What are Institutions and Why

do they Matter for

Development?
 Introduction.
Simple transaction in a developed economy:
buying a used car is difficult because of hidden
quality (Akerlof, 1970).
Methods have developed to alleviate this
problem: garage checks, warranties, databases
to track car history, regulations to protect
consumers.
In developing countries, hidden quality is not the
only problem. Car may be stolen, difficult to sue
or even track down the seller, consumers less
likely to be protected, courts work less well
This simple example for a simple transaction is
an illustration of the importance of institutions in
minimizing transaction costs and encouraging
economic development.
 Introduction
In Singapore, it takes 6 days to start a business
(for 11 procedures),
In Congo, it takes 155 days for 13 procedures
In Venezuela, it takes 141 days for 14
procedures
In Laos, it takes 163 days for 8 procedures
In Vietnam, it takes 50 days for 11 procedures
In China, it takes 35 days for 13 procedures.
In India, the same.
In New Zealand, it takes 12 days for 2
procedures
In the US, 5 days for 5 procedures.
The institutionalist point of view
Fundamental concept for institutionalists is rule
of law: executive decisions can only be
exercised in accordance with written and
publicly disclosed laws. Moreover, law
enforcement itself follows well-established
procedures. The rule of law contrasts with
autocratic regimes.
Rule of law usually taken for granted but is
fragile or absent in many developing countries.
In advanced economies, took centuries to
establish.
The institutionalist point of view
Douglas North (Nobel prize in 1993) has argued
consistently that institutions are a key
determinant to explain success in development.
England introduced checks on power of the king,
gave power to the parliament, established rule of law
and was the first country to industrialize.
Spain had a very autocratic regime, despotism,
unbridled military spending and predatory
bureaucracy. Despite strong colonial conquests, gold
and power, Spain did not develop and became one of
Europes poorest countries until late twentieth century.
The institutionalist point of view
Institutionalist approach to economics
(North, Williamson, Acemoglu, Johnson,
Robinson ) claims that differences in
institutional setups in different countries
are a key factor to explain successes and
failures in development.
 Why Doesnt capital flow from rich
to poor countries?
Robert Lucas (1990), other Nobel prize winner
estimated that a dollar invested in India should
earn a return 58 times (fifty-eight!) higher than a
dollar invested in the US economy.
Reason: So little capital in developing countries.
Truck with capacity of 25 tons to transport
wooden planks 10 miles easily replaces 4000
man-days of manual labor (assuming truck
makes 4 roundtrips and one man transports 50
pounds in one day)!
Why and where is this potential marginal
productivity lost if capital does not flow to poor
countries?
 Why Doesnt capital flow form rich
to poor countries?
Weakness of institutions might account for this
puzzle.
Investments may be expropriated if property
rights not well protected.
Corrupt bureaucrats may extract bribes.
Contracts may not be respected.
Courts might not be helpful
Infrastructure may be lacking.
Local entrepreneurs face similar problems as
foreign investors and do not invest much.
 What are Institutions?
Definition by Douglass North (1990: 3):
constraints on behavior imposed by the
rules of the game in society: Institutions
include any form of constraint that human
beings devise to shape human
interaction.
Includes formal and informal institutions.
Very broad definition as it includes social
norms.
 Trade or steal?
Imagine Abuu, East African farmer on the road to
sell maize. He meets Nabil who sells cotton
tissue.
Economists are used to thinking that
advantageous trade will take place. But this
presupposes institutions.
Theft might be a more natural outcome.
Trade instead of violence presupposes
internalization of formal rule (fear of being
caught breaking the law) or informal rules of
behavior (ethical or religious rule of conduct).
 Differences in institutions make
large differences.
If human energies can be channeled away from violent
activities towards peaceful and productive activities, it
makes a much larger difference than differences in skills
or endowments.
The level of human capital in Russia was quite high
before the fall of communism.
However, the institutions that emerged during the
transition process were not conducive to strong
development.
The Russian economy declined for many years. During
those critical years of early transition, the education
system suffered enormously and the level of human
capital in Russia started declining strongly. The high
level of initial human capital could not help Russia avert
economic decline.
 Institutional diversity
Good institutions can reduce transaction costs, prevent
violence and predatory behavior and channel energies
towards productive activities.
Bad institutions can increase transaction costs and lead
to underdevelopment, violence and poverty.
A simple transaction like the purchase of a commodity
say a car, requires the transfer of a commodity from the
seller to the buyer and the transfer of cash from the
buyer to the seller. If the two operations are not
synchronized, there may be problems depending on who
moves first. The seller may never show up to deliver the
car or deliver a lemon. The buyer may never bring the
money.
The more sophisticated the transaction, the more
opportunities for cheating and predatory behavior.
Without adequate institutions, transactions would be
much more costly.
 What are Institutions?
Recognizing that institutions are important is
only a first step. We must study different
institutions and their effects.
Distinction between formal and informal
institutions.
Formal institutions have written codified rules
enforced by the government. Ex: Political and
legal institutions.
Informal institutions are conventions, social
norms related to culture. Formal and informal
institutions interact.
Interaction between institutions.
Laws evolve with culture and social norms. Ex.:
Abolition of death penalty.
Tensions between informal and formal
institutions.
In Africa, arbitrariness of national boundaries
and continuation of ethnic loyalties. May lead to
violent conflicts but also different functioning of
government (nepotism seen as moral duty and
not a bad thing)
Difficulty of imposing laws that violate popular
religious obligations.
Interaction between institutions.
Complementarities between congruent
institutions: norm of honesty backed by
laws punishing cheating.
Tensions between formal and informal
institutions may lead to unexpected
consequences but may also destroy
traditional institutions without replacing
them (gender roles, kinship ties)
 What do institutions do?
Provide different solutions to
1) informational problems,
2) hold-up problems,
3) commitment problems,
4) cooperation problems,
5) coordination problems
 Informational problems.

