Chap ter Two: Institutions for Rural Development

 Think about the following questions.

 Why are some countries rich and others poor?
 Is it because the riches are more intelligent?
 Because they work harder?
 Because they are morally more just?
 Because they have abundant natural resource
 Because they have good culture, Demographic growth, Geography?
 Why are the citizens of some countries more free to realize their potential than
others?
 Why are some organizations more efficient and effective at what they do than
others?
 Definition and Concepts of Institution
 Institutions are the written and unwritten rules, norms, and constraints that
humans devise to reduce uncertainty and control their environment.
 Institutions are the rules of the game in a society or, more formally, are the
humanly devised constraints that shape human interaction.
 Central role of institutions broadly defined as the rules that govern economic and
political behavior.
 North (1991) defined institution as “humanly devised constraints that structure
political, economic, and social interaction among a given society”.
 According to him, institutions consist of both informal and formal constraints.
 Where,
 informal constraints include sanctions, customs, and codes of conduct, and
 formal constraints are constitutions, laws, property rights
 The definition of institutions and organizations are traditionally overlapping and
peoples use them interchangeably. But they are quite different.
 Thus, organization is a functional body that organized within the rules set by
institutions to achieve particular goals.
 Organization can be family, particular community, firm, and group of individuals,
ministry, and so on.
 Whereas, institutions are marriage, the constitution, property rights, the market,
state, and etc. that guide organizations.
 According to Acemoglu and Robinson ( 2012), institution is classified as
 Extractive institutions (Extractive economic institutions and Extractive Political
institutions)
 Inclusive institutions (Inclusive economic institutions and Inclusive political
institutions)
 All economic institutions are created by society.
Inclusive economic institutions
 Inclusive economic institutions secure property rights, law and order, markets and
state support (public services and regulation) for markets; open to relatively free
entry of new businesses; uphold contracts; access to education and opportunity
for the great majority of citizens.
 Inclusive economic institutions create inclusive markets, which not only give
people freedom to pursue the vocations in life that best suit their talents but also
provide a level playing field that gives them the opportunity to do so. 
 Those who have good ideas will be able to start businesses, workers will tend to
go to activities where their productivity is greater, and less efficient firms can be
replaced by more efficient ones.
 Inclusive economic institutions also pave the way for two other engines of
prosperity: technology and education.
Inclusive Political Institutions
 Politics is the process by which a society chooses the rules that will govern it. 
 We refer to political institutions that are sufficiently centralized and pluralistic as
inclusive political institutions.
 Political institutions allowing broad participation-pluralism and placing
constraints and checks on politicians; rule of law (closely related to pluralism).
 But also some degree of political centralization for the states to be able to effectively
enforce law and order.
 Political institutions that distribute power broadly in society and subject it to
constraints are pluralistic. Instead of being vested in a single individual or a
narrow group, political power rests with a broad coalition or a plurality of groups.
Extractive economic institutions
 Extractive economic institutions:
 Lack of law and order.
 Insecure property rights; entry barriers and regulations preventing functioning
of markets and creating a non-level playing field.
 Citizens will not be able to own property, start a business, or become more
prosperous even if many people engage illegally in private economic activities to
make a living.
 They also know that they will not have legal access to markets where they can use
their skills or their earnings to purchase the goods they need and desire. They are
even unsure about what kind of human rights they will have.
 Extractive economic institutions extractive because such institutions are designed
to extract incomes and wealth from one subset of society to benefit a different
subset.
Extractive Political Institutions
 If the distribution of power is narrow and unconstrained, then the political
institutions are absolutist.
 Extractive political institutions concentrate power in the hands of a narrow elite
and place few constraints on the exercise of this power. Economic institutions are
then often structured by this elite to extract resources from the rest of the society. 
 Extractive economic institutions thus naturally accompany extractive political
institutions. 
