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Bulletin of the ERI, 2008/09 no. 3

Contents: July 2009

Institutions and economic performance

Institutions matter for economic performance. But what is meant by “institutions”? In the words of the Nobel laureate Douglass North, “institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction.” While the study of markets has dominated economics scholarship over the past fifty years, the importance of institutions on economic outcomes has recently been emphasized by some economists. There is now a sizeable and growing literature on this subject.

Political institutions (such as legislative bodies), for example, play a critical role in the determination of policy. Until recently, however, much scholarship in economics was based on the assumption that policy is determined by a benevolent dictator. Many economists continue to adopt this approach. While in some (limited) instances this can be a reasonable working assumption, in general it is utterly silly. The analyses of policy when political institutions are taken into account are relatively more complex. While simplicity is a good virtue, it should not however be pursued at the cost of flawed analyses and potentially misleading conclusions. As Albert Einstein noted, “make everything as simple as possible, but not simpler.”

The point being made here applies equally to other organizations such as universities and firms. The institutional structure, which delineates who has what decision-making authority, is an important determinant of the performance of an organization. While the qualities of the people who are appointed (or elected) to take those decisions are of equal import, the constraints imposed on them by the institutions need to be optimally designed.

A concern not mentioned thus far is that institutional designers may have their own (private) interests. This suggests the desirability of setting up an appropriate institutional structure within which they are to operate. Recall that they are entrusted to design the institutions within which policy would subsequently be determined, by other people. Sometimes, however, these “other people” could include some of these very institutional designers (such as when members of a parliament are involved in the design of the rules governing their own expenses). How nice it would be if only one could have impartial and wise people (such as the founding fathers that designed the US constitution) as institutional designers. If only life were that simple!

The institution of marriage is another type of (social) institution that impacts on economic performance. While there are a number of economists who study this institution, it is not something that is in the mainstream of the discipline. This is unfortunate as the household is a central organizational unit in society. Economists have overemphasized the centrality of markets at the neglect of institutions like the family for economic performance and well-being. This needs to change.

I close these brief observations on the importance of institutions for economic performance by recommending, as further reading, Douglass North’s classic treatise Institutions, Institutional Change and Economic Performance.

Abhinay Muthoo

Abhinay Muthoo is director of the Economic Research Institute and chair of the Department of Economics.