Institutions and Economic Development

Dr. Amit Kumar Sahoo

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Topics to Learn
• Role of institutions in economic development
• Characteristics of good institutions and quality of institutions
• The pre-requisites of a sound institutional structure
• Different measures of institutions – aggregate governance index, property rights and
risk of expropriation
• The role of democracy in economic development
• Role of markets and market failure; Institutional and cultural requirements for
operation of effective private markets
• Market facilitating conditions
• Limitations of markets in LDCs
• Corruption and economic development – tackling the problem of corruption

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Institutional Economics
▪ Institutional economics focuses on understanding the role of the evolutionary process and the role of
institutions in shaping economic behavior.
▪ The conventional view is that the “founders” of institutionalism were Thorstein Veblen, Wesley
Mitchell, and John R. Commons.
▪ Thorstein Veblen provided much of the intellectual inspiration for institutionalism.
▪ He rejected what he saw as the static view of mainstream economics, which focused on individual action
and market equilibrium.
▪ Veblen instead believed that economic behavior was socially determined based on a process of the
historical evolution of social institutions.
▪ According him, human biological instincts and psychological tendencies, in turn, shape these social
institutions and other way round.
▪ Veblen perceived as a systemic failure of “business” institutions to channel private economic activity in
ways consistent with the public interest.
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Institutional Economics
▪ Institutional Economics’ name and core elements trace back to a 1919 American Economic Review article
by Walton H. Hamilton. ["The Institutional Approach to Economic Theory," American Economic Review,
9(1)].
▪ 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).
▪ Their approach is characterized by:
a) underlining the role of institutions as constraining and enabling behavior, and highlighting the
institutional role in shaping values, beliefs and preferences
b) incorporating a social psychology which is consistent with recognizing that institutions influence values,
beliefs and preferences, and a related rejection of the idea of utility maximizing
c) an open empirical and critical investigation of social phenomena
d) critically examining the functioning of prevailing institutions
e) adhering a pragmatic and humanistic approach to social value
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New-Institutional Economics
▪ But in recent years, the term “new institutional economics” has become well-established as referring
to the tradition of work stemming primarily from the transactions cost approach of Ronald Coase,
Oliver Williamson, and Douglass North.
▪ “New institutional economics” label is often extended to cover game theoretic approaches to the
evolution of social conventions, and sometimes to the Austrian approaches to institutions and
institutional change that build from Carl Menger and Frederick von Hayek.
▪ 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.
▪ Original Institutional Economics (OIE) vs New-institutional economics (NIE)
o The distinction hinges on the theoretical treatment of the individual.
o In the new institutional economics the preferences or purposes of the individual are taken as given,
whereas in the 'old' institutional economics they were seen as molded and reconstituted by social
circumstances.

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Who are the advocates of institutional economics
▪ Veblen, Thorstein. (1904. The Theory of Business Enterprise.
▪ Ronald H. Coase(1937). "The Nature of the Firm". Economica. 4 (16): 386–405.
▪ Roland H. Coase (1960). "The Problem of Social Cost". Journal of Law and Economics. 3 (1): 1–44.
▪ Olson, M. (1982) The Rise and Decline of Nations (New Haven, CT: Yale University Press).
▪ Douglass North (1990) first brought to the fore the role of institutions in economic development.
▪ Douglass North (1990) Institutions, Institutional Change and Economic Performance (New York: Cambridge University Press)
▪ Rodrik, D. (2008) One Economics: Many Recipes (Princeton, NJ: Princeton University Press).
▪ Rodrik, D. and Subramanian, A. (2008) ‘The Primacy of Institutions and What This Does and Does Not Mean’, in G. Secondi (ed.) The
Development Economics Reader (London: Routledge).
▪ Sachs, J. (2008) ‘Institutions Matter but not for Everything: The Role of Geography and Resource Endowments in Development Shouldn’t be
Underestimated’, in G. Secondi (ed.) The Development Economics Reader (London: Routledge).
▪ Shirley, M. (2008) Institutions and Development (Cheltenham: Edward Elgar).
▪ Rodrik, D. (2008) One Economics: Many Recipes (Princeton, NJ: Princeton University Press).
▪ Bardhan, P. and Udry, C. (1999) Development Microeconomics (New York: Oxford University Press).
▪ Bardhan, P. (2005b) ‘Institutions Matter, But Which Ones?’, Economics of Transition, 13(3): 499–532.
▪ Acemoglu, D. (2008) ‘Root Causes: An Historical Approach to Assessing the Role of Institutions in Economic Development’, in G. Secondi (ed.)
The Development Economics Reader (London: Routledge).
▪ Acemoglu, D. and Robinson, J.A. (2012) Why Nations Fail: The Origins of Power, Prosperity and Poverty (New
▪ York: Crown Publishers).
▪ Acemoglu, D., Johnson, S. and Robinson, J.A. (2001) ‘The Colonial Origins of Comparative Development: An Empirical Investigation’, American
Economic Review, 91(5): 1369–1401.
▪ Acemoglu, D., Johnson, S. and Robinson, J.A. (2002) ‘Reversal of Fortune: Geography and Institutions in the Making of the Modern World
Income Distribution’, Quarterly Journal of Economics, 117(4): 1231–94

