CoBE, Department of Economics

Introduction to Institutional And Behavioral

Economics
Course Code: Econ 4161
 Chapter One: Basic Concepts of Institutions
1.1. Introduction
 Institutional economics become influential field in
economics, despite the prevalence of orthodox
neoclassical economics
 Recently both (classical and neoclassical) schools
of thought recognize the role of institutions and
agree that institutions do matter.
 Institutional economics (also known as
institutionalism) has flourished in the United
States during the 1920s.
 The American economist and social scientist
Thorstein Veblen laid the foundation for
institutional economics.
 Another economist commonly associated with the
institutional school was John R. Commons.
 He emphasized the collective action of various
groups in the economy and viewed their operation
within system of continually evolving institutions
and laws
 Institutional economics studies about the role of
human made institutions in shaping economic
relations and the society
 Institutional economics is concerned with
institutions that constrain or promote the use and
exchange of resources and their consequences for
economic performance
What is institution?
Definition: Institutions are the formal and informal
rules and norms that organize social, political and
economic relations (North, 1990)
 Institutions are the rules of the game in a society
or they are humanly devised constraints that
shape human interaction and economic
transaction
 Institutions are the written and unwritten rules,
norms and constraints that humans devise to
reduce uncertainty and control their env’t.
 The primary motive of devising or creating
institution is just to reduce transaction cost
 1.3. Institution versus Organization

• Institutions consist of formal rules, informal

constraints (norms of behavior, conventions, and
self-imposed codes of conduct), and the level of
enforcement of both.
• Institutions are the rules of the game and the purpose
of rule is to define the way the game is played
• Effectiveness of institution depends on
enforcement of rules
• Enforcement is carried out by the first party (self-
imposed codes of conduct), by the second party
(retaliation), or by a third party (societal sanctions or
coercive enforcement by the state)
• Organizations consist of groups of individuals
engaged in purposive activity. Organizations are
the players
• Organizations include political bodies (political
parties, the senate or parliament, a city council, a
regulatory agencies, ministries), economic bodies
(firms, trade unions, family farms, cooperatives),
social bodies (churches, clubs, athletic
associations), and educational bodies (schools,
universities, vocational training centers)
 Key features of institutions

1. They are brought to life by people and

organizations
2. They provide predictable structure for everyday
social, economic and political life
 Institutions shape people’s incentives (calculations
of returns from their actions) and behavior
 Some argue institutions shape but do not
necessarily always determine behavior
3. They lead to enduring patterns of behavior over
time but they also change
 Institutions are constantly being reformed through
people’s actions
 However, it is very hard to change institutionalized
behaviours
4. They produce positive or negative development
outcomes.
 This depends on the kinds of relations and
behaviours that institutions enable, and the
outcomes for the enjoyment of rights and
allocation of resources in society
 Formal versus Informal Institutions
 Institutions are both formal and informal
 Formal institutions include the written
constitution, laws, rules, policies, rights and
regulations that govern politics, government,
finance, contractual relations and corporate
governance, and society more broadly
 Informal institutions are (usually unwritten)
social norms, customs or traditions, beliefs, codes
of conduct, that shape human thought and
interactions.
 They are also called social capitals
 Informal institutions are conventionally accepted
standards of behaviors defined in terms of rights
and wrongs in the society
 People learn informal norms by observation,
imitation, socialization and indoctrination
Note: Formal and informal rules and norms can be
complementary, competing or overlapping.
Class Activity:
 How you define certain actions/activities as right
or wrong? As good or bad?
 1.2. Functions of Institutions

• Institutions enhance economic efficiency by

economizing inefficient transaction
• Institutions reduce uncertainty by providing a
structure to every day life
• Institution minimize (reduce) transaction costs by
creating organizational arrangements
• Institution alleviates the problem of externalities:
i.e. institutions as a formal rules correct the
negative effects of externalities by assigning
taxes and property rights
• Alleviate market failure and free rider problems
• The objective function of the organization may
include maximizing profit, promoting public
welfare, winning elections, regulating businesses,
excellence in acquiring skills and knowledge etc.
• Organizations are shaped by institutions and, in
turn, influence how institutions change
• Institutions, together with the technology
employed, affect economic performance by
determining transaction and production costs.
 Outcomes of Institutions
• Institutions determine the success and failure history
of nations
• The economics of poverty and prosperity depends,
among other things, on the level and effectiveness of
economic and political institutions over time
• Institution produce positive or negative outcomes
• Inclusive institutions bestow equal rights and
entitlements, enable equal opportunities, voice and
access to resources and services.
• Inclusive institutions are typically based on principles
of universality, non-discrimination & targeted action
(i.e. differential treatment to disadvantaged groups)
• Inclusive institutions foster economic growth and
development, reduce poverty, promote peace and
democracy.
• Exclusive (extractive) institutions withhold
rights and entitlements, and undermine equal
opportunities, voice and access to resources and
services
• They range from deliberate discriminatory
legislation to rules that fail to respond to the
particular needs of marginalized groups
• Chronic poverty, inequality, rent-seeking &
corruption etc. are the outcomes of exclusive
(extractive) institutions.
• Exclusive political institutions generate political
conflict between groups and individuals
• Political exclusion and inequality between regional,
religious, or ethnic groups will result in higher
prevalence of civil wars
• Inclusive institution will shape the outcomes of
exclusive institutions via regulatory frameworks on
rent-seeking & corruption, land, housing, labour &
credit markets, property rights, investments etc.
• Inclusive social norms such as social trust has a
strong positive effect on economic growth
• Norms of non-discrimination against women,
ethnic, religious and caste minorities may be
particularly important in this regard.
NB:
 According to institutional economics, economics is
defined as the science of contract where as NCE
define economics as the science of choice.
 Institutional economics suffer from cooperation
failure whereas NCE suffer from competition
failure.