The institutional turn In the 1990s, the role of institutions in understanding the functioning of the
The institutional turn In the 1990s, the role of institutions in understanding the functioning of the
economy became prominent, signalling what has been described as ‘the institutional turn’ in development policy (Evans, 2007). The recognition of the role of institutions in the economy came to the forefront of economic thinking with the work of Nobel Prize-winning economist Douglass North. In his book Institutions, Institutional Change and Economic Performance (1990), he argued that institutions are a key factor in determining a country’s economic performance.
North defines institutions as ‘the rules of the game in society, or the humanly devised constraints that shape human interaction’ (1990, p3). North goes on to elaborate that institutions provide structure to everyday life, limiting the nature of exchange and determining the forms incentives take. It is this effect on incentives that is critical from the point of view of economics. Depending on how institutions work, they can affect the way in which incentives to produce are structured. This can therefore determine the nature and speed of economic development. ‘Good’ institutions are seen as those that enable actors, such as entrepreneurs, to make profits, work hard and continue to invest. This arises when contracts can be easily enforced, property rights are
INSTITUTIONS, MARKETS AND ECONOMIC DEVELOPMENT
secure and governments pursue growth-promoting policies that encourage a virtuous circle of innovation, capital accumulation and increased economic output. If, on the other hand, states extract these surpluses from their citizens and do not use them productively, a vicious cycle of exploitation and low or negative growth can occur.
For North, the underlying institutions are endogenous to (i.e. determined within) the system being studied. Institutions can change as a result of groups within the system perceiving the possibility of gains through, for example, changes to property rights or mechanisms that enforce such rights and related contracts. They may act politically to change property rights and other regulations in order to be able to capture greater benefits. Putting this in historical perspective, this dynamic occurs in relationships between organizations and institutions. Organizations, such as firms or political groups, who are what North calls the ‘players of the game’, are formed out of the incentives inherent in any underlying institutional context. Once formed, they produce new knowledge and ideas through which they identify how to improve their respective contexts and act to change the rules in order to achieve this. This means that change is what is called a ‘path-dependent’ process, i.e. the past has a strong influence, with changes happening only slowly and gradually. But, at the same time, the organizations that have sought to change the rules to their benefit will seek to defend and maintain them, leading to a significant degree of inertia. In analysing trajectories of economic development in different countries, North argues that these ideas can be applied to examine how specific economies have developed.
That institutions matter for economic development is not new in economics – there is a long tradition of studying them by economists such as John Commons and Clarence Ayres – known as (old) ‘institutional economics’. Where mainstream economics is primarily concerned with resource allocation, the distribution of income and how output and prices are determined, institutional economics is concerned with how the economic system as a whole is organized and controlled, and hence with the power structures within it. Where for mainstream economists the market (and this includes the sale and purchase of goods and services by the public sector) is the sole means through which economic activity takes place, institutional economists argue that the market is itself an institution that is supported by, and interacts with, a wide range of subsidiary institutions in society. The economy is therefore more than the market and it is this larger organizational complex that allocates resources. However, institutional economists – in contrast to North – tend to see underlying institutions as immutable, exogenous and impervious to change.
The recent emphasis on the role of institutions in development has not, however, primarily drawn from this heritage. Instead, it has been based on what is called the ‘new institutional economics’. This approach, developed by Ronald Coase, responded to problems related to certain core assumptions in neoclassical economics about the costless and perfect information on which actors make their utility-maximizing decisions. Before making decisions, actors
TOPICS
must search for information and may incur a range of costs when finding out about the products or services they happen to be interested in. This leads to the so-called problem of imperfect information (when information is not easily accessible) and asymmetric information (when one party in an exchange may have information that they are unwilling to reveal to the other party). These in turn generate a range of other problems relating to the ‘principal’s’ ability to assess and/or monitor a contract with an ‘agent’. ‘Moral hazard’ is one such problem and arises when an agent is not fully exposed to the risk of a situation and therefore acts in a different way. For example, suppose that a lender (principal) has lent funds to a borrower (agent) for a specific project. There is
a risk that the entrepreneur will not invest all of the funds in the proposed project or that she may not adequately manage and supervise the project because the funds invested are not hers, thus leading to low returns and to the lender not recouping her funds. In this case, the lender may decide to closely monitor the borrower to overcome the problem, but this tends to incur additional costs for the lender.
Recognizing problems such as these at the micro level has led mainstream economics to explain a number of forms of contracts and economic arrangements with the use of concepts of asymmetric information and transactions costs incurred. Previously, many types of behaviour in markets, such as the use of collateral in credit markets, could not be theorized, and were found to be inefficient or sub-optimal, but could be understood once they were seen to help protect against moral hazard. Another example is the practice of share-cropping in many agrarian societies. Landlords often needed to find ways to incentivize tenants to optimize production, since the costs of supervision would otherwise be too high. Share-cropping is thus an institu- tional solution, i.e. a set of rules effectively addressing information problems. More generally, then, North suggested that economic development would be constrained without the presence of institutions that effectively solve information problems at a sufficiently low cost.