markets of the neoclassical model. The polity specifies and enforces
the property rights of the economic marketplace, and the characteristics of the political
market are the essential key to understanding the imperfections of markets.

What would make the political market approximate the zero transaction
cost model for efficient economic exchange? The condition is easily stated.
Legislation would' be enacted which increased aggregate income and in which the
gainers compensated losers at a transaction cost that is low enough to make it jointly
worthwhile. The informational and institutional conditions necessary to realize such
exchange are:

1. The affected parties must have the information and correct model to know that
the bill affects them and to know the amount of gains or losses they would
incur.
2. The results can be communicated to their agent (the legislator) who will
faithfully vote accordingly.
3. Votes will be weighted by the aggregate net gains or losses so that the net result
can be ascertained and the losers appropriately compensated.
4. This exchange can be accomplished at a low enough cost of transacting to
make it worthwhile.
 The institutional structure most favourable to approximating such conditions is
a modern democratic society with universal suffrage. Vote trading, logrolling, and
the incentive of an incumbent's to bring his or her deficiencies before constitutions and
hence reduce agency problems all contribute to better outcomes.

For my purpose, it is necessary to emphasize two essential conditions that

loom large. They are that the affected parties have both the information and the
correct model to accurately appraise the consequences and that all the affected
parties have equal access to the decision-making process. These conditions are not
even approximately met in the most favourable institutional framework in all of
history for efficient political decision making.

Because polities make and enforce economic rules, it is not surprising that
property rights are seldom efficient. But even when efficient property rights are
devised, they will still typically have features that will be very costly to monitor or
enforce, reflecting built-in disincentives or at the very least aspects of the exchange
that provide temptation to renege, shirk, steal, or cheat. In many cases informal
constraints will evolve to mitigate these disincentive consequences.

The consequences of institutions for contemporary economic analysis can

be summarised as follows:

1. Economic (and political) models are specific to particular constellation of

institutional constraints that vary radically both through time and cross sectionally in
different economies. The models are institution specific and in many cases highly
sensitive to altered institutional constraints. A self-conscious awareness of these
constraints is essential both for improved theory construction and for issues of public
policy. It is not just how well would the model play in Bangladesh or in the United
States during the nineteenth century, but much more immediately, how would it play
in another developed country like Japan or even in the United States next year?

Even more important is that the specific institutional constraints dictate the
margins at which organizations operate and hence make intelligible the interplay
between the rules of the game and the behavior of the actors. If organizations firms,
trade unions, farm groups, political parties, and congressional committees to name a
few devote their efforts to unproductive activity, the institutional constraints have
provided the incentive structure for such activity. Third World countries are poor
because the institutional constraints define set of payoffs to political/economic
activity that do not encourage productive activity. Socialist economies are just
beginning to appreciate that the underlying institutional framework is the source of
their current poor performance and are attempting to grapple with ways to restructure
the institutional framework to redirect incentives that in turn will direct organizations
along productivity-increasing paths. And as for the first world, we not only need to
appreciate the importance of an overall institutional framework that has been re-
sponsible for the growth of the economy, but to be self-conscious about the
consequences of the ongoing marginal changes that are continually occurring not only
on overall performance but a so on specific sectors of the economy. We have long
been aware that the tax structure, regulations, judicial decisions, and statute laws,
to name but a few formal constraints, shape the policies of firms, trade unions,
and other organizations and hence determine specific aspects of economic
performance; but such awareness has not led to a focusing of economic theory on
modelling the political/economic process that produces these results.

2. Our preoccupation with rational choice and efficient market hypotheses has
blinded us to the implications of incomplete information and the complexity of
environments and subjective perceptions of the external world that individuals hold.
There is nothing the matter with the rational actor paradigm that could not be cured by
a healthy awareness of the complexity of human motivation and the problems that
arise from information processing. Social scientists would then understand of only
why institutions exist, but also how they influence outcomes.

3. Ideas and ideologies mater, and institutions play a major role in

determining just how much they matter. Ideas and ideologies shape the subjective
mental constructs that individuals use to interpret the world around them and make
choices. Moreover, by structuring the interaction of human beings in certain
ways, formal institutions affect the price we pay for our actions, and to the degree
the formal institutions are deliberately or accidentally structured to lower the price of
acting on one's ideas, they provide the freedom to individuals to incorporate their
ideas and ideologies into the choices they make. A key consequence of formal in-
stitutions is mechanisms, like voting systems in democracies or organizational
structures in hierarchies, that enable individuals who are agents to express their own
views and to have a very different impact upon outcomes than those implied by the
simple interest-group modelling that has characterized so much of economic and
public choice theory.

4. The polity and the economy are inextricably interlinked in any understanding of
the performance of an economy and therefore we must develop a true political economy
discipline. A useful model of the macro aspect or even micro aspects of an economy must
build the institutional constraints into the model. Modern macroeconomic theory, for
example, will never resolve the problems that it confronts unless its practitioners recognize
that the decisions made by the political process critically affect the functioning of
economies. Although at an adhoc level we have begun to recognize this, much more
integration of politics and economics than has been accomplished so far is needed. This can
only be done by a modeling of the political-economic process that incorporates the specific
institutions involved and, the consequent structure of political and economic exchange.

Path dependence is the key to an analytical understanding of long-run economic

change. The promise of this approach is that it extends the most constructive building
blocks of neoclassical theory both the scarcity/competition postulate and incentives as
the driving force but modifies that theory by incorporating incomplete information and
subjective models of reality and the increasing returns characteristic of institutions. The
result is an approach that offers the promise of connecting micro level economic activity
with the macro level incentives provided by the institutional framework. The source of
incremental change is the gains to be obtained by organizations and their entrepreneurs from
acquiring skills, knowledge, and information that will enhance their objectives. Path
dependence comes from the increasing returns mechanisms that reinforce the direction once
on a given path. Alterations in the path come from unanticipated consequences of choices,
external effects, and sometimes forces exogenous to the analytical framework. Reversal
of paths (from stagnation to growth or vice versa) may come from the above described
sources of path alteration, but will typically occur through changes in the polity.

The background

England had developed a relatively centralized feudalism. Spain, in contrast,

had just emerged from seven centuries of Moorish domination of the Iberian Pen-
insula. It was not a unified country both England and Spain faced, in common with the
rest of the emerging. European nation-states, a critical problem: the need to acquire
additional revenue to survive in the face of the rising costs of warfare.

This fiscal crisis of the state, first described by Joseph Schumpeter (1954), forced
rulers to make bargains with constituents. In both countries, the consequence was the
development of some form of representation on the part of constituents (Parliament in
England and the Cortes in Spain) in return for revenue. In both countries, the wool trade
became a major source of crown revenue. But the consequences of the common relative
price change arising from the new military technology were radically different in the two
countries. In one, it led to the evolution of a polity and economy that solved the fiscal crisis
and went on to dominate the Western world. In the other, in spite of initially more
favorable conditions, it led to unresolved fiscal crises, bankruptcies, confiscation of assets,
and insecure property rights and to three centuries of relative stagnation.

In England, the tension between ruler and constituent surfaced with the Magna
Carta in 1815. The fiscal crisis came later with the Hundred Years War. Stubbs describes
the consequence as follows: "The admission of the right of parliament to legislate, to
enquire into abuses, and to share in the guidance of national policy, was practically
purchased by the money granted to Edward I and Edward III." The subsequent history to
1689 and the final triumph of Parliament is well known.

In Spain, the union of Aragon (comprising approximately Valencia, Aragon, and

Catalonia) and Castile joined two very different regions. Aragon had been reconquered
from the Arabs in the last half of the thirteenth century and had become a major
commercial empire extending into Sardinia, Sicily, and parts of Greece. The Cortes
reflected the interests of merchants and played a significant role in public affairs. In
contrast, Castle was continually engaged in warfare, either against the Moors or in internal
strife, and although the Cortes existed it was seldom summoned. In the fifteen years after
their union, Isabella succeeded in gaining control not o1 over the unruly warlike barons,
but over church policy in Castile as well.

The institutional framework

It was not simply centralization or decentralization in the polity that differentiated

the two societies. Nevertheless, this feature made a critical difference and was symptomatic
of the broad differences in both the polity and the economy. Not only did the Parliament in
England provide the beginning of representative government and a reduction in the rent-
seeking behavior that had characterized the financially hard-pressed Stuart monarchs, but
also Parliament's triumph betokened increased security of property rights and a more
effective, impartial judicial system

Spain's polity consisted of a large centralized bureaucracy that "administered the

ever-growing body of decrees and juridical directives, which both legitimized the
administrative machinery and laid down its course of action. The result was bankruptcy,
increased internal taxation, confiscations, and insecure property rights.

The organizational implications

In England, Parliament created the Bank of England and a fiscal system in which
expenditures were tied to tax revenues. More secure property rights, the decline of
mercantilist restrictions. Both the growing markets and the patent law encouraged the
growth of innovative activity. In Spain, repeated bankruptcies between 1557 and 1647 were
coupled with desperate measures to stave off disaster.

Path dependence

To make the contrasting brief stories convincing illustrations of path dependence

would entail an account of the political, economic, and judicial systems of each society as a
web of interconnected formal rules and informal constraints that together made up the
institutional matrix and led the economies down different paths. It would be necessary to
demonstrate the network externalities that limited the actors' choices and prevented them
from radically altering the institutional framework.

The traditional characteristics- patriarchal domination, extended family , low status

of women, tight knit and closed peasant villages, self-sufficiency, and the family as the
work unit all were conspicuously absent by the thirteenth century. Instead, Macfarlane
paints a picture of a fluid, individualistically oriented set of attitudes involving the structure
of the family, the organization of work, and the social relationships of the village
community complemented by an array of formal rules dealing with property, inheritance,
and the legal status of women. Macfarlane wants to make the point that England was
different and that the difference went way back in time, but in doing so he amasses evidence
to make clear the complex interdependent network of formal and informal constraints that
made for the increasing returns characteristic of path dependence. The most telling evidence
of the increasing returns feature of the Spanish institutional fabric was the inability of the
crown and its bureaucracy to alter the direction of the Spanish path in spite of their
awareness of the decay and decline overcoming the county

Both England and Spain faced fiscal crises in the seventeenth century, but the
contrasting paths that they took appear to have reflected deep underlying institutional
characteristics of the societies.

