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Institutions, Institutional Change, and Economic Performance Article ·
June 2009
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UVA-BP-0475 Institutions, Institutional Change, and Economic Performance
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UVA-BP-0475
INSTITUTIONS, INSTITUTIONAL CHANGE, AND ECONOMIC PERFORMANCE
Why are some countries much richer than others? This technical note proposes a framework to begin answering this question. The first part identifies inefficient institutions as the root cause of the economic differences between societies. The second part analyzes how these institutions change. And the final part suggests how lessons from this institutional framework can be applied.
Institutions and Economic Performance
Economic theory implies that over time the economies of different countries will attain similar levels of wealth. When there is competition between organizations (be they tribes, companies, or countries), the less effective organizations die out and are replaced by more effective organizations. It is hard to deny that the world’s organizations are not in competition with each other. Competition is most dramatically manifested in open warfare between countries. But the more important form of competition is expressed in the daily economic contests waged between countries and companies in world markets. Given open competition we should see the surviving societies converge over time in terms of economic development. Why then do countries continue to show large disparities in terms of wealth? What causes some societies to flourish and others to stagnate and decline? The simple answer is differences in the effectiveness of a co untry’s institutions. Institutions Are Rules That Structure How People Interact
Institutions are the rules of the game. They shape how humans interact with each other. They structure the incentives that shape how society evolves. Institutions can be thought of as a continuum. Formal rules are on one end and informal rules on the other.
This note was prepared by Victor Abiad under the supervision of Wei Li, Professor of Business Administration. Copyright © 2003 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
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UVA-BP-0475
Formal rules are rules that are created and are often set down in writing. These often complement and increase the effectiveness of the informal rules of a society. Examples of formal institutions include political rules (the US constitution, government laws), economic rules (property rights, money as storage of value), and contracts between two parties. On the other end of the continuum are informal rules. These are rules that evolve. They often aren’t written down, yet they influence actions more pervasively than formal rules. Many informal rules come from a society’s culture. Culture can be defined as knowledge, values, and beliefs that are passed along from one generation to another. Examples of cultural informal rules are siestas in the afternoons, women not working outside the home, and business agreements completed on handshakes rather than contracts. Economic Theories Ignore the Effects of Inefficient Institutions
Economic theory cannot explain the disparity between the rich and the poor because for the most part these theories assume efficient institutions. One assumption is that efficient institutions mean costless transactions. In reality transaction costs are significant. Even the simplest currency conversions carry transaction fees that can be easily measured. Other transaction costs are harder to measure. For example how does one account for delays and possible bribes as goods go through customs? Or for costs for gathering information? A second assumption is that efficient institutions lead to correct mental models. Mental models are ways people analyze data to make decisions. Those organizations that utilize accurate models make correct decisions and are economically rewarded. Those that utilize wrong models are penalized. If institutions are efficient, there will be effective feedback to help organizations correct wrong models. In reality this does not happen and many organizations continue to make decisions based on models that are wrong. A third assumption is that efficient institutions effectively collect and share information. In reality many situations are very complex which makes it difficult and expensive to gather information. Those parties that do devote resources collecting the information are often reluctant to share it. A fourth assumption about efficient institutions is that the goal organizations is to maximize profits. Though profits can account for a substantial portion of people’s motivation, it cannot account for all of it. Other things that motivate people and organizations include ideology, values, and religion. Inefficient institutions result in costly transactions, subjective models, poor information, and non-profit maximizing goals. These inefficiencies lead organizations to make decisions that do not maximize economic benefits. The root cause of economic divergence between rich and poor countries is that their institutions vary in their levels of efficiency. These differences lead to different decisions being made and ultimately lead to the different economic results.
