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                                                    ippg Briefing paper no. Three
                                                                     July 2006
                                                   By STeve WigginS & Junior DaviS 
                                               Assisted by comments from Adrian Leftwich & John Morton
                                                    Economic institutions
        inTroDucTion                                                            Box a: DefiniTionS of economic 
             Economic institutions have re-emerged at the 
         centre of attention in development economics after                     inSTiTuTionS
         a long period when their existence and smooth                              ‘Essentially,  institutions  are  durable  systems 
         functioning was assumed in the hypotheses of neo-                      of  established  and  embedded  social  rules  and 
                                   
         classical economics.   Recent analyses using cross-                    conventions  that  structure  social  interactions’ 
         country regressions – see, for example, Rodrik,                        (Hodgson 2001 p.295) 
         Subramanian & Trebbi 2002 – suggest that it is                             ‘A  social  institution  is  a  regularity  in  social 
         the quality of institutions that is the single most                    behaviour that is agreed to by all members of 
         important difference between those economies in                        society, specifies behaviour in specific recurrent 
         the developing world that have grown strongly and                      situations, and is either self-policed or policed by 
         those that have not.                                                   some external authority.’ (Schotter 1981, quoted 
             However, these insights  have  not  necessarily                    in Langlois 1986 p.11)
         produced useful guides for policy-makers. It is one                        ‘Institutions         are       rules,       enforcement 
         thing to recognise the importance of institutional                     characteristics of rules, and norms of behaviour 
         quality, but quite another to specify what makes                       that structure repeated human interaction.’ (North 
         for quality and to suggest how it may be improved.                     1989)
         As a first step towards understanding more about                           ‘Institutions      are     ‘repetitive      patterns       of 
         institutions and their quality, three questions arise:                 interaction  through  which  society  undertakes 
         how are economic institutions created, how do they                     certain functions.’ (King 1976)
         function, and with what effects? To begin to answer                        ‘Wide  sense:  persistent  groups  of  norms  of 
         these questions, we need a working definition of                       behaviour which serve collectively valued purposes; 
         economic  institutions  and  an  associated  set  of                   or in narrow sense of , a set of rules to facilitate 
         concepts.                                                              co-ordination via allowing expectations to form.’ 
        Defining inSTiTuTionS                                                   (Nabli & Nugent 1989)
             Definitions of institutions vary – see Box A; most                 would accept the idea that institutions comprise 
          1.     The institutional context is largely missing from most         norms,  regulations  and  laws  that  establish  the 
          neo-classical models of market exchange and human interaction.        ‘rules of the game’ – that is, that they condition 
          In the neo-classical view, rules, social norms and preferences        and modify the behaviour of individuals and groups 
          are a given – thus understanding of economic institutions and         so  that  their  actions  become  more  predictable 
          human behaviour that does not conform to economic notions             to others. They do so through both formal rules 
          of the ‘rational individual’ is left to other disciplines such as     that include laws and contracts and, as well as 
          politics  and  sociology.  Institutional  economics  may  be  seen 
          to bring economics closer to other disciplines by arguing that        through  informal  means  such  as  social  norms 
          individuals  make  choices  that  are  at  least  partly  culturally  and conventions that evolve over time. This use 
          determined – thus moving beyond the longstanding focus of             of ‘institution’ is quite different to that where it is 
          economics on individual utility as the main guide to resource         taken as synonymous with ‘organisation’.
          allocation. 
             Paper prepared for the DFID-funded Research Programme, Institutions and Pro-Poor Growth (IPPG). The authors are grateful to 
         DFID for the funding that made this research possible. The views expressed in this paper are entirely those of the author and in no 
                         way represent either the official policy of DFID or the policy of any other part of the UK Government. 
                                                                     All rights reserved. 
             No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means without 
           prior permission; for permission to reproduce this paper, or any part of thereof, please contact the editor at the address above.
