t

UV0987

os
INSTITUTIONS, INSTITUTIONAL CHANGE,
AND ECONOMIC PERFORMANCE

rP
Why are some countries much richer than others? This technical note proposes a
framework to begin answering this question. The first part identifies inefficient institutions as the
root cause of the economic differences between societies. The second part analyzes how these
institutions change. And the final part suggests how lessons from this institutional framework
can be applied.

Institutions and Economic Performance

yo
Economic theory implies that over time the economies of different countries will attain similar
levels of wealth. When there is competition between organizations (be they tribes, companies, or
op
countries), the less effective organizations die out and are replaced by more effective organizations.

It is hard to deny that the world’s organizations are not in competition with each other.
Competition is most dramatically manifested in open warfare between countries. But the more
important form of competition is expressed in the daily economic contests waged between
countries and companies in world markets.
tC

Given open competition we should see the surviving societies converge over time in
terms of economic development. Why then do countries continue to show large disparities in
terms of wealth? What causes some societies to flourish and others to stagnate and decline? The
simple answer is differences in the effectiveness of a country’s institutions.

Institutions Are Rules That Structure How People Interact

No

Institutions are the rules of the game. They shape how humans interact with each other.
They structure the incentives that shape how society evolves.

Institutions can be thought of as a continuum. Formal rules are on one end and informal
rules on the other.
Do

This note was prepared by Victor Abiad under the supervision of Wei Li, Professor of Business Administration.
Copyright © 2003 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights
reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part of this publication may be
reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording, or otherwise – without the permission of the Darden School
Foundation.

This document is authorized for educator review use only by JUAN NICOLAS GARZON ACOSTA, Universidad del Rosario until Aug 2018. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860
 t
-2- UV0987

os
Formal rules are rules that are created and are often set down in writing. These often
complement and increase the effectiveness of the informal rules of a society. Examples of formal
institutions include political rules (the US constitution, government laws), economic rules
(property rights, money as storage of value), and contracts between two parties.

rP
On the other end of the continuum are informal rules. These are rules that evolve. They
often aren’t written down, yet they influence actions more pervasively than formal rules.

Many informal rules come from a society’s culture. Culture can be defined as knowledge,
values, and beliefs that are passed along from one generation to another. Examples of cultural
informal rules are siestas in the afternoons, women not working outside the home, and business
agreements completed on handshakes rather than contracts.

yo
Economic Theories Ignore the Effects of Inefficient Institutions

Economic theory cannot explain the disparity between the rich and the poor because for
the most part these theories assume efficient institutions. One assumption is that efficient
institutions mean costless transactions. In reality transaction costs are significant. Even the
op
simplest currency conversions carry transaction fees that can be easily measured. Other
transaction costs are harder to measure. For example how does one account for delays and
possible bribes as goods go through customs? Or for costs for gathering information?

A second assumption is that efficient institutions lead to correct mental models. Mental
models are ways people analyze data to make decisions. Those organizations that utilize accurate
tC

models make correct decisions and are economically rewarded. Those that utilize wrong models
are penalized. If institutions are efficient, there will be effective feedback to help organizations
correct wrong models. In reality this does not happen and many organizations continue to make
decisions based on models that are wrong.

A third assumption is that efficient institutions effectively collect and share information. In
reality many situations are very complex which makes it difficult and expensive to gather information.
No

Those parties that do devote resources collecting the information are often reluctant to share it.

A fourth assumption about efficient institutions is that the goal organizations is to maximize
profits. Though profits can account for a substantial portion of people’s motivation, it cannot account
for all of it. Other things that motivate people and organizations include ideology, values, and religion.

Inefficient institutions result in costly transactions, subjective models, poor information,

and non-profit maximizing goals. These inefficiencies lead organizations to make decisions that
Do

do not maximize economic benefits.

The root cause of economic divergence between rich and poor countries is that their
institutions vary in their levels of efficiency. These differences lead to different decisions being
made and ultimately lead to the different economic results.

