Types of Internal Institutions

Informal and Formal Internal Institutions

Internal institutions Opens in new window are generally classed in to two broad categories, namely:

  1. Informal, that is, they are not sanctioned by formal mechanism. Informal rules are subsequently classed into conventions, internalized rules, and customs and manners.
  2. Formalized rules, where the sanctions are implemented in an organized manner by some members of society.

Combining these rules, they make up the Four Types of Internal Institutions, as discussed below.

The distinction between the formalized and informal institutions consists in the way in which the sanction is applied, spontaneously or in an organized manner. In other words, they differ in the ways in which adherence is monitored and breaches are sanctioned (Kiwit, 1996; p. 10).

1.   Conventions

Conventions are rules that are of obvious, immediate benefit to the person, whose behavior (behaviour) they control, and violations harm their self-interest.

Conventions are so obviously convenient that people automatically enforce them, by and large, out of self-interest. For example, people adhere to certain word definitions and grammatical rules because it is in their own interest to make themselves understood.

Further examples for largely self-enforced conventions are the tacit agreement in the market that interest rates are expressed in terms of a percentage per annum and that prices are quoted in terms of money.

A vegetable seller who might try to express all vegetable prices in terms of grams of apples, which is theoretically possible, would soon discover that she does little business.

People adhere to conventions because it obviously pays and they easily exclude themselves from profitable interchange by choosing not to stick to the conventions (de Jasay, 1995).

2.   Internalized Rules

Internalized rules are a second type of internal institution. Violations of internalized rules are sanctioned primarily by a bad conscience.

People have learnt these rules by habituation, education and experience to a degree where the rules are normally obeyed spontaneously and without reflection (conditioned reflex Opens in new window).

People have turned many rules into more or less automatic habits, which they consider a personal preference and apply fairly consistently.

One’s morality is, for example, made up of such internalized rules. That you should not lie or not pay your debts punctually are rules of conduct, which people have learnt and now normally obey as a conditioned reflex Opens in new window.

Internalized rules are both personal preferences and constraining rules. They operate as rules in the heat of battle protecting people from instinctual, shortsighted opportunism Opens in new window, often saving them coordination costs and conflict.

Violations of internalized rules are typically sanctioned by a bad conscience—in other words, people suffer a psychic cost. But violations may also be met by reprimand; if you hit me, I will hit you! The tit-for-tat rule in the prisoners’ dilemma Opens in new window settings is such an example.

A variety of simulations on computer and in lab experiments suggest that, rather than a strict tit-for-tat strategy, a strategy, which is more trusting and forgiving of transgressions, yields higher pay-offs.

But there is no escaping the need to have retaliatory strategies at one’s disposal. Without a credible commitment to punish those who violate the rules of cooperative play, the game will break down. These punishment mechanisms tend to be exercised mildly and with empathy vis-à-vis children, who get often educated in that way.

As children grow up, the sanctions are applied more strictly. Where this sort of education is neglected (because it requires patience and is not always pleasant), there is a danger of institutional decay, that is, a danger that harsher and costlier means of mutual control have to be resorted to or certain beneficial acts of cooperation no longer occur. Overall wellbeing then declines (Giersch, 1989).

These sanctions may be reinforced by reference to the transcendental or to certain symbols.

For example, the ethical rule that ‘you shalt not steal’ has—in the Judeo-Christian tradition—become a violation of a Commandment, which displeases God (Hazlitt, 1988, pp. 342 – 353).

As Adam Smith put it: “Religion, even in its crudest form, gave sanction to the rules of morality long before the age of artificial reasoning and philosophy” (cited after Hayek, 1988, p. 135).

In the East-Asian tradition, especially the Confucian, great attention is paid to moral education, which makes young people internalize rules of interpersonal conduct.

Members of society are then imbued with strongly held moral institutions that make them comply seemingly voluntarily, or at least without much reliance on formal legal rules and processes.

One benefit of internalized rules, which encourage reflexive obedience and a high degree of rule compliance, is that members of society save on coordination costs.

In societies, where people are spontaneously honest because they have internalized honesty, agents have lower decision-making costs and risk fewer ‘accidents’ than their competitors in societies where cheating is habitual and agents speculates all the time whether, in this particular instance, they will get away with cheating, and what possible penalty they risk.