The downstream consequences

U.S. economic history has been characterized by a federal political system, checks
and balances, and a basic structure of property rights that have encouraged the long-term
contracting essential to the creation of capital markets and economic growth. Even one of
the most costly civil wars in all of history failed to alter the basic institutional matrix. Latin
American economic history, in contrast, has perpetuated the centralized, bureaucratic
traditions carried over from its Spanish/Portuguese heritage.

The divergent paths established by England and Spain in the New world have not
converged despite the mediating factors of common ideological influences. In the former, an
institutional framework has evolved that permits the complex impersonal exchange necessary
to political stability and to capture the potential economic gains of modern technology. In the
latter, personalistic relationships are still the key to much of the political and economic
exchange. They are a consequence of an evolving institutional framework that produces
neither political stability nor consistent realization of the potential of modern technology.

Network externality

Network externality has been defined as a change in the benefit, or surplus, that an
agent derives from a good when the number of other agents consuming the same kind of
good changes.

Network externality is an economics term that describes how the demand for a
product is dependent on the demand of others buying that product. In other words, the
buying patterns of consumers are influenced by others purchasing a product.
 The two main types are positive and negative network externalities. The outcomes of
different situations determine whether they are positive or negative

Positive network externalities exist if the benefits (or, more technically, marginal
utility) are an increasing function of the number of other users
 Institutional Change and Economic Performance

All human interactions are characterized by pervasive uncertainty, which

manifests itself in transaction costs to exchange. Institutions are a way to reduce this
uncertainty and make it possible to capture gains from trade. Institutions can be informal
(norms of behaviour, societal codes of conduct) or formal (laws, rules). Both forms
involve enforcement, and as society becomes more complex, the need for third-party
enforcement arises. This role is played by the state/centre with its coercive powers.
A major issue then, becomes the credible commitment by the polity not to abuse its
force. Because institutions are designed by people with different bargaining
strength and not for sake of efficiency, some patterns may be less efficient than
others and due to path dependency they may persist for a long time, resulting
stagnant economy.

The lack of credible commitment by the state not to appropriate property rights
accounts for the inefficient institutions that have evolved in different countries. Such
environment provides disincentives to investment in socially profitable enterprises, and
creates groups with vested interests in maintaining the status quo constraints. The key
to economic efficiency are efficient property rights, which depend on political
efficiency.

Institutions provide the basic structure by which human beings create order and
attempt to reduce uncertainty in exchange. Together with technology employed, they
determine transaction and transformation costs and hence the profitability and
feasibility in engaging in economic activity. The current forms of political, economic,
and military organization and their maximizing directions are derived from the
opportunity set provided by the institutional structure that in turn evolved
incrementally. One gets efficient institutions by a polity which has built-in incentives
to create and enforce efficient property rights.

As indicated already, the institutions are humanly devised constraints that shape
human interactions. They reduce uncertainty by establishing a stable (not necessarily
efficient) structure to human exchange, whether political, social, or economic.
Institutions (together with technology) affect the performance of the economy by their
effect on the costs of exchange and production. Transaction cost in political and
economic markets can result in inefficient property rights and the interaction
between institutions and organizations can produce a lock-in with perverse
feedback that accounts for the persistence of inefficiency. Institutions are not
usually created to be socially efficient; rather, they (at least the formal rules) are
created to serve the interests of those with the bargaining power to devise new
rules. If economies realize the gains from trade by creating efficient institutions, it is
because the circumstances provided incentives for those with bargaining strength to
alter institutions in ways that turn out to be socially efficient.
Institutions have three dimensions:

i. Formal rules
ii. Informal constraints and
iii. Enforcement mechanisms.

i. Formal rules: Formal rules may increase the effectiveness of informal constraints,
modify them, or supersede them. Given the initial bargaining strength of the parties,
rules facilitate exchange. The extent of diversity of interests will influence the rules'
structure. In equilibrium, a given structure of property rights and their enforcement
will be consistent with a particular set of political rules and their enforcement. High
transaction costs in the political market often result in property rights that do not
induce economic growth and organizations that have no incentive to create more
productive economic rules.

ii. Informal constraints: They come from socially transmitted information and are
part of culture. They are not mere extensions of formal rules and will not change
immediately in reaction to such rules. These constraints arise from the need to
structure interaction and reduce uncertainty.

iii. Enforcement Mechanism: There are costs associated with imperfect

enforcement due to (i) costs of measuring contract compliance, and (ii)
enforcement agents having their own utility functions. The inability of societies to
develop effective, low-cost enforcement of contracts is the source of economic
stagnation. The complex contracting that too capture the gains from trade in a
world of impersonal exchange must be accompanied by third-party enforcement.
However, the state with its control of coercive force is not a neutral party. Thus,
the development of credible commitment on the part of political bodies not to
violate contracts is a necessary condition for economic growth.

Why do inefficient institutions persist?

The process of change is immensely incremental (through continuous
marginal adjustment) and the sources of change are changing relative prices or
preferences. Changes in relative prices, such as changes in the ratio of factor
prices, or changes in the cost of information and technology, can be exogenous
(e.g. due to plague) but are mostly endogenous, reflecting the maximizing efforts
of entrepreneurs. Why do inefficient institutions persist? From literature on
evolution of technology we know that it is possible to adopt a technology, which
turns out to be less efficient than the available alternatives. This is due to
i. Multiple equilibria - A number of possible solutions, indeterminate
outcome.
ii. Possible inefficiencies - A better technology loses out due to bad luck in
gaining adherence
iii. Lock-in-once reached - A solution is difficult to exit from, and
iv. Path dependence - the consequence of small events and chance can
determine solutions that lead to a particular path. There are two forces
that shape the path of institutional change:
(i) Increasing returns; and

(ii) Imperfect markets with significant transaction costs.

Path dependence narrows the choice set and links decision making through
time. Unproductive paths can persist because the initial set of institutions can
provide disincentives to productive activity and create interests with a stake in
existing constraints.
 Institutions, Institutional change and Economic performance- Maks Kobonbaev

Economic growth is a function of institutions. North contends that the cumulative of

formal and informal institutions and their enforcement effectiveness is indeed the formula of
development.

North claims that economic growth is not only a function of transformation costs such
as land, labor, and capital (Y=AF(K,L), where A is technology) but it is also a function of
transaction costs. The point is that institutions play a huge role in decreasing or increasing
transaction costs, and therefore in directly and indirectly altering economic production. If
institutions decrease transaction costs, exchange develops and economies progress. If
institutions increase transactions costs, exchange can become impossible because costs are
higher than benefits and therefore economies regress.

North makes his point clear by discussing personal vs. impersonal exchange. Personal
exchanges such as local trade, family production and other small scale forms of exchange
based on informal norm have very low transaction costs because of the lack of third party
enforcement. However, with the growing complexity and specialization of economy, there is
a need for impersonal exchange with third part enforcement. North implies that the shift from
personal exchange toward impersonal exchange distinguishes the modern advanced
economies from the developing world.

However, the implication that personal exchange is conducted via informal norms
does not mean that informal institutions are necessarily inimical to economic growth. Indeed,
it is too costly to enforce formal institutions and therefore self-enforcing informal institutions
play a great role in making exchange viable by reducing measurement and enforcement costs.
North shows that institutions form the incentive structure of a society made of formal and
informal constraints, and thus are the underlying determinants of economic performance.

North’s vantage point is that economies grow when organizations set up institutions
that provide adaptive efficiency, which is concerned with the willingness of a society to
acquire knowledge and learning, to induce innovation, to undertake risk and creative activity
through time. The concept of adaptive efficiency traces as far back as the theory of evolution.
The implication of the theory is that over time inefficient institutions are wedded out,
efficient ones survive, and thus there is a gradual evolutionary convergence of more efficient
and optimal forms of organization. North disagress. He states that though it is true that
institutions evolve over time, there is nothing to ensure the survival of efficient institutions
over time. According to North, there are two forces shaping the path of institutional change.
Increasing returns and imperfect markets characterised by significant transaction costs. In a
world in which there are no increasing returns to institutions and market are
competitive, institutions do not matter. Under these conditions, initial incorrect models of
agents will be eliminated because efficient information feedback will induce agents to
modify their models. According to North, long run economic change is function of short-run
decisions by political and economics entrepreneurs that both directly and indirectly shape
performance. The choices of entrepreneurs reflect their subjective modelling of the
environment and therefore they cannot be perfect. Because of the imperfect subjective
modelling of the environment, inefficient institutions may indeed evolve over time.

Thus, we have both stability and evolution of institutions. STABILITY is accomplished

by a complex set of constraints that include formal rules nested in a hierarchy, where
each level is more costly to change than the previous one. They also include informal
norms that have tenacious survival ability because they have become part of habitual
behaviour. The evolution of institutions can be continuous and discontinuous. By
discontinuous change North means a radical change in the formal rules, usually as a
result of conquest or revolution. Discontinuous change can range from a very simple kind
to what Skocpol (1979) calls political revolutions, in which a restructuring of political
institutions resolves gridlock crises to very complex ones. They key is that entrepreneurs
may form a coalition of groups to break out of the deadlock by strikes, violence and
other means. It is especially the case when entrepreneurs have limited bargaining freedom
and there are no mediating institutions to resolve the problem. It is also important to note that
though formal rules change both incrementally and discontinuously, informal norms
change only incrementally. The change in the formal rules of and stability in the
informal constraints may lead to collision. It is possible that formal rules can supplant
the informal constraints in the partial equilibrium context. The result over time tends to
be a restructuring of the overall constraints.

Institutions link the past with the present and the future and therefore history is an
incremental story of institutional evolution.

