Institutions

Importance of Institutional Economics

Institutions Opens in new window are defined as man-made rules which constrain people’s (possibly arbitrary and opportunistic) behavior in human interaction.

Institutional economics reflects a move to broaden the research and teaching of economics to not only the analysis of choice within constraints, but also to choose between the constraints on choice. Institutions are the formal and informal ‘rules of the game’.

In our definition, institutions are shared in a community and are always enforced by more or less established social sanctions for violators of the rules. Institutions Opens in new window without sanctions are useless.

Rules with effective sanctions channel human actions in reasonably predictable paths, creating a degree of order. They serve a normative purpose Opens in new window.

Only if sanctions apply will institutions make the actions of individuals more predictable.

If various related rules are consistent with each other, the confident cooperation between people is facilitated so that they can take good advantage of the division of labor Opens in new window, knowledge Opens in new window and creativity Opens in new window.

For example, traffic rules — a set of institutions — impose constraints on individual drivers, but allow people on the whole to travel more speedily and safely.

In a similar way, the institutions that establish protected individual property rights enable people to buy, sell and grant credit to others.

The web of trust within a vibrant economic society does not reside necessarily in any one individual, but in the institutions that govern social interaction between individuals.

We trust strangers not because we know them (we do not, by definition), but because we interact with strangers within an institutional setting that we trust.

The general presumption is that institutions have great impact on how well people attain their economic and other objectives, and that people normally prefer institutions which enhance their freedom of choice and economic wellbeing.

But institutions will not always serve these ends. Certain types of rules may have deleterious consequences for general material welfare, freedom and other fundamental values.

Indeed, the decay of the rule system can lead to economic and social decline. One therefore has to analyze the content and effect of institutions on the freedom of choice and prosperity.

Importance of Institutions to Order and Economic Life

In the first post Opens in new window, we already defined institutional economics as the two-way relationship between economic life and the various coordinative rules individuals utilize and enforce.

The key function of institutions is, as we noted there, to facilitate order — a systematic, non-random and therefore comprehensible pattern of actions and events.

In social chaos, interaction with others is excessively costly, confidence is shattered and cooperation disintegrates. The division of labor and knowledge, which is the major source of economic wellbeing, is difficult and may be next to impossible.

In such a world where the social gains from cooperation would go unrealized, as Thomas Hobbes famously wrote, life would indeed be nasty, brutish and short. Nature is red in tooth and claw, and we humans are not well equipped to survive in isolation from others.

We survive and thrive only because of our ability to cooperate with others and to form social networks.

We shall therefore focus here on how institutions promote order in economic interaction: patterns emerge when individuals try to come to grips with the scarcity of resources.


Order inspires trust and confidence, and reduces the costs of coordination.

When order prevails, people are able to make predictions; individuals are then better able to shape their own plans, cooperate with others and feel enough confidence to risk innovative experiments of their own.

Institutions can also make it easier for people to find specialists with whom they can cooperate, guess what such cooperation is likely to cost and estimate what benefits it might bring. More useful knowledge will then be discovered and used.

Economics Opens in new window deals with scarcity. This means that a decision in favor of one course of action inevitably implies rejection of alternative actions. We call the most-valued alternative use of a resource the opportunity cost Opens in new window.

Each reader of this post is foregoing other uses of her or his time and attaches different costs to reading this.

Such decisions are always subjective — different individual decision makers evaluate alternatives differently. For example, one reader’s opportunity cost may be the attendance at a lecture, and another’s a flirt with a friend or time on the beach (Buchanan, 1969, Forewood).

Even where the alternative foregone by a certain choice is technically the same — for example, that we cannot listen to a rock concert because we read this post — the value of the sacrifice will differ between us.

You may bear much higher opportunity costs than we do. This point is fundamentally important: economic decisions should be left to individuals, as individuals know their own subjective opportunities. Collective decision makers are less informed about the diversity and subjective values of the opportunities people face.

When people with different aspirations and capabilities make choices and assess their opportunity costs, order and trust are greatly appreciated, since information is then easy to convey to others and a sophisticated division of labor is possible. The content of order-supporting institutions is therefore of great relevance to economic outcomes that satisfy diverse people in their ever-changing environments.