This is why widespread corruption—the non-enforcement or uneven enforcement of the rules—makes entire economies uncompetitive and hinders economic growth Opens in new window.

Internalized rules that establish trustworthiness also save costs as against a situation where trust depends on explicit, mutual contracts that have to be negotiated and monitored.

3.   Customs and Good Manners

Customs and good manners are a third type of internal institution Opens in new window. They are sanctioned informally by the reactions of others, for example by reprimand, tit-for-tat and exclusion.

Violations of customs do not automatically attract organized sanctions, but others in the community tend to supervise rule compliance informally, so that violators earn a bad reputation, lose respect or even find themselves excluded, in the extreme even banned or ostracized (Benson, 1995, pp. 94 – 96). Thus, children who misbehave in East Asian families are often not allowed back into the house or apartment.

Punishment in the West tends to rely on a different type of exclusion:

Badly behaved kids are ‘grounded’ and thereby excluded from their friends outside the home. People with bad manners tend to be lonely, which can be an extremely powerful sanction. For example:

  • an Australian Aborigine or American Indian, who was expelled from his tribe, was most likely condemned to certain death as individuals could hardly survive for long outside the group.
  • Similarly, an international currency trader, who loses his reputation because he repeatedly violates the unwritten rules of the foreign exchange trade, will not be able to pursue his profession. He will soon fail to find contract partners, because bad reputations are quickly known throughout professional networks.

Other types of enforcement for such customary institutions are that misbehaving parties lose the repeat business, normally a serious penalty, because much trade is not one-off.

Since the search for contract partners costs considerable resources, much business is conducted in ongoing bilateral relationships. Only in an ‘end game’ is there no such sanction. Many exchanges are conducted as repeat games for the very purpose of retaining a sanction.

Customs can also be reinforced by contract partners who offer up ‘hostages’. For example:
  • A down-payment that is forfeited in the case of non-acceptance of a delivery.
  • Another ‘hostage’ may be one’s reputation that suffers if one sells bad products.

A borderline case to the second category of internalized institutions is the case where one’s bad conscience is reinforced by reprimand or shaming, ensuring that violators face the sanction of losing face.

East Asians tend to rely on this type of sanction more heavily than Europeans who have long been able to rely on the formal enforcement of external institutions. Reliance on magistrates and external institutions is still frowned upon in Chinese society even nowadays.

To recapitulate: sanctions may be enforced spontaneously by reprimand (‘tut-tut’), by reciprocity (‘tit-for-tat’), by exclusion and ostracism (‘out!’).

4.   Formalized Internal Rules

Formalized internal rules are a fourth type of internal institution. Their sanctions are implemented in an organized manner by some members of society.

These rules have emerged with experience, but are formally monitored and enforced within a group.

Communities create much law internally but then enforce it among themselves in organized ways relying on outside third parties.

These may be adjudicators (people who clarify the rules and spell out possible sanctions) and arbitrators (third parties who make binding decisions on interpretation and sanctions).

An example of this is the self-regulation of the professions, such as the medical, journalistic and legal fraternities.

Formalized internal rules also regulate most sports. Experience may have shown that the game of soccer requires formalized rules, which soccer clubs and federations apply. They adjudicate disputes and hand down penalties.

Football codes are spelled out and enforced formally, but without reliance on outside authorities such as government bodies. Only rarely are these rules enforced in public courts. Instead, sports bodies rely on formal internal procedures and sanctions, such as excluding offending clubs from the competition for a given period.

Tribunals ruling on what constitutes a breach of professional standards may enforce internal rules in formalized ways.
  • Trade and finance in most societies are based on similar internal institutions Opens in new window, which the merchants and bankers have created to facilitate their business.
  • Oriental bazaars and European markets have, for example, developed complex trading rules that community leaders or designated market experts interpret and formally enforce.

To cite another example of this type of internal rule:

International trade relies on merchant-made laws (lex mercatoria) that are often enforced by professional associations and arbitrators but not by a court of transnational authority.

Formal internal institutions are often much more effective in facilitating the business than externally imposed and government-enforced laws because self-monitoring and formal enforcement by members of the profession are done by people with much knowledge specific to time, place and the profession, whereas outside judges have only limited knowledge. Indeed, their rulings may trigger unintended, deleterious consequences.