Internal Institutions

Internal versus External Institutions

There exists important distinction between internal and external institutions.

Internal institutions are defined as rules that evolve within a group in the light of experience, and external institutions are rules designed externally and imposed on the community from above by political action.

South African economist Ludwig Lachmann Opens in new window made this distinction to show that many rules, which influence our behavior, are the result of evolution and that communities functioned on the basis of rule-bound behavior long before government Opens in new window was even invented (Lachmann, 1973; Bernholz et al., 1998, 13-34).

The distinction between internal and external institutions relates to the genesis of the rules—how they came into existence.

In practice, one can of course observe fluid transitions between internal and external institutions.

Institutions Opens in new window can also be classified as to whether the sanction for non-compliance comes in the form of decentralized, spontaneous social feedback (informal institutions) or by a formally organized mechanism (formal institutions).

As we shall see, the distinctions between internal and external, and informal and formal do not always coincide.

What matters is the degree of constraint and discipline that institutions exercise over individual actions.
  • Internal institutions appeal to voluntary compliance, but non-compliance with the rules has consequences. In specific circumstances, it is the individual that decides whether or not to accept the consequences of non-compliance.
  • By contrast, coercive orders, which rely heavily on external institutions and formal sanctioning, leave the individual much less leeway to evaluate the specific situation (Radnitzky, (ed.) 1997, pp. 17 – 76).

How Internal Institutions Evolve

Humans interaction is governed by numerous internal institutions that keep evolving spontaneously in the light of experience.

Some discovered a rule and found it useful, making interaction with others possible in the first instance, and easier, once these rules of conduct were imitated, and gained critical mass to become a norm widely obeyed in the community.

A good example of how such evolved institutions develop and work is language.

We order the sounds that we are able to produce and hear into recognizable patterns called words Opens in new window, and, by applying rules of grammar, we order words into sentences.

These rules have evolved over time and contain much knowledge how to communicate. No one has designed a living language, which is an ever-evolving system ruling the interaction of millions of people.

New words arise, meanings change, and words fall into disuse. Thus, the word app was unknown at the turn of the century, now every iPod and iPad user knows what an app is.

Attempts have been made to design languages, such as Esperanto, but the acceptance of such creations has been limited. Even where the internal institutions of language are supplemented by external rules, which are policed by an authority, such as the Académie Française Opens in new window, the results are often ineffectual or ridiculed.

Another example of how the internal workings of society produce institutions that no one designs, but that emerge from the interaction of millions of people is the custom that people who do not tell the truth lose respect or are shunned in honest society.

The genesis of this habit has no doubt to do with the fact that fibbing to mislead people inflicts costs on others and destroys trust.

The rule not to tell lies is sanctioned by the spontaneous exclusion from social exchange, typically in a fairly informal, but nonetheless powerful manner.

Internal institutions arise and continue to exist through selection processes within society.

Internal rules also govern economic interaction.

Markets Opens in new window depend on some basic rules being respected. For example, people have to be allowed to keep the profit from their exchanges (respected private property rights), and market participants negotiate to narrow the differences between offer and demand price bids.

Reversals of price offers, that widen the gap again, are spontaneously punished by a discontinuation of the negotiation (shunning of potential contract partners).

For markets to function smoothly the relevant rules have to be widely known and adhered to.

Another example of internal market institutions is the convention that a deal, once struck, terminates all further price negotiations. If someone tries to re-open negotiations once a deal has been struck, the sanction will probably be that traders will not deal with him in the future (ostracism Opens in new window).

To give a yet another example: work contracts operate satisfactorily for workers and employers only if institutions about many work practices are widely shared, adhered to and violations are sanctioned.

A one-off experience turns into an internal institution only when a critical mass of people imitates and accepts it.

Institutions may begin within a small group who benefit from sharing certain arrangements, for example the custom that loans are repaid punctually. Once the benefit of this rule becomes apparent, it is likely that more people will adopt it.

Successful institutions spread to bigger and bigger groups of participants. On the other hand, institutions that were no longer found useful—such as the European and American institution that gentlemen defend their honor (honour) by dueling—lost critical mass.

Nowadays, other ways of sorting out attacks on someone’s honor (honour) have been adopted.

Internal institutions are thus subject to gradual evolutionary processes. They are varied, accepted or rejected (selection), and only some gain critical mass.


Traditions that are found to fail when circumstances change are adjusted.

In developing countries, the advent of modernity and the impact of globalization have challenged familiar traditions in manifold ways—by “a million little mutinies”, as Indian writer V.S. Naipaul once aptly put it.

Philosophers and social scientists have long recognized the importance of internal institutions in structuring social interaction, bridging the gaps between self-centered individuals and forming bonds that hold a society together.

As far back as 2500 years ago, the Chinese philosopher Confucius Opens in new window (551-479BC) emphasized the importance of what he called ‘ritual’ in creating harmonious, predictable human behavior (behaviour) and in enabling many people to live together in confined spaces and with limited resources.

French social philosopher Charles de Montesquieu Opens in new window (1689 – 1755) went back to the Roman institution of unwritten laws, known as mos maiorum, when he wrote about the importance of maeurs (customs) in his treatise ‘De l’esprit des lois’ : “Intelligent beings may have laws of their own making, but they have some which they never made”.

The Anglo-Saxon philosophers of the Enlightenment Opens in new window who wrote roughly at the same time, such as John Locke (1632 – 1704), David Hume (1711 – 1776) and Adam Smith (1723 – 1790), also saw that the institutional framework of a society rested on evolved internal institutions.

Consciously made, legislated rules, and the entire structure of politically determined institutions, they taught us, had to rest on internal institutions.

Long before the laws of social interference are codified and written down on parchment, they are written on the hearts and minds of men. In modern times, Friedrich A. Hayek has most forcefully made the same point (1973, 1976, 1979a, especially the Epilogue to 1979a, pp. 153 – 208).