However, nothing is perfect and North’s book is not an exception. Firstly, North
provides a general description of institutional change, but he does not provide precise
specifications on how to test rigorously the implications of his analytical models.
Secondly, North attaches too much importance to incremental changes while the real task for
development economists from my point of view is how to initiate non-incremental reforms
in the poor countries.
 LECTURE-6

INSTITUTIONAL CHANGE: A FRAMEWORK OF ANALYSIS

Douglass North
Models may account for most of the differences in performance between economies on
the basis of differential investment in education, savings rates, etc., they do not account for
why economies would fail to undertake the appropriate activities if they had a high payoff.
Institutions determine the payoffs and assumption of a frictionless exchange process has led
economic theory astray. Among the traditional neoclassical assumptions that are relaxed are
those of costless exchange, perfect information, and unlimited cognitive capabilities.

Institutions and Organizations: Definitions and Descriptions

The degree to which there is an identity between the objectives of the institutional
constraints and the choices individuals make in that institutional setting depends on the
effectiveness of enforcement. Enforcement is carried out by the first party (self-imposed
codes of conduct), by the second party (retaliation), and/or by a third party (societal
sanctions or coercive enforcement by the state). Institutions affect economic performance
by determining (together with the technology employed) transaction and transformation
(production) costs.

If institutions are the rules of the game, organizations are the players. They are groups of
individuals engaged in purposive activity. The constraints imposed by the institutional
framework (together with the other constraints) define the opportunity set and therefore
the kind of organizations that will come into existence. Given its objective function--profit
maximization, winning elections, regulating businesses, educating students--the organization
which may be a firm, a political party, a regulatory agency, a school or college, will engage
in acquiring skills and knowledge that will enhance its survival possibilities in the context of
ubiquitous scarcity and hence competition. The kinds of skills and knowledge that will pay off
will be a function of the incentive structure inherent in the institutional matrix. If the highest
rates of return in a society are to be made from piracy, then organizations will invest in
knowledge and skills that will make them better pirates; if organizations realize the highest
payoffs by increasing productivity then they will invest in skills and knowledge to achieve that
objective. Organizations may not only directly invest in acquiring skills and knowledge but
indirectly (via the political process) induce public investment in those kinds of knowledge
that they believe will enhance their survival prospect.

Oliver Williamson treating the institutional framework as exogenous, explores the

transaction and transformation costs of various organizational forms. My objective (North,
1990 as well as here) is to put forth an explanation of institutional (and organizational)
change that is endogenous, an essential step in my view to further progress in economic
history and economic development.

Institutional Change: Agents, Sources, Process, Direction

The agent of change is the entrepreneur, the decision maker(s) in organizations. The

subjective perceptions (mental models) of entrepreneurs determine the choices they make. The

sources of change are the opportunities perceived by entrepreneurs. The stem from either

external changes in the environment or the acquisition of learning and skills and their

incorporation in the mental constructs of the actors. Changes in relative prices have been the

most commonly observed external sources of institutional change in history, but changes in

taste have also been important. The acquisition of learning and skills will lead to the

construction of new mental models by entrepreneurs to decipher the environment; in turn the

models will alter perceived relative prices of potential choices. In fact it is usually some

mixture of external change and internal learning that triggers the choices that lead to

institutional change.

Deliberate institutional change will come about therefore as a result of the

demands of entrepreneurs in the context of the perceived costs of altering the

institutional framework at various margins. The entrepreneur will assess the gains to be

derived from reconstructing within the existing institutional framework compared to the gains

from devoting resources to altering that framework. Bargaining strength and the incidence of

transaction costs are not the same in the polity as in the economy, otherwise it would not be

worthwhile for groups to shift the issues to the political arena. Thus entrepreneurs who

perceive themselves and their organizations as relative (or absolute) losers in economic

exchange as a consequence of the existing structure of relative prices can turn to the political
process to right their perceived wrongs by altering that relative price structure. In any case

it is the perceptions of the entrepreneur--correct or incorrect--that are the sources of

action.

Changes in the formal rules may come about as a result of legislative changes such as
the passage of a new statute, of judicial changes stemming from court decisions that alter the
common law, of regulatory rule changes enacted by regulatory agencies, and of constitutional
rule changes that alter the rules by which other rules are made.
Changes in informal constraints--norms, conventions, or personal standards of honesty,
for example--have the same originating sources of change as do changes in formal rules; but
they occur gradually and sometimes quite subconsciously as individuals evolve alternative
patterns of behavior consistent with their newly perceived evaluation of costs and benefits.

The process of change is overwhelmingly incremental (although I shall deal with

revolutionary change below). The reason is that the economies of scope, the
complementarities, and the network externalities that arise from a given institutional matrix of
formal rules, informal constraints, and enforcement characteristics will typically bias costs and
benefits in favor of choices consistent with the existing framework. The larger the number
of rule changes, ceteris paribus, the greater the number of losers and hence opposition.
Therefore, except in the case of gridlock , institutional change will occur at those margins
considered most pliable in the context of the bargaining power of interested parties. The
incremental change may come from a change in the rules via statute or legal change. For
informal constraints there may be a very gradual withering away of an accepted norm or social
convention or the gradual adoption of a new one as the nature of the political, social, or
economic exchange gradually changes.
The direction of change is determined by path dependence. Both external sources of
change and unanticipated consequences of their policies may weaken the power of existing
organizations, strengthen or give rise to organizations with different interests and change the
path. The critical actor(s) in such situations will be political entrepreneurs whose degrees of
freedom will increase in such situations and, on the basis of their perception of the issues, give
them the ability to induce the growth of organizations with different interests (or strengthen
existing ones).
 Revolutionary change occurs as a result of gridlock arising from a lack of mediating
institutions that enable conflicting parties to reach compromises that capture some of the
gains from potential trades.

Formal rules may change overnight, but informal constraints do not. Inconsistency
between the formal rules and the informal constraints (which may be the result of deep-seated
cultural inheritance because they have traditionally resolved basic exchange problems) results in
tensions which typically get resolved by some restricting of the overall constraints in both
directions to produce a new equilibrium that is far less revolutionary than the rhetoric.

Toward a Theory of Institutional Change

Let me conclude by summing up the key features of this analytical framework of

institutional change.

1. The continuous interaction between institutions and organizations in the economic setting of
scarcity and hence competition is the key to institutional change.
2. Competition forces organizations to continually invest in knowledge to survive.
3. The institutional framework dictates the kind of knowledge perceived to have the maximum
pay-off.
4. The mental constructs of the players given the complexity of the environment, the limited
information feedback on the consequences of actions, and the inherited cultural
conditioning of the players determine perceptions.
5. The economies of scope, complementarities, and network externalities of an institutional
matrix make institutional change overwhelmingly incremental and path dependent.
THE EVOLUTION OF INSTITUTIONS IN INDIA AND ITS RELATIONSHIP WITH
ECONOMIC GROWTH

INTRODUCTION
The bureaucracy and judiciary there does not seem to be evidence of improvements in
the average quality of institutions over time.

India’s founding fathers bequeathed a strong set of institutions, much stronger

than for the average country. These institutions have played a key role in the
turnaround in India’s recent economic performance, a fact that has been overshadowed
by, and because of the more dramatic and necessary reduction in the ownership/regulatory
functions of public institutions (a process that is usually described as policy reforms). Over
time, though, it is not obvious that India’s public institutions are keeping up with the
demands of a rapidly evolving economy. Thus, contrary to the near-universal views that the
binding constraints to sustained Chinese – style rates of growth are the need to finish the
unfinished task of rolling back the frontiers of the state, giving full play to the energies of the
private sector, this paper implies that a future reform agenda should focus equally on
strengthening, or reversing the decline in, public institutions.

The Role of Public Institutions

First institutions create markets. By protecting property rights, guaranteeing

sanctity of contract, and providing law and order, they create an environment in which
business and private investment can flourish. Thus, the judiciary, bureaucracy, and police are
key institutions in facilitating the development of markets.

Second, institutions regulated and or substitute for markets. The need for these
functions arises from some kind of market failure and or other social objectives such as
income distribution that societies wish to fulfil. That is, markets does not deliver wheat is
socially desirable. For example, banks and other financial institutions need to be regulated to
ensure that they do not take on excessive risk, which can lead to socially costly bank runs or
collapses. The private sector may not deliver education and water to the most needy because
they cannot afford to pay for these services.

Third, institutions, such as the central banks or fiscal, stabilize markets by

ensuring low inflation and macroeconomic stability and helping to avoid financial crises.
Finally, institutions legitimize markets through mechanisms of social protection and
insurance, and importantly, through mechanisms for redistribution and managing conflict.
Democracy is, of course, the institution par excellence for legitimizing markets.

The most interesting evolution has been the market regulating ownership role of
institutions. For much of the post war period up to the 1980s, most countries sought to
address market failures by the state substituting for markets; hence power, education,
telecommunications, and water were provided by the public sector. In the case of India, the
reach of the state was especially pervasive. Not only in these areas but in others, including the
bulk of manufacturing, public sector ownership was the norm. Creating institutions such as
the Securities and Exchange of Board of India (SEBI), Telecommunications Authority
of India (TRAI), Insurance Regulatory and Development Authority (IRDA), Central
Electricity Regulatory Commission (CERC) etc. to undertake the regulatory role.

How are Indian institutions faring?

The Election Commission presided over many difficult elections. The Supreme Court,
has moved beyond the politicized appointments of the late 1970s that gave India a
‘committed’ (Indianspeak for political bias) rather than an independent judiciary.
Telecommunications Regulatory Authority of India (TRAI), Securities and Exchange Board
of India (SEBI), and Insurance Development Regulation Act (IDRA) have performed very
respectably.

The Central Union Public Service Commission still oversees a selection process that
is fair and merit- based. Greater decentralization and transparency have been introduced
through the Panchayati Raj initiatives and the Right to Information (RTI) Act. And the
introduction of computer-based technologies has improved efficiency in a number of areas,
with railway users being the most visible beneficiaries of computerized bookings.