                                                                             
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                                                                       design. In the latter case, it may be government 
         Box B: inSTiTuTionS anD policieS                              that establishes the institution, or it might be an 
            All policy changes can be seen as changing the             initiative from private enterprise or civil society. In 
         rules of the game. If a tariff level is reduced from          both cases, it can be argued that institutions are 
         20% to 10%, for example, the conditions – and                 created and evolve in response to the uncertainty, 
         perhaps thus the ‘rules’ – governing imports have             risk and information costs associated with living 
         changed. Is this, then, an institutional change?              and transacting in an imperfect world. Institutions 
         And  if  so,  are  all  economic  policies  effectively       are  thus  rational  mechanisms  designed  to  cope 
         institutions?                                                 with the imperfections of markets, including the 
            Institutions  are  defined  as  helping  form              asymmetry of information held by different actors, 
         stable  expectations,  hence  institutions  can  only         the problems that principals have in ensuring that 
         be changed infrequently if they are to fulfil this            their  agents  pursue  the  same  goals,  etc.  This 
         function.  Institutions  operate  at  a  deeper  level        explains why seemingly ‘irrational’ and inefficient 
         and are, in effect, constitutional; they establish            institutions such as share-cropping have persisted 
         the framework of rules within which more routine              as ways to solve such imperfections.
         decisions take place.                                            Whatever the origin of the institution, the more 
            In the case of the import tariff, for example,             widely it is recognised the better it will function and 
         the institution is that which empowers the state              such recognition reaches its maximum expression 
         to set such tariffs. Thus, continuing the example,            when the norm is endorsed by the state as legally 
         a country that binds its tariffs in accordance with           binding.  Not  all  institutions  require  the  support 
         the rules of the World Trade Organisation (WTO)               of governments, but some do in order to remove 
         could be seen as changing an institution. This in             ambiguity  and  to  provide  legal  backing  for  the 
         turn modifies the expectations of those engaged               norms in question. Institutions may be seen as 
         in international trade: the WTO norms set limits              public goods in that their benefits (and costs) are 
         to tariffs and discourage quantitative controls on            shared by all in the economy, no matter who took 
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         trade.                                                        the trouble to establish them.  This suggests that 
                                                                       many institutions will require action by governments 
            Institutions can also be seen as constitutional,           to create and implement the norm. 
        they set the rules by which the game is played; it                Most institutions are not lightly changed, even 
        is this that distinguishes them from the wider set             when clearly imperfect or outdated. Institutions are 
        of economic policies – see Box B.                              valued for the predictability that they bring to the 
            By  narrowing  the  definition  to  economic               system; frequent change and experimentation to 
        institutions,    those  institutions  that  perform            established norms is thus not usually encouraged. 
        economic functions are covered; of these, three                Moreover, particular institutions can confer rights 
        sets can be identified:                                        and  advantages  to  particular  groups  in  society 
            •  establishing and protecting property rights;            who will use their power to prevent changes that 
            •  facilitating transactions; and,                         undermine  their  advantages.  There  is  thus  the 
            •  permitting     economic  co-operation  and              possibility of path dependency in that once certain 
        organisation.                                                  institutions  are  in  place,  then  other  norms  and 
            Table 1 presents examples of the institutions              behaviours  ensue,  thus  reinforcing  patterns  of 
        that  perform  these  functions,  together  with  the          development and restricting the range of options 
        agencies both formal and informal that regulate                for policy. 
        such functions. It will be noted that some of the                 Discussion  of  new  institutions  or  changes  to 
        institutions that have economic functions may not              institutions  is  often  intense,  parties  recognise 
        exist primarily for economic reasons – for example,            the  implications  of  creating  new  ‘rules’  for  the 
        councils of elders.                                            game or  of  changing  them  and  each  will  fight 
            The  definition  of  economic  institutions  can           for their  own interests. The political economy of 
        be expanded and discussed by asking three key                  institutional change is therefore important in that 
        questions about institutions, namely:                          they may evolve to confer privileges on particular 
            •  How are institutions, which affect economic             groups, whether or not the institutions are efficient 
        growth and its distribution established, sustained             and effective for society as a whole, and once in 
        and changed?                                                   place  may  be  difficult  to  change.  An  additional 
            •  What        determines        their       effective     consideration  is  that  those  administrating  the 
        functioning?  How  is  this  related  to  the  social,         rules may also resist change simply owing to the 
        cultural and political matrix from which they arise            thereof.
