The Importance of Institutions to Economic Development

Written by Luca Ferrini

The Importance of Institutions to Economic

LUCA FERRINI, SEP 19 2012

Introduction

Cross-country empirical analyses, in combination with micro-level studies, provide strong support for the
overwhelming importance of institutions in predicting the level of development in countries around the world (Hall
and Jones, 1999; Acemoglu, Johnson and Robinson, 2001). Protection of property rights, effective law
enforcement, and efficient bureaucracies, together with a broad range of norms and civic mores, are found to be
strongly correlated to better economic performance over time. This essay aims to explain why institutions are
important to economic development and to provide evidence for the arguments made. It argues that institutions
support economic development through four broad channels: determining the costs of economic transactions,
determining the degree of appropriability of return to investment, determining the level for oppression and
expropriation, and determining the degree to which the environment is conducive to cooperation and increased
social capital. Evidence is derived from the literature, from comparison of countries, and from examples at the
micro level.

Institutions, and the Extent of their Correlation to Development

In the words of North (1990, p. 4): “Institutions are the rules of the game in a society, […] the humanly devised
constraints that shape human interaction. […] They structure incentives in human exchange, whether political,
social or economic”. Institutions comprise for example contracts and contract enforcement, protection of property
rights, the rule of law, government bureaucracies, financial markets. They also, however, include habits and
beliefs, norms, social cleavages and traditions in education (so-called informal institutions). Formal institutions
typically tend to be the crystallization of informal institutions (North, 1990), as social norms in the realms of
gender, class and caste, for example, determine rules of political participation and representation, methods of
economic exchange, and inclusion of different groups in society (Pateman, 1988).

In a landmark study of new institutional economics, Rodrik, Subramanian and Trebbi (2002) assess the relative
importance of institutions, geography and integration (trade) in determining the differences in incomes between
the world’s most developed countries and the poorest ones. They find that institutional determinants “trump” all
others. It is not a new intuition that for the prospering of economic activity institutions matter. Adam Smith had
already noted this is surprising detail, referring to the importance of a justice system, private property rights, and
the rule of law (The Wealth of Nations). Aron (2000) surveys the studies which correlate indices of development to
institutional ones: 7 find a positive correlation with property rights and enforcement, 10 with civil liberties, 10
others with political rights and democracy, 4 with institutions for cooperation (e.g. clubs and associations), and 15
find a negative correlation of development with political instability. The paragraphs below explain why institutions
appear so important to economic development.

Costs

Institutions conducive to economic development reduce the costs of economic activity. The costs include
transaction costs such as search and information costs, bargaining and decision costs, policing and enforcement
costs (Coase, 1992, p 197; Dahlman, 1979, p. 149). They lower transaction costs by providing common legal
frameworks (e.g. contracts and contract enforcement, commercial norms and rules), and they encourage trust by

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providing policing and justice systems for the adherence to common laws and regulations. Communities in LDCs
typically rely on kinship or ethnic and religious ties for trade. Norms and networks of common language and
religion may be enough to ensure compliance with agreements on economic exchange; collective punishment and
social reputation may be enough to ensure the enforcement of (often informal) contracts even in the absence of a
third party. Greif (1993) describes the trade networks of Maghribi traders which permitted the sharing of
information on dishonest traders and their collective punishment. To take advantage of opportunities for trade with
different groups and increase the size of economic transactions, however, cultural ties are not enough. There is
need for greater information about trading partners, and for institutions which ensure agreements on the details of
exchange and compliance to the agreed conditions. These take the form of contracts, codes of conduct,
standardized weights and measures, disclosure agreements, and enforcement through courts and policing.
Where transaction costs are small, the private enforcement of contracts may still be preferred. But as economic
relations develop and become increasingly impersonal, the role of a third party to enforce compliance to rules is
increasingly necessary (Shirley, 2003, p. 2).

Property Rights and the Return to Investment

Such institutions increase the security that the risk of incurring in an economic transaction is matched by the full
appropriation of its eventual benefits. This includes the presence of individual private property rights. If property is
protected individuals are more willing to invest and to incur sunk costs. Recounting the land-ownership system in
Ghana, Pande and Udry (2005) are able to show that where individual perception of security of land tenure is low,
investment in the land is significantly reduced, and output consequently drops. In fact, in the few cases in which
land is obtained through commercial transactions (as opposed to the traditional informal system of land
redistribution), there ceases to be any difference in levels of investment because security of tenure is assured.
This increases output and thus is conducive to economic development.

The protection of property rights requires an expanded role for state authority. Individuals and groups sacrifice a
degree of freedom in order to ensure state protection; they accept levies and taxes to cover policing expenses,
and state monopoly over the use of force for common security (Bates, 2001, p. 65-66). However, there is a risk
that states which have the power to enforce property rights may use that power to expropriate property too.
Instead of reducing risk of economic transactions, this increases it. Thus property rights are by no means
sufficient to spur economic growth, and must be balanced by institutions which limit the extractive capacity of
state power. These typically involve independent parliaments and judiciaries. Democratic institutions of political
representation strongly contribute to this process (Rodrik, 2000).