This document is authorized for educator review use only by JUAN NICOLAS GARZON ACOSTA, Universidad del Rosario until Aug 2018. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860
 t
-3- UV0987

os
Institutions and Organizations are Interdependent

A society’s institutions and organizations are interdependent. Institutions create

opportunities that organizations try to capture. Institutions influence what organizations develop,
and how they operate, by varying the mix of opportunities. For example, by spending more on

rP
highways than on railroads, the U.S. government encouraged the development of a strong
automobile industry and a weak rail system.

Conversely organizations work to induce change in the institutions around them.

Organizations aim to maximize the income from the opportunities they face. The most successful
organizations will try to influence institutions to create conditions that would be most beneficial
to them. For example certain energy companies saw the potential income from deregulated

yo
electricity markets. By successfully lobbying the government they reformed the institutions of
their industry to meet their needs.

To further illustrate this we can use an analogy. Institutions are the rules of the game and
the organizations are the teams that play. Who are on the team and how they play depends on the
rules. The teams can come together and agree to change the rules.
op
Institutions that are key to economic success:
 Institutions that protect property rights
o Land – Ownership and freedom to transfer ownership encourages capital investment
o Labor – Freedom of labor to seek best employers encourages investment in people
o Knowledge - Incentive structures like patent laws accelerates innovation.
tC

 Institutions that lower transaction costs

o Standardized weights, measures, rules and procedures lower negotiation costs
o Economies of scale in markets – easier sharing of information lowers search costs
 Institutions that establish the rule of law and checks and balances between the different
centers of power.
 Institutions that encourage innovation and competition
 Institutions that provide incentives by allowing individual entrepreneurs to capture the
No

value of their efforts. Lower taxes, etc.

Institutions Determine Costs and Economic Performance

Organizations make their production and investment decisions within the framework set
by their institutions. For example if a country’s property rights are poorly defined and protected,
then an organization would tend to use technology that required less fixed capital. This decision
Do

decreases capital costs but often increases operating costs and minimizes opportunities for
economies of scale. Another example would be banking and credit agencies, if these are weak
many players will demand full cash payments rather than credit thus increasing the costs of
doing business.

This document is authorized for educator review use only by JUAN NICOLAS GARZON ACOSTA, Universidad del Rosario until Aug 2018. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860
 t
-4- UV0987

os
If institutions and organizations determine the transaction and production costs, and if
economic performance is determined by these costs, then a country’s economic performance is
very dependent on the effectiveness of its institutions

Each society is a mix of institutions. Some of the society’s institutions increase efficiency

rP
by encouraging productivity and lowering transaction costs. Other institutions do the opposite. It
is the overall balance of these two forces that determine the economic future of each society.

Contrasting the institutional framework of today’s developed countries (see box) with
those of the developing countries or those in the historical past make it clear that the institutional
framework is the key to economic success.

yo
To illustrate the impact of institutions we can compare housing markets in the United
States and in developing countries. What is true for the housing sector is also true for many other
segments of the economy.

The US, because of its institutions, has a vibrant housing market. Strong property rights
give individuals the confidence to invest in real estate. Banks and mortgage corporations make
op
capital accessible to a large segment of the population. Standard credit checks, contracts, and
procedures lower negotiation costs. A wide real estate agent system lowers search costs by
bringing together buyers and sellers. The size of the market allows economies of scale (easy
sharing of information, large number of transactions set market prices, etc.) that lowers
transaction costs.
tC

In contrast a developing country often lacks some of these institutions. In others the
institutions may exist but are in a less efficient form. The result is that most developing countries
have housing markets that are not very dynamic.

How Institutions Change

No

Institutions are useful because they are stable and provide a framework within which
people can interact. Although institutions are stable they are not static. Institutions evolve as
conditions change. The manner in which institutions change is consistent. For the most part
institutional change is incremental and is path dependent.

Institutional Change is Incremental

There are a few broad changes that get implemented over short periods, for example the
Do

installation of Soviet centralized planning with the Russian revolution and its subsequent collapse, but
the vast majority of changes are small incremental changes made by individual organizations and
people.