 This synergistic relationship between extractive economic and political
institutions introduces a strong feedback loop:
 political institutions enable the elites controlling political power to choose
economic institutions with few constraints or opposing forces.
 They also enable the elites to structure future political institutions and their
evolution. 
 Extractive economic institutions, in turn, enrich the same elites, and their
economic wealth and power help consolidate their political dominance. 
 Demand and supply of institutions
 Institutions are demanded to move organizations towards higher levels of efficiency
and effectiveness.
 They directly affected by change in the knowledge, development level, technology,
factor endowment, cultures, and the intended goals of an organization.
 As the economic environment changes, there must be a need for institutional
arrangement, periodical formulations and revisions of institutions to assure the
sustainability of development process.
 The demand for institutions is depends on how they are effective in achieving the
desired goals.
 There are five criteria to differentiate better and effective from worse institutions
1. Efficiency and growth
2. Autonomy and freedom: better institutions allow ‘freedom to choose’ based on
competition and free discussion.
3. Diversity and pluralism
4. Equity and justice: better institutions create equality of opportunity, performance
based rewards, and elimination of exclusion and insecurity.
5. Connectedness and voluntary cooperation: better institutions increase voluntary
interdependence, and capacity to cooperate freely with each other.
 The supply of institutions depends critically on:
 the balance of power among interest groups in a society.
 culture of a given community which includes customs, believes, religion, and
ideology.
 advances in knowledge and technologies also lead to institutional innovations for
their implementations.
Market as institution and rural development
 Under the market-oriented economy, everybody assumed to act rationally to
maximize their own welfare. That is,
 In product market,
 producers produce to maximize profit
 individuals intended to maximize utility
 In the labor (factor) market,
 firms try to hire resources at least cost
 workers are trying to have better paying job with better working environment
 In the foreign market,
countries are trying to have more foreign income and more inflow of foreign
investment, and so on.
 Market outcome under its restricted assumptions
 The fundamental assumptions of free market include:
1. There are large number of buyers and sellers: each buyer and seller is price
takers.
2. There is given and fixed technology
3. There is perfect mobility of factors of production
4. There is perfect information/knowledge
5. Entry and exit is free for all: all economic agents are free to join or leave the
market.
6. There are no transaction costs
7. There are no public goods and externalities: there is a property right.
8. Economic agents are rational: economic agents are assumed to maximize their
respective objectives rationally.
 Efficiency of the Competitive Outcome
 Under these assumptions, market-oriented economy is always efficient in allocation of resources.
 Economists say that a situation is efficient if there is no way to change the situation so
as to make some people better off without making anyone worse off.
 That is, there will be Pareto optimal allocation of resources which is the cornerstone
of any development effort.
o At the Pareto optimal point it is impossible to make someone better-off without
making somebody else worse-off.
o That is, there is no home for the improvement of the allocation of resources.
 At the Pareto optimal point, there are:
 Pareto efficiency in consumption: consumers achieved their best utility from the
limited resource that societies possess. Thus, it is impossible to increase utility of
any customer by changing the composition.
 Pareto efficiency in production: it is impossible to increase the level of production
by changing input composition and efficiency of input use.
 Pareto optimality in distribution: the limited resources that the societies possess are
distributed among firms, and goods and services that can be produced from those
limited resources are distributed optimally among consumers. So, there is no further
distribution.
 Although free (perfect) market is efficient in allocation of resources for economic
agents under its restricted assumptions, the perfection of market is unrealistic in our
real world.
 Thus, even though market is an efficient institution in providing poor rural society
with agricultural inputs, credits, and just price for their outputs, it fails:
 in providing all socio-economic infrastructural facilities (especially in
providing public goods and services)
 due to the existence of externalities and information asymmetry.
 Institutions to deal with market failure

 The term ‘imperfect market ’ or ‘market failure’ means that some ingredients of the
competitive situation are absent:
o a single very large buyer or seller can influence the market price – monopoly
o information about prices & their trends may be unevenly distributed – fevering
some participant
o markets may be fragmented due to poor transport and communications, or they
o may be absent due to high transaction costs, information failures, and other
reasons.