Quantification has its pitfalls, but especially so in relation to institutions because: (i)
distinguishing institutions from say policies is not always easy: (ii) there is a maddening
variety and diversity of Indian institutions; and (iii) the measurement of their performance is
much more difficult.
A Stylized facts on institutional outcomes

Power losses

In 1971, in India, losses were about 9 percent, lower than in Brazil, Mexico, and
Indonesia and about the same as in Malaysia and China. By 2003, losses in India had
increased three-fold to 27 percent higher than in any of the other five countries and much
higher than in China (6.50 percent) and Malaysia (4.60 percent). In 18 largest states in
India, the pattern of losses see a rising trend in losses. The mean and standard deviation for
losses were 17.7 and 4.8 for the period 1985-1990, which increased to 25 and 9.6 respectively
during the period 1996-2000.

Disposal rates for murder related cases

Since 1973, there has been a sharp reduction in the disposal of such cases, from 35
percent in 1973 to about 15 percent in 2005. Judicial system is overwhelmed, and that the
backlog of cases is mounting, resulting in a situation of justice being effectively denied by
being indefinitely delayed.

Conviction rates for murder related cases

Steady decline in conviction rates for murder and culpable homicide at the aggregated
level from close to 50 percent to about 32 percent. At the same time, there was also a slight
increase in the dispersion with the standard deviation of conviction rates increasing from 8.9
percent in 1970 to 13 percent in 2005.

On comparision of large states into the BIMARU (Bihar, UP, Rajasthan, and Madhya
Pradesh) and the peninsular states (Gujarat, Maharashtra, Karanataka, Kerala, Tamil Nadu
and Andhra Pradesh, the peninsular states fare marginally but consistently better than the
BIMARU states; but, more significantly, the decline in conviction rates is evident for both
category of states.

Perception based measure of institutions

In 1960, India’s rating on degree of administrative efficiency was close to 1.5

standard deviations above the mean, a very high rating, placing it amongst the very top of the
74 countries surveyed by Adelman and Morris (1971). In the last decade, India’s score has
been close to zero, denoting an average rating. If these measures are at all plausible, the
picture they convey is one of decline-substantial decline since the 1960s. In the 1960s India
ranked around the 95th percentile, while it fell to about the 50 th – 60th percentile in the last
decade.

Isolating the effect of institutional quality: the case of Indian customs

Recorded exports at the origin and the recorded imports at the India end as a measure
of evasion. The extent of evasion has declined over time by about 20 percent. We tried to see
to what extent this decline in evasion was due to an improvement in the quality of
enforcement by customs administration as opposed simply to the reduction in and
simplification of tariffs following the 1991 macroeconomic crisis. One way of assessing the
quality of enforcement by customs is to see the change in the evasion elasticity over time.
The evasion elasticity is the impact on evasion of a 1 percentage point change in the tariff
rate.

EVASION ELASTICITY CAN BE INTERPRETED AS A MEASURE OF

INSTITUTIONAL QUALITY. Evasion elasticity is invariant with respect to tariffs but
does vary with measures of enforcement for example, the evasion elasticity is significantly
higher for more differentiated goods and for goods where uncertainty about price is
greater. This suggests that where enforcement is “more difficult” because of some
inherent characteristics, the elasticity is indeed higher.

Evasion elasticity does not seem to have declined over time; in some selected
instances we find evidence of an increase in the evasion elasticity. That is, a given increase in
tariffs leads to no less evasion in their early 2000s than it did in the late 1980s/early 1990s.
Overall, the evidence suggests no improvements in the quality of enforcement by customs
administration, at least not enough to affect the marginal impact on evasion.

FROM INSTITUTIONS TO GROWTH

Policy reforms were indeed an important contributing factor, all sides agree that
the magnitude of reforms especially from the early 1980s till the mid-to-late-1990s, when
growth was accelerating was limited.

Argentina, Brazil, and Mexico were deemed to have made the transition from closed
to open in 1991, South Africa in 1991, and Uganda in 1991. In 2000, nearly twenty years
after the growth turnaround, India was still classified as a closed economy from the point
of view of trade and commercial policies. This picture of India as a closed economy well
into the reform process is confirmed more formally using a gravity model of trade Latin
America and sub- Saharan Africa have grown by about 1 percent per capita per year, while
India has grown at about 4 to 4.5 percent.

How does one explain the differential supply or growth response? One possible
explanation could be that it is the quality of institutions. Recent research suggests that in the
long run, the quality of a country’s public institutions are the key fundamentals of long-run
growth. What was holding India back, prior to the 1980s was a policy regime that was
unfavourable to the private sector? Once that was changed through policy reforms the
economic landscape was transformed. The key point here is that even a small trigger i.e.
relatively modest reforms was sufficient to engender a large growth response because of the
considerable under exploited potential provided by the quality of its institutions. India’s
institutions, built up through the decades preceding independence, allowed it to get a big bang
for the relatively small buck of reforms (at least compared with other countries).

India appears to be far inside the institutions (or production possibility frontier)
illustrated this under – achievement and its flip side, namely the potential created by India’s
institutional quality. India is well below the regression line: that is, it is an outlier in this
relationship. And it is a negative outlier, suggesting that given its level of institutions, its
income should have been much greater in 1980, by a factor of 4 or so. Strong positive
relationship exist between institutions (the opposite of T &D losses) and growth after
the 1990s.

In sum, institutions have had an important role in India’s growth turnaround, which is
discernible in the cross-section of countries and across states within India. The focus on the
policy reforms of the 1990s has tended to overshadow this fact.

From Growth to institutions: Disconnect between Growth and Institutions?

Around the world as countries grow, political and economic institutions tend to
improve. As people become richer, they demand more from their public institutions better
public services, more security and law and order, and greater political participation. As
countries become richer, they also on average, become more democratic, granting greater
political freedoms to their citizens. In much of East Asia, for example, rising incomes have
led to greater political freedoms. Impact of income on institutional development is positive.
As Korea got richer the costs of doing business for large and small firms declined.
 In India, the last 25 years have seen a fourfold increase in the income of the average
person. The evidence in Section III suggested that institutions have not improved. Prima facie
this suggests that economic growth is not necessarily and automatically doing the job of
improving institutions. Why is this the case?

Public institutions: Rising demand

Example 1 Crime and Income

Statistically positive relationship between income and crime: that is, rising income
within a state tends to be associated with more crime. This simple relationship offers a clue
for why judicial performance could be weakening over time: development places greater
demands on it, and unless there is a commensurate improvement in resources and quality,
outcomes could worsen.

Example 2 Education and income

Public educational institutions are worse (i.e. have greater teacher absenteeism), have
seen greater entry of private schools. As incomes have risen rapidly, so has the demand for
primary education because the perceived returns to education are now seen as much higher.
But public institutions have not been able to meet this increased demand reflected in the
private sector has stepping in to fill in the gap left by unresponsive public institutions.

PUBLIC INSTITUTIONS- LAGGING SUPPLY

In some ways, the face that supply lags demand is puzzling because over this period
India has witnessed a number of developments that should have facilitated, even forced,
institutional improvement. First, Indian society, open and argumentative as it always was, has
received a further, reinvigorating jolt of transparency: institutions have been exposed to the
grade of public scrutiny thanks to the explosion in the quantity and quality of the media.
Second, the license-quota-permit raj, a big source of corruption and patronage, with its
deeply corrosive effect on public institutions, is being progressively dismantled.

Third, civil society has become a vibrantly assertive presence in India. Indian civil
society has taken on at least two roles: a direct one, in delivering development outcomes, and
an indirect one, striving to hold public institutions accountable. Fourth, with greater
decentralization of political and economic power, the healthy dynamic of competition
between states has been unleashed.

On the other hand, there have also been adverse effect on the supply of
institutions. First, although growth has accelerated and poverty has declined substantially,
divergences have increased too. Adivasis, Naxalite activity. Unequal growth also has
subtler effect on institutions. Albert Hirschman called ‘exit’ the rich opt out of the public
system, turning to the private sector to get essential services.

Kapur (2006) shows that the well – connected and influential class in India may have
less of a stake in higher education because an overwhelming proportion tend to send their
children abroad for graduate education. The second major factor contributing to the
decline of public institutions is its increasing inability to attract talent. This too has
deeper causes, including the growing politicization of the bureaucracy, cynicism about its
role, and the fading sense of public service. But clearly one of them is the very rise of the
private sector which has simply made the public sector a less attractive place to work in. The
allocation of talent has become skewed. With the staggering scale of remuneration that the
new economy is showering on skilled people, the public sector does not stand a chance of
competing with the private sector in attracting high quality people. And, if institutions
ultimately depend on the individuals manning them and the incentives they face, the
prognosis is somewhat grim for public institutions.
 LECTURE- 7

Reserve Bank of India

The Reserve Bank of India, chiefly known as RBI, is India's central bank and regulatory
body responsible for regulation of the Indian banking system. It is under
the ownership of Ministry of Finance, Government of India. It is responsible for the control,
issue and maintaining supply of the Indian rupee. It also manages the country's main payment
systems and works to promote its economic development. Bharatiya Reserve Bank Note
Mudran (BRBNMPL) is one of the specialised divisions of RBI through which it prints &
mints Indian currency notes(INR) in two of its currency printing presses located
in Nashik(Western India) and Dewas(Central India).

RBI established the National Payments Corporation of India as one of its specialised
division to regulate the payment and settlement systems in India.

Deposit Insurance and Credit Guarantee Corporation was established by RBI as one of
its specialised division for the purpose of providing insurance of deposits and guaranteeing
of credit facilities to all Indian banks.

Until the Monetary Policy Committee was established in 2016, it also had full control
over monetary policy in the country. It commenced its operations on 1 April 1935 in
accordance with the Reserve Bank of India Act, 1934. The original share capital was divided
into shares of 100 each fully paid. Following India's independence on 15 August 1947, the
RBI was nationalised on 1 January 1949.

The overall direction of the RBI lies with the 21-member central board of directors,
composed of: the governor; four deputy governors; two finance ministry representatives
(usually the Economic Affairs Secretary and the Financial Services Secretary); ten
government-nominated directors; and four directors who represent local boards
for Mumbai, Kolkata, Chennai, and Delhi. Each of these local boards consists of five
members who represent regional interests and the interests of co-operative and indigenous
banks.