        and in which they operate? How much do they  hoW Do economic inSTiTuTionS funcTion?
        depend upon formal endorsement by the state?                      An important point is that the functioning of an 
            •  How  do  institutional  interactions  influence         institution is not necessarily to be inferred from its 
        economic  growth,  the  pattern  of  growth  and, 
        specifically, the possibilities for pro-poor growth? 
       hoW are economic inSTiTuTionS formeD?                           2.     Not all institutions, of course, necessarily confer benefits 
                                                                       on all in society. Far from it. For example, formal limitations 
            Institutions emerge in two ways: either informally         on the property rights or rights to carry out certain sorts of 
        through repeated interactions between individuals              business, that may apply to specific ethnic groups, or women 
        or  organisations  that  establish  expected  norms            – not to mention institutions such as slavery – are all real-
        of behaviour; or else formally through deliberate              world examples of institutions that confer benefits for some, 
                                                                       but impose high costs on others.
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         TaBle 1: a claSSificaTion of economic inSTiTuTionS
          funcTion                            exampleS                          Typical formal                     informal regulaTing 
                                                                                regulaTing agency                  agency
            Property rights                     Land tenure                       Land registries                   Oral history, chiefs & 
            Establish    rights;    decide                                                                          other local political 
            between  competing  claims;                                                                             authorities
            inform non-owners & police          Inheritance law                   Probate registry                  Custom
                                                Intellectual property             Patent offices
                                                rights: patents, 
                                                copyright
            Reciprocracy:                       Weights, measures,                Standards bureaux
            facilitating transactions           standards
            Establish rules of exchange,        Contract law; dispute             Civil courts;                     Elders, religious 
            respect for contracts               arbitration                       arbitration councils              courts
            Provide information                 Public information on             Market information 
            Reduce or re-allocate risk
                                                markets                           agencies
                                                Physical provision                Local authorities;                Customary points 
                                                & organisation                    stock exchanges/                  for exchange 
                                                of markets (e.g.                  bourses                           (crossroads, etc.)
                                                auction rings, stock                                                Market hierarchies 
                                                exchanges, futures                                                  (Market mammies/
                                                markets)                                                            queens/etc.)
                                                Banking conventions,              Bank regulatory                   Haveli systems
                                                instruments (letters              agencies
                                                of credit, etc.)                                                     
                                                Auditing & accounting             Professional 
                                                conventions                       associations 
                                                Insurance companies               Professional 
                                                                                  associations
            Co-operation &                      Laws on limited                   Register of companies
            Organisation:                       liability & bankruptcy
            Allow                               Competition policy                Commissions on 
            • Interactions within                                                 monopolies & 
            organisations                                                         mergers
            • Collective action & co-
            operation (in labour, price         Regulations on co-                Co-operatives                     Social norms of co-
            negotiation)                        operatives, charities,            ministries, bureaux               operation
            • Realising economies               civil associations
            of scale and managing               Auditing & accounting             Professional 
            diseconomies of scale
                                                conventions                       associations
                                                Employment                        Min labour,                       Custom
                                                regulations                       employment tribunals
         form. For example, very similar institutions exist                    hoW Do inSTiTuTionS affecT economic 
         in many countries that govern the collection of bad                   groWTh anD poverTy reDucTion?