 Government refers to the group of people who are in charge of running a country at
any particular moment of time.
 Government is concerned with political decision making.
 Government change-rather frequently in some countries
 State refers to the whole apparatus of public institutions & bureaucracies – the civil
service & the armed forces.
State is concerned with administration & enforcement of decisions.
State tends to be more enduring in size & scope over lengthy period of history
 The need for government intervention in agriculture and rural development
 Due to market failures, inefficient marketing services, and missing markets, market
allocation will not result on the best possible resource allocation.
 Market a force alone is therefore, will not result in best possible rural development.
 Thus, we need alternative institutions to give complementary signal and to
coordinate diverse activity of many agents toward achievement of fast and
sustainable development.
 Policies are thought of as types of state intervention in the market economy, but there
is no single definition of the term.
 Economists usually think of policies as the goals and methods adopted by
governments in order to influence the level of economic variables like prices,
household income, national income, the exchange rate & so on.
 Policy is defined as the course of action chosen by government towards an aspect of
the economy, including the goals the government seeks to achieve, and the choice of
methods to pursue the goals.
 ‘STATE is usually counter posed to the ‘MARKET’
 During the 1960s to the 1980s major perspective on development was that the state
had a central role to play:
- in accelerating the pace of economic growth,
- for ensuring a more equitable distribution of income,
- carrying out tasks that by their nature would be unlikely or impossible for the
private sector to carry out – provision of social services such as health &
education,
- or investment in public infrastructure – such as roads and communications.
- Some governments chose to replace markets almost entirely by state-led form of
production & exchange, while others opted for co-existence of market & state
 The role of state in rural development as complementary to market and its
rationales are given below:
 To provide public goods and services:
 If the supply of public goods and services are left for the will of the people, there is
an incentive to be a free rider than paying for supply of public goods and services.
 As a result, the supply of public goods and services will be sup-optimal.
 Thus, in order to supply optimal public goods and services like roads, schools,
defense, public administration, and so on people expected to pay a mandatory
taxation.
 Using the tax revenue, state is needed and expected to supply the efficient (optimal)
public goods and services which are essential for development.
 To internalize externality:
 If market demand is the same as social marginal benefit and if market supply is the
same as social marginal cost, market forces will result in the best possible resource
allocation.
 However, when there is negative externality, social marginal cost will be higher than
private marginal cost.
 To make the private marginal cost equal to social marginal cost, mandatory tax has to
be laid.
 When mandatory taxes are laid in production, market forces will result in efficient
and optimal production of good or service.
 For example, factories produce goods and services to maximize their private profit by
ignoring the negative externality exerted on society in terms of river pollution, air
pollution, etc.
 The tax revenue can be used to compensate the adversely affected parties and/or to
invest on the purification of pollution.
 When there is positive externality, social marginal benefit is higher than private
marginal benefit.
  For example, education, health care, sanitation and other social goods and services
have positive externality on society’s welfare.
 So, market mechanism result in sub-optimal supply of social goods and services.
 Therefore, state has to subsidize the supply of education, health care, sanitation
and other social goods in order to enable people to be more educated, healthy,
clean, etc.
 To deal with imperfect information and risk:
 Given rural areas are highly dependent on farming and farming in turn is
dependent on random natural events, there is high level of risk in rural areas.
- Information, insurance, financial intermediation and future markets are either
missing or highly imperfect.
 Thus, there is a need for state intervention in the form of price stabilization,
safety net, drought relief and other forms which have significant impact on rural
development.
 To create egalitarian society:
 Even if markets are Pareto optimal (efficient), the final distribution of benefits
may not be egalitarian (equal) if the initial distribution of capabilities
(education, wealth, asset, social network and so on) is unfair.