It is a member bank of the Asian Clearing Union. The bank is also active in promoting
financial inclusion policy and is a leading member of the Alliance for Financial
Inclusion (AFI). The bank is often referred to by the name 'Mint Street'.
On 12 November 2021, the Prime Minister of India, Narendra Modi, launched two new
schemes which aim at expanding investments and ensuring more security for investors. The
two new schemes include the RBI Retail Direct Scheme and the Reserve Bank
Integrated Ombudsman Scheme.

The RBI Retail Direct Scheme is targeted at retail investors to invest easily in
government securities. According to RBI, the scheme will allow retail investors to open and
maintain their government securities account free of cost.

The RBI Integrated Ombudsman Scheme aims to further improve the grievance redress
mechanism for resolving customer complaints against entities regulated by the central bank.
The RBI makes it mandatory for all the banks in India to have a safe box in their own respect
strong room. However, exception is given to the Regional Banks and the SBI branches
located in the rural areas but a strong room is compulsory.

Preamble

The preamble of the Reserve Bank of India describes the basic functions of the reserve bank
as

"to regulate the issue of Bank notes and keeping of reserves with a view to securing
monetary stability in India and generally to operate the currency and credit system of the
country to its advantage;

to have a modern monetary policy framework to meet the challenge of an increasingly

complex economy,

to maintain price stability while keeping in mind the objective of growth."

History

The Reserve Bank of India was established [14] following the Reserve Bank of India Act of
1934. Though privately owned initially, it was nationalised in 1949 and since then fully
owned by the Ministry of Finance, Government of India (GoI).

The Reserve Bank of India was conceptualised in accordance with the guidelines presented
by Dr. B.R. Ambedkar to the Hilton Young Commission (also known as Royal Commission
on Indian Currency and Finance) based on his book, 'The Problem of the Rupee – Its Origin
and Its Solution
In 1926, the Hilton Young Commission recommended the setting up of the Reserve Bank of
India.

At the time of establishment, the authorized capital of the Reserve Bank of India
was ₹5 crores. The government's share in this was only ₹20-22 lakhs.

1935–1949

Reserve Bank of India-10 Rupees (1938), the first year of banknote issue.

The Reserve Bank of India was founded on 1 April 1935 to respond to economic troubles
after the First World War. The bank was set up based on the recommendations of the 1926
Royal Commission on Indian Currency and Finance, also known as the Hilton Young
Commission.

1950–1960

In the 1950s, the Indian government, under its first Prime Minister Jawaharlal Nehru,
developed a centrally planned economic policy that focused on the agricultural sector. The
administration nationalised commercial banks and established, based on the Banking
Companies Act, 1949 (later called the Banking Regulation Act), a central bank regulation as
part of the RBI. Furthermore, the central bank was ordered to support economic plan with
loans.
1961–1968

As a result of bank crashes, the RBI was requested to establish and monitor a deposit
insurance system. Meant to restore the trust in the national bank system, it was initialised on
7 December 1961. The Indian government founded funds to promote the economy, and used
the slogan "Developing Banking". The government of India restructured the national bank
market and nationalised a lot of institutes. As a result, the RBI had to play the central part in
controlling and supporting this public banking sector.

1969–1984

In 1969, the Indira Gandhi-headed government nationalised 14 major commercial

banks. Upon Indira Gandhi's return to power in 1980, a further six banks were
nationalised. The regulation of the economy and especially the financial sector was
reinforced by the Government of India in the 1970s and 1980s. The central bank became the
central player and increased its policies a lot for various tasks like interests, reserve ratio
and visible deposits. These measures aimed at better economic development and had a huge
effect on the company policy of the institutes. The banks lend money in selected sectors, like
agricultural business and small trade companies. The Banking Commission was
established on Wednesday, 29 January 1969, to analyse banking costs, effects of legislations
and banking procedures, including non-banking financial intermediaries and indigenous
banking on Government of India economy; with R.G. Saraiya as the chairman. The oil
crises in 1973 resulted in increasing inflation, and the RBI restricted monetary policy to
reduce the effects.

1985–1990

A lot of committees analysed the Indian economy between 1985 and 1989. Their results had
an effect on the RBI. The Board for Industrial and Financial Reconstruction, the Indira
Gandhi Institute of Development Research and the Security & Exchange Board of
India investigated the national economy as a whole, and the security and exchange board
proposed better methods for more effective markets and the protection of investor interests.
The Indian financial market was a leading example for so-called "financial repression"
(Mckinnon and Shaw). The Discount and Finance House of India began its operations in the
monetary market in April 1988; the National Housing Bank, founded in July 1988, was
forced to invest in the property market and a new financial law improved the versatility of
direct deposit by more security measures and liberalisation.

1991–1999

The national economy contracted in July 1991 as the Indian rupee was devalued. The
currency lost 18% of its value relative to the US dollar, and the Narsimham
Committee advised restructuring the financial sector by a temporal reduced reserve
ratio as well as the statutory liquidity ratio. The central bank deregulated bank interests
and some sectors of the financial market like the trust and property markets. This first phase
was a success and the central government forced a diversity liberalisation to diversify owner
structures in 1998.

The National Stock Exchange of India took the trade on in June 1994 and the RBI
allowed nationalised banks in July to interact with the capital market to reinforce their capital
base. The central bank founded a subsidiary company—the Bharatiya Reserve Bank Note
Mudran Private Limited—on 3 February 1995 to produce banknotes.

2000 - 2009

The Foreign Exchange Management Act, 1999 came into force in June 2000. It should
improve the item in 2004–2005 (National Electronic Fund Transfer). The Security
Printing & Minting Corporation of India Ltd., a merger of nine institutions, was founded
in 2006 and produces banknotes and coins.

The national economy's growth rate came down to 5.8% in the last quarter of 2008–2009 and
the central bank promotes the economic development.
Since 2010

In 2016, the Government of India amended the RBI Act to establish the Monetary Policy
Committee (MPC) to set. This limited the role of the RBI in setting interest rates, as the MPC
membership is evenly divided between members of the RBI (including the RBI governor)
and independent members appointed by the government. However, in the event of a tie, the
vote of the RBI governor is decisive.

In April 2018, the RBI announced that "entities regulated by RBI shall not deal with or
provide services to any individual or business entities dealing with or settling virtual
currencies," including Bitcoin. While the RBI later clarified that it "has not prohibited"
virtual currencies, a three-judge panel of the Supreme Court of India issued a ruling on 4
March 2020 that the RBI had failed to show "at least some semblance of any damage suffered
by its regulated entities" through the handling of virtual currencies to justify its decision. The
court challenge was filed by the Internet and Mobile Association of India, whose members
include some cryptocurrency exchanges whose businesses suffered following the RBI's 2018
order.

The bank's current governor is Shaktikanta Das.

Branches and support bodies

The RBI has four regional representations: North in New Delhi, South in Chennai, East
in Kolkata and West in Mumbai. The representations are formed by five members,
appointed for four years by the central government and with the advice of the central board of
directors serve as a forum for regional banks and to deal with delegated tasks from the
Central Board.

Divisions

Bharatiya Reserve Bank Note Mudran

BRBNML was established by RBI on 3 February 1995 for the purpose to enable RBI to
bridge the gap between maintain, demand and supply of Indian rupee notes in the country.

Deposit Insurance and Credit Guarantee Corporation

Deposit Insurance and Credit Guarantee Corporation was established by RBI for the purpose
of providing insurance of deposits and guaranteeing of credit facilities to all Indian banks.

National Payments Corporation of India

National Payments Corporation of India was established by RBI in Dec 2008 for the purpose
of management of the payment and settlement systems in India.

Reserve Bank Information Technology

It has been set up by RBI to serve its Information Technology and cybersecurity needs and to
improve the cyber resilience of the Indian banking industry.

Indian Financial Technology and Allied Services

It was established by RBI, mandated to design, deploy and support IT-related services to all
Banks and Financial Institutions in the country and also to the Reserve Bank of India.

Functions

The central bank of any country executes many functions such as overseeing monetary
policy, issuing currency, managing foreign exchange, working as a bank for government and
as a banker of scheduled commercial banks. It also works for overall economic growth of the
country.

Financial supervision

The primary objective of RBI is to undertake consolidated supervision of the financial

sector comprising commercial banks, financial institutions, and non-banking finance
companies. The board is constituted by co-opting four directors from the Central Board as
members for a term of two years and is chaired by the governor. The deputy governors of the
reserve bank are ex-officio members.

Regulator and supervisor of the financial system

The institution is also the regulator and supervisor of the financial system and prescribes
broad parameters of banking operations within which the country's banking and financial
system functions. Its objectives are to maintain public confidence in the system, protect
depositors' interest and provide cost-effective banking services to the public. The Banking
Ombudsman Scheme has been formulated by the Reserve Bank of India (RBI) for effective
addressing of complaints by bank customers. The RBI controls the monetary supply,
monitors economic indicators like the gross domestic product and has to decide the design of
the rupee banknotes as well as coins.

Regulator and supervisor of the payment and settlement systems

Payment and settlement systems play an important role in improving overall economic
efficiency. The Payment and Settlement Systems Act of 2007 (PSS Act) gives the Reserve
Bank oversight authority, including regulation and supervision, for the payment and
settlement systems in the country. In this role, the RBI focuses on the development and
functioning of safe, secure and efficient payment and settlement mechanisms. Two payment
systems National Electronic Fund Transfer (NEFT) and Real-Time Gross Settlement
(RTGS) allow individuals, companies and firms to transfer funds from one bank to another.
These facilities can only be used for transferring money within the country.

From 16 December 2019, one can transfer money online using the National Electronic Funds
Transfer (NEFT) route 24x7, i.e., any time of the day and any day of the week.

