BUSN-490

NAME: ABDULLAH MUGHAL ROLL NO: 22-10325

SUMMARY
Informal institutions are defined as morals, values, conventions, norms, traditions, codes of
conduct, habits, attitudes, and beliefs. They incorporate culture in general and, therefore, the
societal value system. Hence, the term ‘informal institutions’ is used as a substitute for culture or
cultural factors. Furthermore, North’s theory of institutions incorporated cultural factors since he
faced the fact that informal institutions are constraints implemented by individuals to regulate
social interaction. The effect of culture on economic development was then emphasized by
Landes (1998), who traces the Western European economic success back to its supportive
culture. The challenge is to measure informal institutions and point out concrete features with
which the impact on economic growth can be analyzed.
An often used indicator for culture and societal organization is the level of trust. The role of trust
in an economy has been studied for some time, especially in game-theoretic approaches. An
individual’s level of trust depends on their cultural and societal background, as well as on
experiences, which again are shaped by society, culture, and history (Putnam, 1993). The same is
true if we are taught not to trust others or not to trust a certain group or certain people. Hence, it
might be true that in hierarchical societies, among which the affiliation to the family or tribe is
very distinct, the level of trust within the group is high, but beyond it people might not trust
others. In how far individuals of a society trust each other and trust the members of other
societies depends on upbringing, (religious) beliefs, historical accidents and experiences, and
traditions. At least higher per capita incomes might lead to a general change in perspectives and
priorities and thereby modify a society’s level of trust in the long-term.
The concept of generalized and limited morality corresponds to the organization of society per
se. However, limited morality (collectivist societies) characterizes hierarchical societies, in
which high levels of trust and cooperation are prevalent inside groups such as the family, the
clan, the tribe, and religious or ethnic groups. Therefore, societies that realize a form of
generalized morality need to develop a formal institutional framework to regulate their
interactions and decrease transaction costs.
Innovation and investment are stimulated and so the concept of generalized morality supports
economic development. Generalized morality is a form of societal organization that emerges
from a strategy optimization and depicts a different equilibrium state than does limited morality.
Hence, a society that practices generalized morality concerning its own members might mistrust
geographically or culturally distant societies. That is to say, even if generalized morality is
prevalent within the society, limited morality might be practiced if we extend the geographical
scope.
Societies that practice limited morality can have less respect for the law and be more tolerant of
lax law enforcement, since informal institutions govern their interrelationships. A society
realizing generalized morality is assumed to be indicated by modern values and morals.
Since beliefs and attitudes influencing economic activity are manifold, we concentrate on the
particular variables that can be measured empirically and have been used in econometric analysis
before. An informal institutional feature that depends on the cultural environment and influences
economic activity is an individual’s conviction concerning their control over their own life. The
attitude concerning control over one’s own life originates from religious beliefs since in some
religions God determines everything in life rather than the individual itself. Hence, if people
believe in life after death or reincarnation, these beliefs influence people’s behaviors since they
offer an incentive to live life in a certain way.
Not only life after death but also the belief in heaven and hell offers incentives to abide by
certain rules. On the contrary, if, for example, materialism and modernism are banned by
religious doctrines, if women are not allowed to work, if naturalism is regarded as blasphemy,
then the believers have no incentive to accumulate physical capital and to use their human capital
in a productive way.
However, since work effort and economic success are signs of being a chosen one and dawdling
and accumulating luxuries are a sin, people worked hard to prove to others and to themselves
that they belonged to the chosen ones. Religious doctrines or other convictions regarding destiny,
life after death, reincarnation, or God’s goodwill offer incentives for people to act in a certain
way.
Regarding formal institutions, the protection of property rights is usually described as the
decisive institutional feature concerning growth (De Soto, 2000; Kerekes & Williamson, 2008;
North, 1990; Platteau, 2000; Rodrik, 2000; Williamson & Kerekes, 2009).
Furthermore, property rights highlight the economic potential of an asset, since the owner will
use his property in a way that maximizes his utility. Property rights are usually not afforded in
dictatorships or authoritarian states, where expropriation by the political power or even by
private interest groups is possible since no appropriate law and no independent judiciary exist.
Hence, unsecure property rights are accompanied by less political and economic freedom, fewer
civil rights, and a manipulable judiciary.
Acemoglu, Johnson and Robinson (2005) developed a theoretical approach that ascribes the
emergence of the political, legal, and economic institutional environment to resource endowment
and, therefore, to property rights. In their model, political power is crucial regarding the formal
institutional environment of a state that it is, the elites in power will arrange formal institutions in
a way that best fits their interests. Then, the de facto political power will implement formal
institutions that fit its interests, that is, the retention of political power.
Hence, civil property rights and political participation will not be afforded, since this would
endow individuals with resources that could be used to overthrow the rebels. If a tradition of
property rights is missing and if a society never experiences being entitled to private property,
the positive effects of private ownership cannot be implemented.
The rule of law and an independent judiciary are guaranteed in democratic states.23 Hence, the
allocation of secure property rights is usually accompanied by a democratic system and
postulates an independent judiciary. However, as in the case of property rights, the rule of law
corresponds to an institutional entity that depends on random historical developments, too.
Hedlund (2001, 2005) describes the difference between a state that subordinates itself to the law
and a one that overrides the law with the terms ‘rule of law’ rather ‘rule by law’. Rule by law, as
in the Russian case, does not support a tradition of property rights, civil liberties, and equality
before the law. Even if foreign or indigenous forces try to implement the rule of law at a later
point in time, a tradition and culture of property rights and the rule of law will be missing.
democracy followed by economic liberalization has a negative and significant impact on the
growth rate.
Since definitions are broad and different concepts of democracy exist, we borrow the Polity IV
definition, which states that democracy is conceived as three elements;
1) “The presence of institutions and procedures through which citizens can express effective
preferences about alternative policies and leaders” (p. 13).
2) “The existence of institutionalized constraints on the exercise of power by the executive” (p.
13).
3) “The guarantee of civil liberties to all citizens in their daily lives and in acts of political
participation” (p. 13). “Other aspects of plural democracy, such as the rule of law, systems of
checks and balances, freedom of the press and so on are means to, or specific manifestations of,
these principles” (p. 13).
Institutions in a democracy might not be growth maximizing, and political participation and
universal suffrage will inhibit the establishment of institutions that benefit a small elite. Hence,
democratic institutions might not maximize growth, but, compared with other institutional
environments, democracy guarantees the most efficient economic outcome.
However, the growth effect of democratic institutions again depends on the complex system of
institutions and other relevant determinants.
Therefore, the implementation of democracy might not be efficient if a country has a non-
democratic history, is embedded in a non-democratic institutional environment concerning its
neighboring countries, or if its formal and informal institutions do not support democracy.
Furthermore, the implemented democratic institutions can even have detrimental effects if they
demolish parts of the existing institutional system. Accordingly, democracy supports economic
growth via physical capital accumulation, which in turn fosters democracy.

That is to say, economic liberalization followed by democracy has a positive and significant
effect on economic growth, whereas democracy followed by economic liberalization has a
negative and significant impact on the growth rate.