 Such distribution of quality of life may not be acceptable to society, given the
fact that the social value of the poor persons’ benefit can overweight the social
loss of the rich.
 Thus, it requires the distribution of resources and capabilities from rich to poor
through tax or subsidies.
 Since market is not perfect in developing countries in general and rural areas
of developing countries in particular, government intervention to distribute
factors of production and capabilities is crucial to achieve rural development.
- Open access resources:- resources of communal access (e.g. forests for firewood)
where the private cost of using more of the resource is lower than the social cost
incurred by the community as a whole, resulting in over-exploitation & possible
permanent damage to the resource;
 The other reasons for state intervention:
- Macroeconomic problems:- problems that can only be handled by a central
authority, for example, money supply, inflation, exchange rate, taxation & so on;
- Poverty and inequality: the market outcome may result in a degree of inequality
or an incidence of poverty that is regarded as socially unacceptable.
 The need to create rural-urban balance:
 Missing markets, missing public goods (services) and missing administrative
services are common reality of rural areas of developing economies. These facts
coupled with low organizational capital of rural population, can make development
highly urban biased phenomena.
 To solve this challenge, state intervention to organize rural population into
functional political body, economic organization, and to improve the provision of
goods and services is critically needed in rural areas.

 Market Failure
 The neoclassical school of thought argues that, free market will result in efficiency in
consumption, production, and distribution under its some restricted assumptions.
 In practice however, there is a market failure in providing the Pareto-efficient level of
production and consumption.
 In general, conditions causing market failure are classified into four categories:
monopoly power, externalities, public goods, and asymmetric information.
o Market failure is an economic failure (that occurs) when the resulting market
equilibrium is not efficient. E.g., when a power company sets its price above
marginal cost.
o The conventional approach to market failure is to list the situations in which
resource misallocation may occur: monopoly, interdependence of economic
agents external to the market mechanism, public goods, common access
resources, and so on.
 The observation that markets may fail has been a major factor in supporting
microeconomic activity by governments.
 Traditional Market Failures
 Existence of externality
o Externality is the action of those parties can affect the third party that was not in
the transaction.
o That is, consumers and producers who attempt to pursue their own self-interest may
fail to take into account the effects of their actions on third-parties, such effects are
called externalities.
o An externality is said to exist if some of the variables which affect one decision-
taker’s utility or profit are under the control of another decision-taker.
o Externality is either positive or negative.
o A negative externality is a negative spillover effect on third parties.
o With negative externality however, there could be costs to the society which are not
considered by the firms (health and environmental damage due to water and/or air
pollution for example).
 If there are negative externalities exerted on other economic agents and/or the
environment, social cost would be higher and it will not be equal to the private
marginal cost of each additional output.
 Positive externalities are consequences that benefit society.
 As a result, the price is higher than it should be, and too little of the good is
consumed and produced.
 Merit goods and services like education, health care, etc. will not only benefit the
individual person, but also the society.
 Educated person for example, can have better production and management skill and
will earn high payment for his/her services on one hand.
 On the other hand, educated person will benefit the society by introducing and
providing better production techniques and managerial services.
 Socially optimal level of output (q*) can be supplied at efficient price P*, if a subsidy
equal to P* - Pm is given to the providers of education services and to their customers.
 Monopoly Power
- Markets may fail to control the abuses of monopoly power.
- In real world, markets are imperfect. There are restrictions to firms to enter the
market, there are also restrictions on the mobility of factors of production.
- These situations limit the degree of competition and leads to the suboptimal supply
of output at higher price.
 Property Rights
- Markets work most effectively when consumers and producers are granted the right
to own property, but in many cases property rights cannot easily be allocated to
certain resources.
- Failure to assign property rights may limit the ability of markets to form.
  Market failures related to imperfect information and missing markets
 Information Failure
 Markets may not provide enough information during a market transaction, it
may not be in the interests of one party to provide full information to the other
party.
 Market is the most effective institution in allocation of resources if there is perfect
mobility of factors of production.