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What is Institution?
➢Broad Definition:
• ‘formal and informal rules [or norms] governing human behaviour’ – Douglas North (1990) in
his book entitled as ‘Institutions, Institutional Change and Economic Performance’ (New York:
Cambridge University Press).
• ‘a set of humanly devised behavioural rules that govern and shape the interaction of human
beings, in part by helping them to form expectations of what other people do’. - Lin and
Nugent (1995) article entitled as ‘Institutions and Economic Development’, in J. Behrman and
T. Srinivasan (eds) Handbook of Development Economics (Amsterdam: North-Holland).

➢Precise Definition: institutions can be defined in terms of

• the extent of property rights’ protection
• the degree to which laws and regulations are fairly enforced
• the ability of government to protect the individual against economic shocks and provide social
protection
• the extent of political corruption.

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Cont...
❖Are institutions formal or informal?
✓Formal Institutions: Rules that human beings devise
✓Informal Institutions: institutions can be defined in terms of conventions and codes of
behavior.
❖Institutions may be created, as was the Indian Constitution; or they may simply evolve over
time, as does the common law.
❖ Institutions consist of formal written rules as well as typically unwritten codes of
conduct that underlie and supplement formal rules.
❖Defining institutions as the constraints that human beings impose on themselves makes the
definition complementary to the choice theoretic approach of neoclassical economic theory.

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CLASSIFICATION OF INSTITUTIONS

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A. Degree of Formality
✓ Formal rules and constraints are made up of:
o constitutions, laws, property rights, charters, bylaws, statute and common law, and regulations;
o enforcement characteristics (sanctions, etc.).
o Arising to co-ordinate repeated human interaction, informal rules are: extensions, elaborations,
and modifications of formal rules
o socially sanctioned norms of behaviour (customs, taboos and traditions)
o internally enforced standards of conduct
✓ Although formal rules may change overnight as the result of political or judicial decisions, informal
constraints embodied in customs, traditions, and codes of conduct are much more impervious to
deliberate policies (North, 1990).
✓ The informal and norm-based institutions that small community-based groups rely on tend to support
a less diverse set of activities than do formal legal institutions.
✓ As countries develop, the number and range of partners that market participants deal with increases
and market transactions become more complicated, demanding more formal institutions.
✓ Ideally, informal and formal institutions should complement each other.

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B. Different Levels of Hierarchy
✓ Williamson (2000)
proposed a
classification scheme
based on different
hierarchical levels.
✓ The higher level
imposes constraints
on the lower level, and
feed-back exists from
the lower level to the
higher level.

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C. Area of Analysis
✓ Finally, a third alternative used in the literature to classify institutions is to differentiate between
various areas of analysis.
✓ The four categories most commonly found in the literature are:
o economic institutions
o political institutions
o legal institutions
o social institutions
✓ Under economic institutions, authors usually place rules that define the production, allocation and
distribution process of goods and services, including markets (Bowles, 1998).
✓ Studies of political institutions usually employ variables that provide details about elections,
electoral rules, type of political system, party composition of the opposition and the government,
measures of checks and balances and political stability (Beck et al., 2002).
✓ Studies related to law and institutions refer to the type of legal system, the definition and
enforcement of property rights and legal origin.
✓ Finally, studies on social institutions usually cover rules that have to do with access to health and
education and social security arrangements, have an impact on gender balance and govern more
generally the relationship between economic actors.
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Role of Institution
✓ Nobel Prize-winning economist Douglass North first brought to the fore the role of institutions in
economic development.
✓ The modern exponents of the primacy of institutions are Dani Rodrik of Harvard University and
Daron Acemoglu, Simon Johnson and James Robinson of the Massachusetts Institute of
Technology.
✓ In his well-known book, Institutions, Institutional Change and Economic Performance (1990),
North argued that institution plays a major role in economic development by mentioning that
Third World countries are poor because the institutional constraints define a set of pay-offs to
political/economic activity that do not encourage productive activity.
✓ North (1990) also said that ‘the inability of societies to develop effective low-cost enforcement
of contracts is the most important source of both historical stagnation and contemporary
underdevelopment in the Third World’.
✓ Because the absence of secure property and contractual rights discourages investment and
specialization.
✓ Mancur Olson (1982) makes the same point in his classic book, The Rise and Decline of Nations.