Asymmetric information important in many transactions

(food, cars, software, houses), credit relation.
Example:
good second hand cars worth $10,000 to the seller and
$12,000 to the buyer.
Bad second hand cars worth $5,000 to the seller and
$4,000 to the buyer.
Without informational asymmetry, only good cars sell
and make $2,000 profit.
Assume informational asymmetry and 50% probability
car is good or bad. Risk neutral buyer ready to pay
5x12,000 + .5x4,000= $8,000 for a car. Suppliers
withdraw good cars and no cars sell. Market collapses.
 particularly important in the case of credit. Lender may
not lend to honest borrower.
Assume good and bad borrowers. Good type is
creditworthy and needs money for a project with 10%
return. Bad type does not intend to pay back.
Assume bank must pay depositors 6% interest rate
(otherwise go to competing bank).
Without asymmetric information, bank lends only to good
borrower and gets 4% profit.
Under asymmetric information and 50-50 chance of
having good or bad borrower, needs to charge 12% to
pay depositors. Good borrower does not borrow since
can only make 10%, only bad borrower stays!
 Adverse selection. Bad borrower chasing good
one.
Increasing credit rates does not balance market.
If excess demand for credit, higher interest rates
chase good borrowers and reduces profit of
banks!
Moral hazard. Borrower chooses risky project if
limited liability.
Other examples of moral hazard: land laborer
does not work hard on land, renters do not
maintain apartment, insured drivers are more
reckless, .
Solutions to informational problems
Legal solutions:
Disclosure rules
Regulation of entry in certain professions (lawyers
and doctors).
Contractual or spontaneous solutions:
Association of warranty to sales contract, return policy
Brand names, franchise contracts.
Chain stores as informational intermediaries. Rating
agencies (??), credit report companies, ebay ratings
Contractual solutions work best when backed by
the law (important for dispute resolution)
Solutions to informational problems
Under weak institutions, reputation and repeated
interaction are main instruments to overcome
informational problems.
Relational contracting. Lock-in in long term
relationship to have credible threat of
punishment.
Bad for competition and market development.
Markets and competition develop more
vigorously when good formal institutions are
present.
For reputation to work, importance of good
circulation of information. Poor countries have
weaker institutions and informal institutions work
less well.
 The holdup problem.
One business partner holds up the other after an
investment is sunk.
Ex.: A company produces axles and signs contract with
truck company. Investment of 10,000 is needed and
variable cost of 20 per axle. Truck company promises a
price of 30 and orders 1,000 axles.
Axle company will break even. Costs = 10,000 +
20x1,000 = 30,000 and sales will be 30,000 also.
After the investment of 10,000 is made, the truck
company renegotiates and offers to pay only 25 per axle.
If the subcontractor refuses, loss is 10,000. If accepts,
payoff is 25x1,000 20x1,000 10,000= -5,000. Prefers
to accept! Reason is sunk cost.
Holdup problem hurts investment. Subcontractor would
not have invested if expected holdup!
 The holdup problem.
Holdup problems are ubiquitous.
Holdup problem is more acute if relation-
specific investment. Axle investment used
only for truck company.
No informational asymmetries here, only
relation-specific investment (asset-
specificity), sunk investment and
opportunistic behavior.
Solutions to the holdup problem.
Binding and legally enforceable contracts
obvious solution to holdup problem. First order
effect.
Contracts are incomplete and do not completely
exclude holdup.
Vertical integration. Truck company produces
axles itself. Requires higher level of capital
(difficult for firms in developing countries where
weak formal institutions)!
Social norms do not work well if agents pursue
self-interest.
 The commitment problem.
Commitment problem very general in economics and
human behavior in general. Arises with all sequential
transactions. The holdup problem is a particular
commitment problem.
Ex.: buyer does not pay, supplier does not deliver as
promised, or more subtle forms of reoptimization:
Budgets within bureaucracy, information arriving later,
The inability to commit hurts both parties because one
may forgo transactions profitable for both parties. The
inability to commit may weaken the bargaining power of
the party that is reoptimizing (soft budget constraints,
negotiating with terrorists) and its credibility (central
bank, monopoly with durable goods).
 Solutions to the commitment problem