 But, since information is imperfect, factors cannot be freely move certainly from
one firm to the other or from one sector to the other.
 Information is, of course, always different for buyers and sellers, with buyers
knowing about the tastes and economic circumstances that underlie their demand
for a good and sellers knowing the costs of production that underlie their supply
 Information asymmetries that cause externality problems in markets, however, are
different from simply different sets of knowledge about our own individual tastes
and costs.
 They involve hidden information that impacts others adversely because the
information can be used to “take advantage” of the person on the other side
of the market.
 We will then say that information asymmetries occur whenever buyers and sellers
have different information regarding the nature of the product (or service) that is
being traded or the true costs of providing that product (or service).
 Problems arise in markets such as insurance markets; used car market, labor
markets.
 Unstable Markets
 Sometimes markets become highly unstable, and a stable equilibrium may not be
established.
 Example, agricultural product markets, foreign exchange, and credit markets are
not stable. Such volatility may require intervention.
 Inequality
 Markets may also fail to limit the size of the gap between income earners, the so-
called income gap.
 Market transactions reward consumers and producers with incomes and profits,
but these rewards may be concentrated in the hands of a few.
 Missing Markets
 Markets may fail to provide all goods and services to meet a need or want of the
society. Public goods and services such as, defense, street lighting, highways, and
so on cannot be provided by the market mechanism.
 Incomplete Markets
 Markets may fail to produce enough merit goods, such as education and healthcare.
 De-merit Goods
 Markets may also fail to control the manufacture and sale of goods like cigarettes
and alcohol, which have less merit than consumers perceive.
 Government Action to Market Failure
 Governments can alter resource allocations in a variety of ways.
 First, they can legislate to modify the system of property rights governing the
exchange of goods and services.
 Regulatory bodies can be established to mitigate the market power of
monopolies by limiting their prices or profits.
 Minimum levels of consumption of goods, such as education, generating
beneficial externalities, may be laid down.
 Second, the prices at which exchanges take place may be varied by the imposition of
taxes or subsidies to reduce the production and consumption of commodities which
give rise to detrimental externalities and to increase those of commodities causing
beneficial externalities.

 Third, the state may intervene in the allocation mechanism directly by producing goods
and services itself.
 Government failure
 Government action will not necessarily lead to Pareto efficiency, even of the second
best.
 Two factors are non-altruism and information costs – mean that in order to predict
the ways in which government will intervene in the economy we must examine the
institutions in the public sector.
 A major swing towards policies of minimal state intervention in markets occurred in
the 1980s
 Economists with free-market ideas gained ascendancy as advisors to industrial country
governments & to international agencies such as the World Bank & IMF.
- the view that state interventions are effective in overcoming market failures is
based on the critical assumption that government & state ‘act benevolently to
secure the public interest’.
- The assumption that state was benign in its intentions has been called into question
recently, resulting in the identification of STATE FAILURES.
 State failure refers to the pervasive inefficiency and impropriety of state institutions
in many LDCs
 State failure includes mismanagement, malpractice, overstaffing, nepotism, bribery,
corruption, personal fortune seeking and so on.
  These factors lead to the state sometimes being characterized as a ‘parasitic’ or
‘predator’ rather than as ‘benign’ or ‘beneficial’ state.
 Alternative explanations for state failure:
 The absence in postcolonial societies of a viable capitalist class, causing the state
& its agencies to fill the ensuing vacuum, putting state bureaucratic roles at odd
with its involvement in direct productive activity.
- self-interest motivation of government officials & state employees, which can only
be curbed by a political system that allows the population many & diverse ways of
vetoing the actions of people in state position.
- The state operates on the basis of patrimonial or ‘personal rule’ systems in which
personal loyalty, patron-client relations, reward & coercion override & replace the
rule of law, and
- the weaker the popular credibility of the person in power the more that person has
to resort to ‘personal rule’ mechanisms to stay in power.