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Role of Institution
✓Acemoglu and Robinson (2012), in their book ‘Why Nations Fail’ argued that
without inclusive economic and political institutions, nations will fail.
✓Inclusive institution vs Extractive Institution:
• Inclusive institutions are necessary to challenge and constrain the political power of the
elite, otherwise the elite use political power to protect the status quo and preserve extractive
economic rents, which diminishes the incentive to innovate and invest.
• Inclusive political institutions lead to inclusive economic institutions and this is the basis for
prosperity – a virtuous circle is started.
• Extractive rules/institutional arrangements are reinforcing in the opposite direction – plunder
further empowers the elite.
• Institutions and rules influence how the economy works and the incentives
that motivate people.
• Institutions explain why growth took off earlier in Europe than Africa, Latin
America and Asia, and why there are many failed states today, particularly in
Africa where autocracy is rife and the benefits of natural resources are siphoned
off to an elite.
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Role of Institution
✓Incentives and price signals:
• It is so vital for a market economy, cannot function properly without institutional structures
and rules of behaviour.
• As Rodrik (2008) says: ‘markets require institutions because they are not self-creating, self-
regulating, self-stabilising, or self-legitimising’.
✓Transaction Cost:
• In small rural communities where everyone knows each other, the scope for cheating, fraud
and not honouring contracts is limited.
• Transaction costs associated with the costs of information, negotiBtion, monitoring,
coordination and enforcement of contracts are low, and communities survive by adhering to
norms of behaviour;
• But economic development is limited through a lack of specialization. In contrast, in large,
modern, industrial societies, where transactions are impersonal, there is widespread scope for
opportunistic behaviour (Bardhan and Udry, 1999).
• Transactions (and therefore production) costs may be very high without institutional
structures that curtail such behaviour, such as the enforcement of property rights and the rule
of law, the provision of limited liability, the guarantee of contracts, patent protection and so on.
• With low transaction costs, firms and markets can concentrate on the job of investment in the
knowledge that property rights are secure. 15
Institutional Structure and Economic Performance
What are prerequisites of a sound institutional structure for economic development?

✓ There is no one set of institutions that will suit all countries

✓ But according to Rodrik (2000, 2008); Rodrik and Subramanian (2008) there is a consensus
among development economists that at least five main types of market-supporting institutions
are necessary, if not sufficient, conditions for rapid economic progress
❖ property rights and legally binding contracts: market-creating institutions

❖ regulatory institutions: market-regulating institutions

❖ institutions for macroeconomic stability: market-stabilizing institutions

❖ social insurance institutions: market-legitimizing institutions

❖ institutions of conflict management: market-legitimizing institutions.

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Market-Creating Institutions

Role of Property rights and legally binding contracts:

✓Agents lack the incentive to invest and innovate if they do not have control over
the return on the assets they accumulate.

✓Intellectual property rights are particularly important to encourage invention.

✓ Control is more important than ownership. Formal property rights do not mean very much if there
are not control rights.

✓ But control rights can spur entrepreneurial activity without clearly defined property rights

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Market-Regulating Institutions

Role of Regulatory Institutions:

✓Markets fail if there is fraud or anti-competitive behaviour.

✓Regulatory institutions are needed if markets are to function properly.

✓When markets are liberalized, a regulatory framework is also required to avoid

the consequences of risky behaviour, such as financial crises if the banking system
is not properly regulated (2008 financial crisis).

✓There should be ‘regulatory’ framework to compensate for capital market

imperfections and coordination failures for promoting innovation and growth.