Banker and debt manager to government

Just as individuals need a bank to carry out their financial transactions effectively and
efficiently, governments also need a bank to carry out their financial transactions. The
RBI serves this purpose for the Government of India (GoI). As a banker to the Government
of India, the RBI maintains its accounts, receive payments into and make payments out of
these accounts. The RBI also helps the GoI to raise money from the public via issuing bonds
and government-approved securities. RBI issue taxable bonds for investments. From 1 July
2020, RBI is offering Floating Rate Savings Bonds.
Managing foreign exchange

The central bank manages to reach different goals of the Foreign Exchange Management Act,
1999. Their objective is to facilitate external trade and payment and promote orderly
development and maintenance of foreign exchange market in India.The RBI manages forex
and gold reserves of the nation. On a given day, the foreign exchange rate reflects the
demand for and supply of foreign exchange arising from trade and capital transactions.
The RBI's Financial Markets Department (FMD) participates in the foreign exchange
market by undertaking sales/purchases of foreign currency to ease volatility in periods
of excess demand for/supply of foreign currency.

Issue of currency

Other than the Government of India, the Reserve Bank of India is the sole body authorised to
issue banknotes in India. The bank also destroys banknotes when they are not fit for
circulation. All the money issued by the central bank is its monetary liability, i.e., the central
bank is obliged to back the currency with assets of equal value, to enhance public confidence
in paper currency. The objectives are to issue banknotes and give the public adequate supply
of the same, to maintain the currency and credit system of the country to utilise it in its best
advantage, and to maintain the reserves. The RBI maintains the economic structure of the
country so that it can achieve the objective of price stability as well as economic development
because both objectives are diverse in themselves.

Bankers' bank

Reserve Bank of India also works as a central bank where commercial banks are
account holders and can deposit money. RBI maintains banking accounts of all scheduled
banks. Commercial banks create credit. It is the duty of the RBI to control the credit through
the CRR, repo rate, and open market operations. As the bankers' bank, the RBI facilitates the
clearing of cheques between the commercial banks and helps the inter-bank transfer of funds.
It can grant financial accommodation to schedule banks. It acts as the lender of the last resort
by providing emergency advances to the banks.

Regulator of the Banking System

RBI has the responsibility of regulating the nation's financial system. As a regulator and
supervisor of the Indian banking system it ensures financial stability & public confidence in
the banking system. RBI uses methods like On-site inspections, off-site surveillance,
scrutiny & periodic meetings to supervise new bank licences, setting capital
requirements and regulating interest rates in specific areas. RBI is currently focused on
implementing norms.

Detection of fake currency

To curb the counterfeit money problem in India, RBI has launched a website to raise
awareness among masses about fake banknotes in the market. www.paisaboltahai.rbi.org.in
provides information about identifying fake currency. On 22 January 2014; RBI gave a
press release stating that after 31 March 2014, it will completely withdraw from
circulation of all banknotes issued prior to 2005. From 1 April 2014, the public will be
required to approach banks for exchanging these notes. This move from the reserve bank is
expected to unearth black money held in cash. As the new currency notes have added
increased security features, they would help in curbing the menace of fake currency.

Developmental role

The central bank has to perform a wide range of promotional functions to support national
objectives and industries.[21] The RBI faces a lot of inter-sectoral and local inflation-related
problems. Some of these problems are results of the dominant part of the public sector.

Key tools in this effort include Priority Sector Lending such as agriculture, micro and
small enterprises (MSE), housing and education. RBI work towards strengthening and
supporting small local banks and encourage banks to open branches in rural areas to include
large section of society in banking net.

Related functions

The RBI is also a banker to the government and performs merchant banking function for the
central and the state governments. It also acts as their banker. The National Housing
Bank (NHB) was established in 1988 to promote private real estate acquisition. The
institution maintains banking accounts of all scheduled banks, too. RBI on 7 August 2012
said that Indian banking system is resilient enough to face the stress caused by the drought-
like situation because of poor monsoon this year.

Custodian to foreign exchange

The Reserve Bank has custody of the country's reserves of international currency, and this
enables the Reserve Bank to deal with crisis connected with adverse balance of payments
position.

CSD for G-Sec (Government Securities)

Public Debt Office (PDO) acts as CSD (Central Securities Depository) for G-Sec.

MIFOR (Mumbai Interbank Forward Offer Rate)

With LIBOR cessation in 2021, RBI is set to replace MIFOR with a new benchmark. MIFOR
has LIBOR as one of the components and used in interest rate swap (IRS) markets.

2016 demonetisation

On 8 November 2016, the Government of India announced the demonetisation of

all ₹ 500 and ₹ 1,000 banknotes of the Mahatma Gandhi Series despite being warned by the
Reserve Bank of India (RBI). The government claimed that the action would curtail the
shadow economy and crack down on the use of illicit and counterfeit cash to fund illegal
activity and terrorism. The Reserve Bank of India laid down a detailed procedure for the
exchange of the demonetised banknotes with new ₹ 500 and ₹ 2,000 banknotes of
the Mahatma Gandhi New Series and ₹ 100 banknotes of the preceding Mahatma Gandhi
Series.
Repo rate

Repo (repurchase) rate also known as the benchmark interest rate is the rate at which
the RBI lends money to the commercial banks for a short-term (a maximum of 90 days).
When the repo rate increases, borrowing from RBI becomes more expensive. If RBI wants to
make it more expensive for the banks to borrow money, it increases the repo rate similarly, if
it wants to make it cheaper for banks to borrow money it reduces the repo rate. If the repo
rate is increased, banks can't carry out their business at a profit whereas the very opposite
happens when the repo rate is cut down. Generally, repo rates are cut down whenever the
country needs to progress in banking and economy.

To curb inflation, the RBI increases repo rate which will make borrowing costs for banks.
Banks will pass this increased cost to their customers which make borrowing costly in the
whole economy. Fewer people will apply for loans and aggregate demand will be reduced.
This will result in inflation coming down. The RBI does the opposite to fight deflation. When
the RBI reduces the repo rate, banks are not legally required to reduce their own base rate.

The present repo rate is 4.90%.

Reverse repo rate (RRR)

As the name suggest, reverse repo rate is just the opposite of repo rate. Reverse repo rate is
the short term borrowing rate in which commercial bank Park their surplus in RBI The
reserve bank uses this tool when it feels there is too much money floating in the banking
system. An increase in the reverse repo rate means that the banks will get a higher rate of
interest from RBI. As a result, banks prefer to lend their money to RBI which is always safe
instead of lending it to others (people, companies, etc.) which is always risky.

Repo rate signifies the rate at which liquidity is injected into the banking system by
RBI, whereas reverse repo rate signifies the rate at which the central bank absorbs
liquidity from the banks.

Currently, reverse repo rate is 3.35%.

Statutory liquidity ratio (SLR)

Apart from the CRR, banks are required to maintain liquid assets in the form of gold,
cash and approved securities. Higher liquidity ratio forces commercial banks to
maintain a larger proportion of their resources in liquid form and thus reduces their
capacity to grant loans and advances, thus it is an anti-inflationary impact. A higher
liquidity ratio diverts the bank funds from loans and advances to investment in
government and approved securities.

The present SLR is 18.00%.

Bank rate

Bank rate is defined in Section 49 of the RBI Act of 1934 as the 'standard rate at which
RBI is prepared to buy or rediscount bills of exchange or other commercial papers
eligible for purchase'. When banks want to borrow long term funds from the RBI, it is the
interest rate which the RBI charges to them.

It is currently set to 4.65%.

Liquidity adjustment facility (LAF)

Liquidity adjustment facility was introduced in 2000. LAF is a facility provided by the
Reserve Bank of India to scheduled commercial banks to avail of liquidity in case of need or
to park excess funds with the RBI on an overnight basis against the collateral of government
securities. RBI accepts applications for a minimum amount of ₹5 crore and in multiples
of ₹ 50 million thereafter.

Cash reserve ratio (CRR)

CRR refers to the ratio of bank's cash reserve balances with RBI with reference to the
bank's net demand and time liabilities to ensure the liquidity and solvency of the
scheduled banks. The share of net demand and time liabilities that banks must maintain as
cash with the RBI. The RBI has set CRR at 4.5% ] A 1% change in CRR affects the economy
by 1,37,000 crore. An increase draw this amount from the economy, while a decrease injects
this amount into the economy. So if a bank has ₹2 billion (US$25 million) of NDTL then it
has to keep ₹80 million (US$1.0 million) in cash with RBI. RBI pays no interest on CRR.

Let's assume the economy is showing inflationary trends and the RBI wants to control this
situation by adjusting SLR and CRR. If the RBI increases SLR to 50% and CRR to 20% then
bank will be left only with ₹600 million (US$7.5 million) for operations. Now it will be very
difficult for the bank to maintain profitability with such a small amount of capital. The bank
will be left with no choice but to raise its interest rate which will make borrowing by its
customers more costly. This will in turn reduce the overall demand and hence prices will
eventually come down.
Open market operation (OMO)

Open market operation is the activity of buying and selling of government securities in open
market to control the supply of money in banking system. When there is excess supply of
money, central bank sells government securities thereby sucking out excess liquidity.
Similarly, when liquidity is tight, RBI will buy government securities and thereby inject
money supply into the economy.

On 23 March 2020, Reserve Bank of India infuse Rs 1 trillion (short scale) through term repo
auction, a massive OMOs (open market operations) purchase of government securities. The
Reserve Bank is monitoring the financial market conditions and liquidity situation in the
economy as COVID-19 pandemic in India fears of a recession.

Marginal standing facility (MSF)

This scheme was introduced in May 2011 and all the scheduled commercial bank can
participate in this scheme. Banks can borrow up to 2.5% per cent of their respective net
demand and time liabilities. The RBI receives application under this facility for a minimum
amount of ₹ 10 million and in multiples of ₹ 10 million thereafter.

The important difference from repo rate is that bank can pledge government securities from
its SLR quota (up to one per cent). So even if SLR goes below 20.5% by pledging SLR quota
securities under MSF, the bank will not have to pay any penalty. The marginal standing
facility rate currently stands at 4.25%.

Qualitative tools

Margin requirements

Loan-to-value (LTV) is the ratio of loan amount to the actual value of asset purchased.

