Institutional Economics

Introduction to Institutional Economics

Economics is the study of how people who face scarcity satisfy their diverse wants by finding and testing useful knowledge.

Scarcity results from the fact that people tend to increase their wants faster than they are able to increase their knowledge and other resources to satisfy them. Consequently, scarcity is a pervasive and prevalent trait of the human condition.

Institutions are rules of human interaction that constrain — possibly opportunistic and erratic — individual behavior; they make the actions of others more predictable, thus facilitating the division of labor and knowledge and therefore wealth creation.

Institutions, to be effective, always imply some kind of sanction for rule violations. The terms ‘institution’ and ‘rule’ will be used interchangeable in this topic.

Institutional economics, therefore, covers the two-way relationship between economics and institutions. It is concerned with the effects of institutions in the economy, as well as how institutions respond to a dynamic world.

Why Do Institutions Matter?

People cannot survive, let alone thrive for long without interacting with their fellows. And they cannot work together without a degree of predictability.

Individual actions become more predictable when people are bound by enforceable rules (which otherwise has come to known as institutions).

Economics is the field of study that deals with the fundamental fact that humanity has to live with scarcity; individuals tend to have unlimited wants, but limited means for satisfying those wants.

Scarcity has nothing to do with material wealth per se. Even Bill Gates copes with scarcity every day as he makes choices.

Scarcity necessitates choice, and choice entails the economic meaning of cost — the highest foregone alternative in making a choice. In other words, all decisions involve trade-offs Opens in new window and decision makers in all settings require various aids to help negotiate those trade-offs.

The aids to human actors in their effort to negotiate the complex trade-offs of life come in a variety of forms in a political, social and economic context.

Within the market economy Opens in new window we speak of the incentives Opens in new window of profits and losses in using private property, the information of prices, and the innovations that are spurred on by the lure of expected profit (as well as the disciplinary feedback of loss).

In democratic politics, the currency of the realm is votes and the exchange is largely over public policies, while in society the currency of the realm is trust and reputation, and the exchange often relates to community status and the network of friendships and connections that enable us to negotiate trade-offs and come to live better together (Heyne et al., 2012).

When economists speak of resources, they refer not only to natural resources (land, water, climate, minerals) but also to all scarce ingredients that are needed to produce the goods and services that we want.

Both labor and capital are important resources.

Capital goods are tangible things that one may call the ‘hardware of the economy’. Implements, machinery, buildings, and infrastructures make labor more productive but frequently require skills, or human capital, to be operated properly.

In addition, a lot of technical and organizational knowledge is either built into or needed to manage the capital goods.

It is also important to know how flexible and the structural composition of the capital stock and the skill base is:

Rigid structures lend themselves to less adaptation when wants and other resources change than flexible ones.

Economists sometimes refer to knowledge and structural flexibility as third production factors, that is, factors (or resources) other than labor and capital.

The various resources are combined in production processes, which can be compared to what happens in a kitchen: ingredients are mixed together and exposed to energy by someone who — one hopes — has the required knowledge.

Knowledge is the key to the culinary outcomes.

But neither a meal, nor other goods and services come about automatically. This requires entrepreneurs—people with energy and vision to initiate the production process, tap into the available resources, and find additional ones.

Entrepreneurs often imagine and then implement new ways of combining the ingredients; they also often try to stimulate human wants (by advertising, for example) and try out new methods of production and new products (innovation).

Producing all those countless, diverse goods and services that people want in different places and at different times is an unimaginably complex task.

Even a simple department store stocks 50,000 different items, in different sizes and colors.

And to put an airliner into service, there are tens of thousands of components that thousands of different people have to design, produce, and transport to where these components are needed. Even producing a simple pencil Opens in new window requires the cooperation of countless people who never meet or know each other.

Enterprising people are not engaging in all these complicated and costly actions simply because of their enterprising nature. They have to be motivated.

Coordinating millions of partly ignorant people, who often struggle to find out pertinent facts, to do what millions of others want is unimaginably complex — and all these activities must ceaselessly adjust to changing circumstances (idem).

This is where institutions come in:

Institutions—customs, laws, and the like—are known, enforceable rules of behavior that come with penalties for not obeying the rules of the game (called sanctions).

Institutions can make the actions of individuals more predictable and help enormously with the difficult coordination problem.

In particular, institutions help in situations where enterprising people try out new factor combinations, new products or new ways of producing existing products.

Humans are social beings. To survive and thrive for any length of time they must interact with their follows.

However, one person cannot interact with another without some shared understanding about how the other will respond and be sanctioned for responding arbitrarily or contrary to previous agreement.

Individuals and businesses can only buy, sell, employ labor, invest, and explore innovations if they can have some confidence that their expectations will be met.

Much of the exchange between individuals and firms is based on repetitive operations. We prefer these to be predictable because that reduces frictions and uncertainties.

Human interactions, including in economic life, depend on some sort of mutual trust that is based on an order facilitated by institutions that sanction unpredictable and opportunistic behavior.

In our daily lives we interact with numerous people and organizations whom we scarcely know, but in whose predictable behavior we place great faith.

We hand over our hard-earned money to a teller clerk, whose face we may not remember five minutes later, in a bank, about whose reserves and management we know nothing.

We allow ourselves to be operated upon by surgeons we have hardly met, in hospitals we had never seen from the inside before. We prepay for the delivery of a car made in a foreign country by workers we never met.

Yet, in all these situations, we trust that we will get worthwhile service and that promises made will be kept. Why?

Because all these people are bound by constraints on their opportunistic temptations not to deliver or to short-change us we are able to assume that selfish breaches of the contracts we enter will incur sanctions of one sort or another.

Modern economic life therefore depends rather precariously on numerous written and unwritten rules. If they are widely violated—as in cases when society collapses after a lost war or during international chaos—many of the human interactions that we depend on are no longer possible; living standards and the quality of life then plummet.

The institutions that normally prevent this are therefore the very foundations on which our material wellbeing and sense of security are built.