This document is authorized for educator review use only by JUAN NICOLAS GARZON ACOSTA, Universidad del Rosario until Aug 2018. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860
 t
-5- UV0987

os
Institutions are constantly evolving and change in reaction to changes in prices and
preferences. The main agent of change is the individual entrepreneur who responds to incentives
provided by current institutions. Institutions change when there are changes to relative prices and
preferences. Prices change when things, such as new technologies, change the cost of production
of certain goods. Preference impacts demand and thus impacts prices. These changes give rise to

rP
new incentives that entrepreneurs chase.

Institutional change is path dependent.

Once one institutional path is chosen, other alternatives are ignored even if they are better.
There are four reasons for path dependence. The first is the high initial costs of establishing
institutions. Once an institution is established there is reluctance to invest time and effort to modify it.

yo
The second is the learning effects. Organizations are established to take advantage of
opportunities created by the institution. The existence of these organizations reinforces the current
institutions.

The third reason is the coordinating effect. Contracts and agreements between institutions
op
serve to reinforce the current institutions.

The fourth is adaptive expectation. As more contracts are made under a particular
institution the expectation that the institution is permanent grows.

Path dependence means history matters because we cannot understand today’s institutional
tC

choices without understanding the historical evolution from the past to today. Path dependence also
means that care must be exercised in building today’s institutions and the impact what happens in the
future.

To illustrate the sequential characteristics of path dependent institutional development it

might be useful to look at an example contrasting the England-North American path and the
Spanish-Latin American path.
No

England in the 16th century saw the beginning of representative government in the
establishment of Parliament. It also saw the creation of the Bank of England that led to
financially sound government and laid the groundwork for the development of a private capital
market. Laws evolved that led to more secure property rights. A reduction of trading and guild
restrictions led to expanded opportunities and encouraged entrepreneurial and innovative
activities.
Do

Many of these institutions were carried to the English colonies in North American and
downstream effects from 16th century England are seen in the 20th century United States. A
federal political system, checks and balances, and strong property rights characterize US
economic history. These encourage long term contracting essential to the creation of capital
markets and strong economic growth.

This document is authorized for educator review use only by JUAN NICOLAS GARZON ACOSTA, Universidad del Rosario until Aug 2018. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860
 t
-6- UV0987

os
On the other hand, when we examine 16th century Spain we see centralized planning for
the benefit of the crown. There are also repeated bankruptcies that led to desperate measures
such as confiscations of silver remittances, tax increases, and price ceilings on wheat. These
meant that secure property rights were insecure and that there were fewer incentives to produce.
Rewarding occupations were predominantly in the military, priesthood, and judiciary. The

rP
downstream effects are seen in Latin American economic history which is characterized by
bureaucratic traditions. Business is often highly politicized. There is reliance on political
influence and kinship networks to gain economic advantage. The result is poorer economic
performance.

Even when similar institutions are imposed on the two different societies, the results remain
different. The US constitution was adopted (with modifications) by many Latin American societies

yo
in the 19th century. The results however are not similar to those in the US. Although the rules are the
same the enforcement mechanisms are not. Because of these differences, the incentives and
opportunities are different, the resulting organizations act in different ways and thus we get different
results.
op
Consequences of Institutions on Business

All individuals and firms use economic models, whether formally or intuitively, to make
decisions. These economic models are institution specific. As institutions evolve, the economic
models themselves, or the way they are applied, needs to be modified.
tC

Many corporations are actively involved in lobbying the government to implement rules
that are favorable to the corporation’s current businesses. These corporations need to take a long
term view and ensure that the rules they lobby for are good for the long term health of the
economy and not just for short term profits.

The lessons learned about the impact of institutions on societies can be extended on a smaller
scale to organizations. When setting up an organization attention needs to be given toward setting up
No

the proper company institutions that foster innovation and reward individuals for investing time and
effort.

Reference

North, Douglass. Institutions, Institutional Change, and Economic Performance. Cambridge,

England: Cambridge University Press. 1992.
Do

This document is authorized for educator review use only by JUAN NICOLAS GARZON ACOSTA, Universidad del Rosario until Aug 2018. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860