The RBI regulates this ratio so as to control the amount a bank can lend to its customers. For
example, an individual wants to buy a car using borrowed money and the car's value
is ₹10 lakh (US$13,000). If the LTV is set to 70% he can borrow a maximum
of ₹700,000 (US$8,800).

The RBI can decrease or increase to curb inflation or deflation respectively.

Selective credit control

Under this measure, the RBI can specifically instruct banks not to give loans to traders of
certain commodities e.g. sugar, edible oil, etc. This prevents the speculation/hoarding of
commodities using money from banks.

Moral suasion

Under this measure, the RBI try to persuade banks through meetings, conferences, media
specific things under certain economic trends. For example, when the RBI reduces repo rate,
it asks banks to reduce their base rate as well. Another example of this measure is to ask
banks to reduce their non-performing assets.

Limitations of monetary policy

In developing countries like India, monetary policy fails to show immediate or no results
because the following factors:

1. People do not employ alternative investment options. A

large section of society still depends on saving accounts,
fixed deposits, Public Provident Fund for investment.
Commercial banks have large deposits. RBI is not the
main or even prominent money supplier for these banks.
So whatever monetary action central bank takes has little
or late impact on the economy.
2. Many people in rural areas are out of the banking net and
whatever the RBI does, has no impact on their financial
activities.
3. Monsoon uncertainty adversely affects food production
and thereby cause food inflation. Monetary policy has no
impact on food inflation.

RTGS and NEFT transactions' charges removal

RBI decided to remove charges on RTGS (Real Time Gross Settlement System) and NEFT
(National Electronic Funds Transfer).

Publications
A report titled "Trend and Progress of Banking in India" is published annually, as required
by the Banking Regulation Act, 1949. The report sums up trends and developments
throughout the financial sector. Starting in April 2014, the Reserve Bank of India publishes
bi-monthly policy updates.

Committees set up by RBI

KV Kamath Committee

In August 2020, RBI set up a five membered Committee under the chairmanship of KV
Kamath, the former CEO of the ICICI bank in order to make recommendations on the norm
for resolution of COVID-19 related stressed loans. In order to restructure the loans up
to ₹15,000 crores the expert Committee was tasked with coming up with a sector specific
plan for successful resolution of the stressed loans. The parameters were to include aspects
related to leverage, liquidity and debt serviceability.
Attempt to caution customers against virtual currencies

In April 2018, RBI had banned banks from supporting crypto transactions after cases of fraud
through virtual currencies were reported. However, the Supreme Court had struck down the
ban in March 2020. Among the reasons cited was that cryptocurrencies were not illegal
though unregulated in India.
 World Bank

 With 189 member countries, the World Bank Group is a unique global partnership: five
institutions working for sustainable solutions that reduce poverty and build shared
prosperity in developing countries.
 The Bank Group works with country governments, the private sector, civil society
organizations, regional development banks, think tanks, and other international
institutions on issues ranging from climate change, conflict, and food security to
education, agriculture, finance, and trade.
What does the World Bank Group Comprise?
Together, the International Bank for Reconstruction and Development (IBRD) and
International Development Association (IDA) form the World Bank, which provides
financing, policy advice, and technical assistance to governments of developing countries.
While the World Bank Group consists of five development institutions.
 International Bank for Reconstruction and Development (IBRD) provides loans,
credits, and grants.
 International Development Association (IDA) provides low- or no-interest loans to
low-income countries.
 The International Finance Corporation (IFC) provides investment, advice, and asset
management to companies and governments.
 The Multilateral Guarantee Agency (MIGA) insures lenders and investors against
political risk such as war.
 The International Centre for the Settlement of Investment Disputes (ICSID) settles
investment-disputes between investors and countries.
All of these efforts support the Bank Group’s twin goals of ending extreme poverty by
2030 and boosting shared prosperity of the poorest 40% of the population in all countries.
How did World Bank Come into Existence?
 The Bretton Woods Conference, officially known as the United Nations Monetary
and Financial Conference, was a gathering of delegates from 44 nations that met from
July 1 to 22, 1944 in Bretton Woods, New Hampshire (USA), to agree upon a series
of new rules for international financial and monetary order after the conclusion of
World War II.
 The two major accomplishments of the conference were the creation of
the International Bank for Reconstruction and Development (IBRD)
and International Monetary Fund (IMF).
 Founded in 1944, the International Bank for Reconstruction and Development
(IBRD) — soon called the World Bank — has expanded to a closely associated
group of five development institutions.
 Originally, its loans helped rebuild countries devastated by World War II. In time,
the focus shifted from reconstruction to development, with a heavy emphasis
on infrastructure such as dams, electrical grids, irrigation systems, and roads.
 With the founding of the International Finance Corporation (IFC) in 1956, the
institution became able to lend to private companies and financial institutions in
developing countries.
 Founding of the International Development Association (IDA) in 1960 put greater
emphasis on the poorest countries, part of a steady shift toward the eradication of
poverty becoming the Bank Group’s primary goal.
 International Centre for Settlement of Investment Disputes (ICSID) founded
in 1966 settles investment disputes between investors and countries.
 Multilateral Investment Guarantee Agency (MIGA) founded in 1988 insures lenders
and investors against political risk such as war.
1.What is International Bank for Reconstruction and Development (IBRD)?
 Following the recovery from World War II, the International Bank of Reconstruction
and Development broadened its mandate to increasing global economic growth and
eliminating poverty.
 The Bank only finances sovereign governments directly or projects backed by
sovereign governments.
 Today, the IBRD focuses its services on middle-income countries or countries where
the per capita income ranges from $1,026 to $12,475 per year. These countries, like
Indonesia, India, and Thailand, are often home to fast-growing economies that attract a
lot of foreign investment and large infrastructure building projects.
 At the same time, middle-income countries are home to 70% of the world’s poor
people, as the benefits of this economic growth are unevenly distributed across their
populations.
 Governance of IBRD:
 o IBRD Boards of Governors: The Boards of Governors consist of one Governor
and one Alternate Governor appointed by each member country. The office is
usually held by the country's minister of finance, governor of its central bank. The
Board of Governors delegates most of its authority over daily matters such as
lending and operations to the Board of Directors.
o IBRD Board of Directors: The Board of Directors consists of currently 25
executive directors and is chaired by the President of the World Bank Group.
Executive Directors are appointed or elected by the Governors. Executive
Directors select the World Bank President, who is the Chairman of the Board of
Directors. Executive Directors are authorised for daily matters such as lending and
operations.
 IBRD raises most of its funds in the world's financial markets. This has allowed it to
provide more than $500 billion in loans to alleviate poverty around the world since
1946, with its shareholder governments paying in about $14 billion in capital.
 IBRD has maintained a triple-A rating since 1959. This high credit rating allows it
to borrow at low cost and offer middle-income developing countries access to capital
on favourable terms — helping ensure that development projects go forward in a more
sustainable manner.
 IBRD earns income every year from the return on its equity and from the small
margin it makes on lending. This pays for World Bank operating expenses, goes into
reserves to strengthen the balance sheet, and provides an annual transfer of funds to
IDA, the fund for the poorest countries.


2. What is the International Finance Corporation (IFC)?

 IFC is the largest global development institution focused exclusively on the private
sector in developing countries. The Bank Group has set two goals for the world to
achieve by 2030: end extreme poverty and promote shared prosperity in every country.
 It is a private-sector arm of the World Bank Group, to advance economic
development by investing in for-profit and commercial projects for poverty reduction
and promoting development.
 IFC is also a leading mobilizer of third-party resources for projects.
 Governance of IFC
 o IFC Boards of Governors: The Boards of Governors consist of one Governor
and one Alternate Governor appointed by each member country. The office is
usually held by the country's minister of finance, governor of its central bank. The
Board of Governors delegates most of its authority over daily to the Board of
Directors.
o IFC Board of Directors: The Board of Directors consists of executive directors
and is chaired by the President of the World Bank Group. Executive Directors are
appointed or elected by the Governors. Voting power on issues brought
before them is weighted according to the share capital each director represents.
The directors meet regularly to review and decide on investments and provide
overall strategic guidance to IFC management.
 IFC raises virtually all funds for lending activities through the issuance of debt
obligations in international capital markets. Our borrowings are diversified by
country, currency, source, and maturity in order to provide flexibility and cost-
effectiveness.
 Since first being rated in 1989, IFC has been rated triple-A every year by Standard
and Poor's and by Moody's. Our high credit rating is essential for maintaining our
ability to access markets globally and to maintain our low cost of funding.
 IFC makes loans to businesses and private projects generally with maturities of seven to
twelve years. It determines a suitable repayment schedule and grace period for each
loan individually to meet borrowers' currency and cash flow requirements. It may
provide longer-term loans or extend grace periods if a project is deemed to warrant it.
 It does not have a policy of uniform interest rates for its investments. The interest
rate is to be negotiated in each case in the light of all relevant factors, including
the risks involved and any right to participation in profits, etc.
 Through its Global Trade Finance Program, the IFC guarantees trade payment
obligations of more than 200 approved banks in over 80 countries to mitigate risk for
international transactions. The Global Trade Finance Program provides guarantees to
cover payment risks for emerging market banks regarding promissory notes, bills of
exchange, letters of credit, bid and performance bonds, supplier credit for capital
goods imports, and advance payments.
 IFC attempts to guide businesses toward more sustainable practices particularly with
regards to having good governance, supporting women in business, and proactively
combating climate change.