 The Role of State in Rural and Agricultural Development
 According to Robert Chambers (1989), the state has three universal functions
which are fundamental for the rural poor. These are:
 Maintaining peace and democratic rule of law
 Provide basic infrastructure and services
 Manage the economy

 State failure to coordinate rural development

 State can solve some market failures, but it cannot solve every market failure
problem everywhere.
 The state may fail due to:
 Information asymmetry and managerial diseconomies from the state side.
 The failure of voting to consider intensity of want
 Lack of incentive and high inefficiency in public sector
 The bureaucratic system in public sectors is less flexible and the incentive that
given for public servants are lower. These situations lead to:
 Corruption
 less productive, inefficient and ineffective public servants.
 Institutional innovation to deal with market and state failure in rural development
 State, both institutions are the most important for the development.
 In such case, what is to be needed for efficient attainment of development is just the
mix of market and state institutions.
 However, in our real world, we have imperfect market and state. Due to this reason,
we need complementary institutions in order to improve the efficiency of the market
and state.
 Some of the complementary institutions include: service cooperatives, Value chain
and contract farming, Microfinance institutions, Social Capital and community
development, Civic societies and NGOs etc.
 Service Cooperatives
 In order to improve the bargaining power of small scale farmers and to minimize their
transaction cost and to close the information gap, there is a need to organize them into
service cooperatives.
 This will enable them to have more market power that can balance the power of
manipulative middle man.
 It also helps them to have access to credits at least cost.
 It helps them also to use new farming technologies, experience sharing, and efficient
use of their resources.
  Value Chain and Contract Farming
 Contract farming refers to the formation of linkages among farmers and other economic
agents such as exporters, a wholesalers and manufactures, research centers and
extension workers to insure the provision of agricultural inputs and hence the supply of
agricultural outputs.
 Such activity can solve lack of credit, lack of appropriate farming technology, lack of
extension service, and market uncertainty.
 Value chain on the other hand refers to adding value to the agricultural products, and
managing the process of collection and the transaction of an output from farm land to
the final consumer.
 It helps to insure the supply of quality product that demanded by the consumers
 Microfinance Institutions (MFIs)
 Rural economy is mainly depend on the risky and uncertain natural random which
affects agricultural products.
 So, it is impossible for the formal and modern banks as well as insurance companies to
provide credits and to insure the agricultural sectors.
 In addition, banks request collateral that farmers may not have to lend their money.
 Local money lenders are also inefficient in providing credit for small scale farmers
since they can exploit farmers by forcing them to pay high interest rate.
 Due to these facts its MFI which has the nature of formal and informal money
lenders can play a great role in providing efficient financial support and credits for
the farmers.
 Social Capital and Community Development
 The use of socially developed cultures, norms, beliefs, and established community
networks help the process of development at high rate.
 Socially developed practices and norms help:
 to shape the behavior of individuals and groups towards the desirable goals.
 to solve the problem of information asymmetry and work ethics
 Participation of community in the development process help to formulate and
implement the socially desirable development policies.
 Civic Societies and NGOs
 Civic societies and NGOs are basically established based on individuals or groups
consent to provide voluntary services to the society especially for the poor rather than
their self interest.
 The Institution of Property Right
 Property is considered as an asset that benefits the owner, and right is a set of actions
and behaviors that allows the owner of the property to use and to prevent others from
using its own property.
 That is, property rights over assets consist of the rights, or the powers, to consume,
obtain income from, and alienate these assets.
 The structure of property rights that could produce efficient resource allocations in a
well-functioning market economy has three main characteristics:
1. Exclusivity: All benefits and costs accrued as a result of owning and using the
resources should accrue only to the owner.
2. Transferability: All property rights should be transferable from one owner to another
in a voluntary exchange.
3. Enforceability: Property rights should be secure from involuntary seizure or
encroachment by others.
 “End of Chapter Two”
Thank you for your attention!