         debts, but how long it may take to recover such                            The functioning of institutions potentially affects 
         debts can vary greatly, depending on the details of                     three factors that help determine economic growth, 
         administrative requirements and the efficacy of the                           3
         legal system. Similarly, there are often significant                    thus:
         differences in the extent to which property owners                         •  Investment:  when  property  rights  are 
         feel  secure  in  their  rights,  even  when  the  form                 secure,  owners  of  capital  are  more  likely  to 
         of  entitlement  may  be  the  same.  The  study  of                    invest, all other things being equal. If it is easy 
         institutions thus requires detailed investigation of                    to trade, obtain credit, retain a reasonable share 
         actual functioning, rather than merely recording                        of the profits (that is, without excessive taxation) 
         the apparent form.                                                      and to insure against risks, investment is again 
             Functioning  may  be  determined  by  deeper                        encouraged. Investment may also be stimulated 
         underlying norms in society on matters such as the                      when  establishing  companies  or  more  informal 
         extent of generalised trust, and individual freedom                     economic groups, (and the organization of their 
         versus  obligations  to  wider  collectives.  More 
         generally, then, institutions are often embedded in                     3.      There  is  a  fourth  factor,  widely  recognised  in  the 
         social and cultural characteristics of the particular                   literature  –  human  capital.  It  is  not  obvious  that  economic 
         context.                                                                institutions affect this directly – although it might be argued 
                                                                                 htat when economic institutions function well, and economic 
                                                                                 growth accelerates, there is greater incentive for governments 
                                                                                 and individuals to invest in human capital.
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        functioning) is relatively straightforward. 
           •  Technical  innovation:  again,  secure 
        intellectual property rights are likely to promote 
        private investment in research and development of 
        innovations.
           •  Economic  organisation:  is  likely  to  be 
        more effective and efficient, delivering the benefits 
        of  specialisation  and  economies  of  scale  where 
        they apply, when institutions facilitate transactions 
        and co-operation between individuals, whether in 
        formal companies or less formal co-operatives. 
           It is easy to imagine that there will be reinforcing 
        interactions  between  the  factors.  For  example, 
        economies  that  generate  technical  innovations 
        readily  and  where  economic  organization  is 
        efficient are likely to be seen as having a good 
        business environment and consequently likely to 
        attract investment, thus it may well be that sets 
        of  institutions  function  in  synergy  to  generate 
        growth.
           Institutions are also likely to have a profound 
        influence on the pattern of economic growth and 
        the distribution of rewards within economies and 
        societies – and thereby affect levels of poverty. 
        Property rights will clearly be important, since they 
        assign entitlements to factors of production and 
        may also affect the bargaining power of different 
        groups in society. More subtle are the ways in which 
        institutions governing transactions and economic 
        co-operation  allow  those  without  immediate 
        access to factors of production to obtain credit, 
        rent land, trade and to form small companies or 
        co-operatives, and thereby earn their livelihoods. 
       referenceS
           Langlois, Richard N., 1986, ‘The New Institutional 
        Economics: an introductory essay’, in Richard N. 
        Langlois  (Ed.),  Economics  as  a  process:  essays 
        in  the  New  Institutional  Economics.  Cambridge, 
        Cambridge University Press.
           North, D C., 1989, ‘Institutions and economic 
        growth:     an    historical   introduction’,    World 
        Development, 17 (9), 1319–32.
           Nabli, M. K. & J. B. Nugent, 1989, ‘The New 
        Institutional  Economics  and  its  applicability  to 
        development’, World Development, 17 (9), 1333–
        1347.
           Rodrik, Dani, Arvind Subramanian & Francesco 
        Trebbi,  2002,  ‘Institutions  rule:  the  primacy  of 
        institutions  over  integration  and  geography  in 
        economic  development’,  IMF  Working  Paper, 
        WP/02/189.       Washington      DC,     International 
        Monetary Fund.
           Hodgson, Geoffrey M., 2001, How economics 
        forgot history. London, Routledge.
           King,  Roger,  1976,  Farmers  co-operatives  in 
        northern Nigeria, PhD thesis. Reading, University 
        of Reading.
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