3. What is International Development Association (IDA)?

 IDA is the part of the World Bank that helps the world’s poorest countries. Overseen
by 173 shareholder nations, IDA aims to reduce poverty by providing loans (called
“credits”) and grants for programs that boost economic growth, reduce inequalities, and
improve people’s living conditions.
 IDA is one of the largest sources of assistance for the world’s 75 poorest countries, 39
of which are in Africa, and is the single largest source of donor funds for basic social
services in these countries.
 IDA supports a range of development activities that pave the way toward equality,
economic growth, job creation, higher incomes, and better living conditions. IDA's
work covers primary education, basic health services, clean water and sanitation,
agriculture, business climate improvements, infrastructure, and institutional
reforms.
 Governance of IDA:
o IDA Boards of Governors: The Boards of Governors consist of one Governor
and one Alternate Governor appointed by each member country. The office is
usually held by the country's minister of finance, governor of its central bank. The
Board of Governors delegates most of its authority over daily matters such as
lending and operations to the Board of Directors.
o IDA Board of Directors: The Board of Directors consists of executive directors
and is chaired by the President of the World Bank Group. Executive Directors are
appointed or elected by the Governors.
 IDA lends money on concessional terms. This means that IDA credits have a zero or
very low-interest charge and repayments are stretched over 30 to 38 years, including a
5- to 10-year grace period. IDA also provides grants to countries at risk of debt
distress.
 To borrow from the IDA's concessional lending programs, a country's gross national
income (GNI) per capita must not exceed $ 1,145 (the fiscal year 2019).
 IDA also provides significant levels of debt relief through the Heavily Indebted Poor
Countries (HIPC) Initiative and the Multilateral Debt Relief Initiative (MDRI).

4. What is International Centre for Settlement of Investment Disputes (ICSID)?

 ICSID was established in 1966 by the Convention on the Settlement of Investment
Disputes between States and Nationals of Other States (the ICSID Convention). The
ICSID Convention is a multilateral treaty formulated by the Executive Directors of the
World Bank to further the Bank’s objective of promoting international investment.
 States have agreed on ICSID as a forum for investor-State dispute settlement in
most international investment treaties and in numerous investment laws and
contracts.
 Bilateral investment treaties (BITs) are proliferating, many such treaties contain text
that refers present and future investment disputes to the ICSID.
 ICSID provides for settlement of disputes by conciliation, arbitration or fact-finding.
 Governance of ICSID
o Administrative Council:
 One representative of each Member State, and one vote per State.
 Adopts ICSID arbitration, conciliation and fact-finding rules.
 Adopts an annual budget and approves annual report.
 Elects Secretary-General and Deputy Secretaries-General.
 Each State designates persons to a list of arbitrators and conciliators.
o Secretariat:
 Led by Secretary-General. Provides technical and administrative support to
proceedings.
 Offers training and technical assistance to governments and the public.
 Contributes to the development of investment law through publishing and
outreach.
o ICSID Panel of Arbitrators and Panel of Conciliators:
 Each ICSID Member State may designate four persons to each Panel.
o Conciliation Commission or Arbitral Tribunal: an Arbitral tribunal or
Conciliation Commission is constituted by Secretary-General. In most instances,
the tribunals consist of three arbitrators: one appointed by the investor, another
appointed by the State, and the third, presiding arbitrator appointed by
agreement of both parties.
 Each case is considered by an independent Conciliation Commission or Arbitral
Tribunal, after hearing evidence and legal arguments from the parties. A dedicated
 ICSID case team is assigned to each case and provides expert assistance throughout the
process.
 An ICSID award according to Article 53 of the ICSID Convention is final and binding
and immune from appeal or annulment, other than as provided in the ICSID
Convention.
 India is not a member of ICSID.

5.What is the Multilateral Investment Guarantee Agency (MIGA)?

 MIGA is a member of the World Bank Group and its mandate is to promote cross-
border investment in developing countries by providing guarantees (political risk
insurance and credit enhancement) to investors and lenders.
 MIGA was created to complement public and private sources of investment
insurance against non-commercial risks (currency inconvertibility and transfer
restriction, government expropriation, war, terrorism, and civil disturbance, breaches
of contract, and the non-honouring of financial obligations) in developing countries.
 MIGA convention that defined its core mission was submitted to the Board of
Governors of the IBRD in 1985 and went into establishing MIGA as the newest
member of the World Bank Group in 1988.
 The Convention can be amended by the Council of Governors of MIGA.
 The agency opened for business as a legally separate and financially independent
entity. Membership was open to all IBRD members.
 Governance of MIGA
o Council of Governors: MIGA is governed by its Council of Governors which
represents its member countries. The Council of Governors holds corporate
authority, but primarily delegates such powers to MIGA's Board of Directors.
o MIGA Board of Directors: The Board of Directors consists of directors and
votes on matters brought before MIGA. Each director's vote is weighted in
accordance with the total share capital of the member nations that the director
represents.
 MIGA aims to promote foreign direct investment into developing countries to
support economic growth, reduce poverty and improve people’s lives.

What is the Criteria for World Bank Group Membership?

 To become a member of the Bank, under the IBRD Articles of Agreement, a country
must first join the International Monetary Fund (IMF).
 Membership in IDA, IFC, and MIGA are conditional on membership in IBRD.
 Membership in ICSID is available to IBRD members, and those which are a party to
the Statute of the International Court of Justice (ICJ), on the invitation of the ICSID
Administrative Council by a vote of two-thirds of its members.
What are the Major Reports of the World Bank?
 Ease of Doing Business (Stopped publishing recently).
 Human Capital Index.
 World Development Report.
 Other Recent Publications:
o World Bank Paper on india’s Poverty
o South Asia Economic Focus (Bi- Annual)
o Groundswell report

What about the Coopeation between World Bank Group and India?
 India was one of the forty-four original signatories to the agreements
reached at Bretton Woods that established the International Bank for Reconstruction
and Development (IBRD) and the International Monetary Fund (IMF).
 It was also one of the founding members of the IFC in 1956 and the IDA in 1960.
India later became a member of the MIGA in January 1994.
 India is not a member of ICSID. India claimed ICSID Convention is not fair,
convention's rules for arbitration leaned towards the developed countries. In
ICSID, the Chairman of the Centre is the Chairman of the World Bank. The Chairman
appoints the arbitrators. If the arbitration award is not satisfactory, then the aggrieved
party would appeal to a panel, which will also be constituted by the ICSID. There is no
scope for a review of the award by an Indian court, even if the award is
against public interest.
 IBRD lending to India commenced in 1949 with a loan to the Indian railways, the first
investment by the IFC in India took place in 1959, and by IDA in 1961 (a highway
construction project).
 During the 1950s, the IBRD was India's sole source of World Bank borrowings.
 By the end of the decade, India's mounting debt problems became an important factor in
the launch of the IDA, the soft loan affiliate of the World Bank (WB) group.
 By the end of the 1960s, the United States, until then India's largest source of external
resources, sharply cut its bilateral aid program. Since then, the WB emerged as the most
important source of official long-term finance.
 During the 1960s and 1970s, the IDA accounted for nearly three-fourths of all WB
lending to India and, in turn, India was by far the largest recipient of IDA funds,
accounting for more than two-fifths of all its lending.
 The subsequent decade, with China joining the WB in 1980 and accordingly entering
its own claims to limited IDA resources, the worsening economic fortunes of Africa,
and India's better performance, saw a sharp decline in India's share in IDA.
 Instead, its share of IBRD lending grew sharply in the 1980s, buoyed by its
improving credit-worthiness and the Indian government's waning inhibitions with
regard to non-concessional borrowing.
 During the 1980s, while the WB shifted its emphasis to stress policy reforms
and greater economic liberalization, it continued to lend to poorly governed public
sector institutions in India and was muted in its criticism of India's closed economy.
 The lending portfolio changed sharply after the 1991 macroeconomic crisis. In the
immediate aftermath, India became one of the last important WB borrowers to partake
of structural adjustment lending, which supported policy reforms in finance,
taxation, and the investment and trade regime.
 India is currently classified as a “blend” country — defined as one
in transition from lower middle-income to middle-income — and is creditworthy for
lending from both IDA and IBRD.
 India is the largest IBRD client of the World Bank. Between 2015 and 2018, the World
Bank lent around $10.2 billion to India.
 The World Bank Group (WBG) has approved a $25-30 billion commitment plan for
India for the period 2019-22.
 MIGA Performance Standards are environmental and social standards which help to
structure and implement sustainable projects. For Indian market, one of the options is a
breach of contract insurance which MIGA would offer to investors. In case the
government doesn’t perform its obligation, under the contract arrangement, then
MIGA can come and cover that risk for investment.
 In July 2020, the World Bank and the Government of India signed the USD 750 million
agreement for an Emergency Response Programme for MSMEs (Micro, Small, and
Medium Enterprises).
o Earlier i.n May 2020, World Bank approved USD 1 billion for accelerating
India’s Covid-19 Social Protection Response Programme.
 In November 2021, India and the World Bank signed a USD 40 million for Meghalaya
Health Systems Strengthening Project.
o The project aims to invest in infection prevention and control for a more resilient
response to future outbreaks, pandemics, and health emergencies
o It also aims to improve the overall ecosystem for bio-medical waste management
(both solid and liquid waste), segregation, disinfection, and collection while
safeguarding the environment and improving the quality of health service and
patient safety.

Why is there a Need for Reforms within the World Bank?

 Some critics have pointed out that the World Bank really caters to the agenda of World
Capitalism in the garb of its “Structural Adjustment Programme’ (SAP) and
continues to be dominated by rich countries. SAP is a set of "free market" economic
policy reforms imposed on developing countries by the World Bank as a condition for
receipt of loans.
 It is argued SAP policies have increased the gap between rich and poor in both local
and global terms.
 The emerging new economic powers, particularly India and China, and some other
Asian and Latin American countries of the world should be given due place and role.
 The leadership succession debate should be used to create space for reflection on the
purpose of the multilateral body, the substantive role it should play in the future, the
need to strengthen inclusive multilateralism, and the actions needed to bolster the
position of emerging economies and developing countries.
 Failure of World Bank to adapt to the changing world order may see rising
economies going their own way.
o Eg. Establishment of the Asia Infrastructure Investment Bank (AIIB) by
China.
 o Such a development would signify the emergence of multi-polarity without
multilateralism, and create a climate of conflicting interests and values among a
diverse group of countries.
 Deep reforms of the World Bank are necessary as part of rethinking the current world
order, and giving rising powers and developing countries a meaningful voice in this
institution.