Formal contracts are first order. Third party

enforcement.
Informal means. Witnesses on markets.
Informal ways of signalling credibility:
cutting bridges, yakuza methods, making
large investment as commitment to
compete.
Informal enforcement agencies sometimes
used but often criminal orgin.
 The cooperation problem.
The prisoners dilemma
B Stays Silent B confesses
Prisoner A serves ten years
A Stays Silent Both serve six months
Prisoner B goes free
Prisoner A goes free
A confesses Both serve two years
Prisoner B serves ten years

Symbol of inefficiency of self-interest maximization

 The cooperation problem.
Protection of the environment.
Tragedy of the commons.
Collective action problem.
Different forms of association (Unions, parties,
NGOs, ) help overcome the cooperation
problem.
Political institutions help overcome the collective
action problem (democracy) or exacerbate it
(dictatorship).
International cooperation requires international
institutions.
 The coordination problem.
Different from the cooperation problem.
Different equilibria are possible.
Ex.: Drive on the right or on the left.
Meet at the train station or airport.
Law abidance problem.
Tax evasion problem.
 Solutions to the coordination problem.

Traffic laws and laws in general.

Regulation of standards. Rail tracks!
Many informal solutions: conventions
(calling back, nodding, body language, )
Cultural misunderstandings arise because
of incorrect decoding of conventions.
Focal points (Schelling, Nobel prize 2005).
Informal and formal institutions.
Informal institutions only do not give as
good a solution to the transaction
problems mentioned:
relational contracting bad for competition and
market development
reputation requires good circulation of
information
Enforcement of social norms relies on peer
pressure which works better under lack of
mobility, strong cohesion and rigid and closed
societies.
 Why do institutions emerge?
Understanding what institutions do and how they emerge
are different questions.
We know what a microwave oven does but this does not
tell us how it was discovered.
Danger of functionalist fallacy, explaining the historical
emergence of an institution by what it does.
Inefficient institutions exist and persist (dictatorial
regimes, rampant corruption, inefficient courts,).
Overcoming inefficient institutions is difficult in part
because of the collective action problem.
Inefficient social norms also exist (discrimination against
women) and maybe even more difficult to overcome.
 Conclusion.
Institutions matter for development as they
can solve many important transaction
problems, reduce transactions costs and
lead to higher development.
Difference between formal and informal
institutions.
We have seen what institutions do, we
have not seen how and why they emerge.