Power of Expropriation

Thus institutions determine the extent to which those in power are able to expropriate the economy’s resources to
their private advantage. Unequal institutions strongly limit development by reducing the capacity of individuals to
access resources, expand production and increase their incomes. A comparative analysis of development
trajectories of countries indicates that institutions which benefit elites and allow their appropriation of resources
and products have perpetuated underdevelopment.

Countries which have undergone colonial domination tend to be plagued by such extractive institutions. These
have outlived the gaining of independence on behalf of these countries, and their control has largely been taken
over by local elites. There are countless examples of societal outcomes the cause of which can be traced to
institutional arrangements of many decades before.

The unequal landownership system in Latin America (latifundios) has been indicated a fundamental cause of its
underdevelopment. There is evidence that it limits the development of greater rural employment and higher rural
incomes (World Bank, 2008, ch 6). ECLA, the Economic Commission for Latin America, has repeatedly flagged
the importance of land reform in the process of poverty-reducing agriculture and rural development. A report by
the United Nations Food and Agriculture Organization stresses that this is particularly urgent as population growth
threatens to increase income inequalities, and technological developments in agriculture may serve the landowner

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elites to further consolidate their grip on land and agriculture, thus perpetuating the process of path dependency in
the formation of institutions (UNFAO, 2006; see also Myrdal, 1992).

Greater equality and functional economic institutions are also seen as the cause for the successful development
of Vietnam compared to a similar country as Nicaragua, where high inequality has concentrated power in the
hands of a restricted elite, and governments have failed to adequately invest in infrastructure and public welfare.
Similarly, institutional capacity to exploit domestic primary resources is indicated as the key to the success of
Botswana and Mauritius in comparison to other developing countries for which primary resources have turned into
a curse, i.e. Sierra Leone (diamonds), Angola, Equatorial Guinea and Nigeria (oil) (Birdsall et al., 2005, p. 138).
The outcomes of institutions have effects which lie deep in the socio-economic fabric of societies. Banerjee and
Duflo (2011) recount the finding by Abhijit and Lakshmi Iyer (2005) that in India the coexistence of two systems of
land-revenue collection under the British colonization caused very different outcomes; under one system, the
landlord was responsible for collecting taxes, and this strengthened his role, while under the other farmers
themselves were responsible for the taxes. The regions where the second system was dominant, 150 years later
(with the tax system long gone) exhibit higher agricultural yield, more schools and more hospitals, due to the
development of more horizontal and cooperative social relationships among the inhabitants.

Cooperation and Social Capital

Institutions which are conducive to development ensure greater self-expression, allow the free flow of information
and encourage the formation of associations and clubs. These form prosperous social relationships, which are
conducive to greater economic interaction by increasing levels of trust and wider availability of information
(Putnam, 1993). They allow greater sharing of resources through democratic institutions and the use of the state
to reduce the risk attached to economic activity (Bardhan, 2006, p.5). The welfare state is an example of an
institution which pools resources to limit the negative effects of business cycles on incomes and unemployment.
Institutions conducive to development pool resources to provide the investments in education, health and
infrastructure which lie at the basis of economic interaction and are necessary and complementary to private
investment. Informal institutions lie at the basis of an economy. They include public agencies, trade unions,
community structures and professional associations. They make up the fabric which determines the response to
laws and government decisions. Most often they shape these outcomes themselves.

Conclusion

There is wide-ranging evidence that institutions matter a great deal in determining the level of economic
development of a country. Cross-country analyses use indicators such as degree of protection of property rights,
the rule of law, and civic liberties and find that they are strongly correlated to economic performance. This essay
has described why institutions are so important for economic development and has provided evidence for the
claims made. It has identified four broad channels through which the correlation can be explained. Institutions
determine the costs of economic transactions: they spur development in the form of contracts and contract
enforcement, common commercial codes, and increased availability of information, all of which reduce the costs
of transactions, risk, and uncertainty. Institutions determine the degree of appropriability of return to investment:
protection of property rights and the rule of law spur investment and thus increase incomes. Institutions also
determine the scope for oppression and expropriation of resources by elites: unequal institutions which allow the
dominance of powerful elites over economic exchange strongly limit development, as can be seen in the case of
many ex-colonial countries. Lastly, institutions determine the degree to which the environment is conducive to
cooperation and increased social capital; inclusive and participatory institutions increase the flow of information
and the extent to which resources can be pooled to reduce risk and ensure sustained levels of wealth. This fits
nicely with the finding of historical studies that high quality institutions today are rooted in greater equality, political
competition and cooperative norms in the distant past. Institutions strongly affect the economic development of
countries and act in society at all levels by determining the frameworks in which economic exchange occurs. They
determine the volume of interactions available, the benefits from economic exchange and the form which they can
take.

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—
Written by: Luca Ferrini
Written at: University of Reading
Written for: Marina Della Giusta
Date written: March 2012

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