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Market-Stabilizing Institutions
Role of institutions for macroeconomic stability:
✓Monetary and fiscal policy institutions are necessary to provide an enabling
environment in which private investment can flourish.
✓Market economies are not self-regulating, and macroeconomic instability creates
risk and uncertainty.
✓The minimization of risk is vital if entrepreneurs are to take informed, long-term
investment decisions.
✓Financial markets are inherently unstable, which can have damaging real effects,
and they need careful supervision.
✓A central bank, a responsible banking system and fiscal prudence are all important
ingredients of macroeconomic stability.

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Market-Legitimizing Institutions
Role of social insurance institutions:

✓ These institutions are required to provide security to those who can’t withstand the change
occurred in the economy or society.

✓ Insurance against unemployment, crop failures and price fluctuations for agricultural commodities
are all important if traditional agriculture is to be transformed.

✓ Economic reforms of any type, particularly in the process of liberalizing markets, will meet
resistance if not enough attention is paid to creating social security institutions to protect the
vulnerable.

✓ Social stability and cohesion within a market economy in the process of structural change require
social insurance and safety nets.

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Institutions of Conflict Management
Role of Institutions for Conflict Management:

✓ Many developing countries have deep ethnic, tribal and religious divisions.

✓ Social conflict damages economies because it diverts resources from directly productive activities
and creates uncertainty, which deters investment.

✓ To minimize conflict requires a full range of institutions – the rule of law, a fair legal system, a
political voice for minority groups.

✓ The potential winners of social conflict will not benefit and potential losers will be properly
safeguarded.

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How are good institutions acquired?
✓ Because of history and the diversity of countries, there is no one unique set of institutions that can
be prescribed for every country.
✓ Rodrik and Subramanian (2008): ‘there is growing evidence that desirable institutional
arrangements have a large element of context specificity arising from differences in historical
trajectories, geography, political economy and other initial conditions ... institutional
innovations do not necessarily travel well’.
✓ it is not easy to bring about institutional change, because of a collective action problem
✓ free-rider problem about sharing the cost of change
✓ bargaining problem relating to sharing the potential benefits of change
✓ The need for state to foster institutional change and development without destroying markets, or
allowing itself to be influenced by special interest groups or corrupted by rent-seeking behaviour
on the part of politicians and bureaucrats.
✓ Rodrik (2000) argues that ‘institutions need to be developed locally, relying on hands-on
experience, local knowledge and experimentation’.
✓ participatory political institutions (Bottom-Up approach)

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What is missing in Poor Countries?
✓ Rodrik (2000) highlights the following institutional arrangements that are conspicuously absent
in poor countries:

❖ a clearly defined system of property rights

❖ a regulatory apparatus curbing the worst forms of fraud, anti-competitive behaviour, and
moral hazard

❖ a moderately cohesive society exhibiting trust and social cooperation

❖social and political institutions that mitigate risk and manage social conflict

❖the rule of law and clean government.

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A Framework for Analysing the Impact of Institutions on Development Outcomes

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Different Measures of Institutions
✓The challenge of treating institution as an exogeneous variable to explain economic
development.
✓Because institution and economic development are endogenous in nature.
✓ Measure of Quality institutions are endogenous because the measures themselves are
partly a function of the stage of development and economic success.
✓To cope with this difficulty, one can either find instruments to proxy for present-day
institutions.
✓Several different measures of institutions are as follows:
▪ An aggregate governance index (Kaufman et al., 1999)
▪ A measure of property rights and risk of expropriation (Keefer and Knack, 1995)
▪ An index of democracy, political rights and civil liberties (Gastil Index)
▪ An index of corruption (Transparency International)
▪ Economic freedom (Heritage Foundation)
▪ An index of social division
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Three Important Characteristics of Good Institutions
Acemoglu (2008) identifies three important characteristics of good institutions:

✓The enforcement of property rights and the rule of law, so that individuals have the
incentive to save, invest and take risks (as argued above).

✓Constraints on those in positions of power so that they cannot expropriate the

resources of a country for their own benefit.

✓Equal opportunities for all, so that everyone has the incentive to better themselves
and to participate productively in society.

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Three Important Characteristics of Good Institutions
Acemoglu (2008) identifies three important characteristics of good institutions:

✓The enforcement of property rights and the rule of law, so that individuals have the
incentive to save, invest and take risks (as argued above).

✓Constraints on those in positions of power so that they cannot expropriate the

resources of a country for their own benefit.

✓Equal opportunities for all, so that everyone has the incentive to better themselves
and to participate productively in society.

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