INSTITUTIONAL ECONOMICS: INSTITUTIONS – INDIVIDUAL RULES

Institutions are broadly durable systems of established and embedded social rules that structure social interactions. According to this definition, language, money, law, systems of weights and measures, traffic conventions, table manners, markets, firms (and other organisations) are all institutions.

Institutions are social rules that are meant to constrain possibly opportunistic human behaviour. They always carry some kind of sanction for non-compliance. Institutions should be simple, certain, abstract, open and reasonably stable.

Prescriptive institutions instruct and command people positively what to do and create an order of actions which is imposed by political authorities. Proscriptive rules leave actors much freedom in what they do, but rule out certain harmful classes of actions (i.e. negative freedom – don’ts).

The analysis of institutions emphasises the importance of habits, the complexity of information and institutional change.

Habits: Given that fully conscious rational deliberation is impossible (recall the knowledge problem), human agents have acquired mechanisms for reducing the need for continuous rational assessment. These are known as habits. Habits play a key part in economic behaviour; e.g., shopping, labour practices, business network ties.

Neoclassical economist holds that habit can be analysed within rational choice model (repeated actions economise on lack of information, outcomes of preceding rational choice and rational selection). However, people are usually unaware of the costs of dropping a habit. Nor are habits acquired from conscious o rational choice. Indeed, we acquire habits in various ways.

To sustain a more adequate notion of habits, we have to include levels of actions that are not open to full, conscious deliberation, and which do not necessarily all lead to a consistent outcome. In most cases, actions spring from both deliberative and non-deliberative sources. They are acquired through imitation and learning.

Complexity of Information: Habits and routines have a functional significance in that they reduce the amount of deliberation involved in the complexity of day-to-day behaviour. Routines and formal institutions establish fixed patterns of, boundaries to, regulations over, or constraints upon human action. They communicate information to other agents.

In other words, institutions and routines, other than acting as rigidities and constraints, play an enabling role, by providing reliable information, regarding the likely actions of others, despite the uncertainty and complexity of the world.

It is important to emphasise that we depart from orthodoxy theory, which negatively views institutions as constraints. Also, we note that social institutions have a social, and not purely subjective, character: they are established by routinised behaviour of a group of individuals, though they may be different interpretation of institutions.

Institutional Change: The interaction between habitual and deliberative action, and the consequent tension between institutional stability and structural breaks should be emphasised. The adoption of an institutionalist view of the formation and development of conduct does not imply an adherence to determinism. It is possible to stress both the weight of routine and habit in the formation of behaviour and the importance of some elements of strategic deliberation and their possibly disruptive effects in stability. Institutions change, leading to a change in actions and attitudes. There will be moments of crisis situations or structural breaks.

Internal institutions are spontaneous structures that have evolved through experience, and learning. Usually, a small group of people discovers a useful rule, and then it spreads and is widely adhered to. They can be:

• informal, that is, not sanctioned by formal mechanisms:

• formalised, where the sanctions are implemented in an organised manner by some members of society (e.g., professional and trade associations).

The distinction between internal and external relates to the origins of an institution (spontaneous order or planned). The distinction between informal and formal relates to the way in which the sanction is applied (spontaneously or organised).

Third-party enforcement occurs in the case of formal internal institutions where adjudicators or arbitrators are included in the process of enforcing institutional arrangements. This may occur when one party does not obey a trading rule, and an arbitrator is called in to settle the conflict.

External institutions are designed, imposed and enforced from above by a political authority. External institutions are always formal in that a predetermined authority enforces sanctions in an organised way. We can distinguish between them:

• external rules of conduct are intended to constrain the actions of citizens in ways similar to internal rules. They work in open-minded and abstract ways; e.g., private property rights.
• specific directives are aimed at particular purpose or outcome; e.g., taxes
• procedural (or meta) rules are needed for the administration of government to facilitate the internal coordination of the various agents of government; e.g. procedures governing welfare benefits.

• codification of rules means that existing internal rules are formally written down in ways that make them visible and unambiguous, so improving their enforcement;
• internal rules may be haphazard and biased; e.g., the rich and powerful use the internal institutions to strengthen their positions in society;
• when judgements have to be enforced and informal sanctions are inadequate, government should have the monopoly over the legitimate use of force;
• the government agencies are needed to make contractual promises credible (as a third-party to formally enforce and adjudicate agreements and conflicts);
• the governments are required to facilitate cooperation among individuals when better collective goal is at stake (the tragedy of the commons, where individual self-interest leads to overexploitation of common and public goods);
• the government can overcome free-riding in situations where information and exclusion costs are impossible to exclude others from benefiting from a good;
• as internal institutions can discriminate and exclude in unreasonably and unjust ways, the government can bring about an open order.

The protective government is concerned with designing, imposing, monitoring and enforcing external institutions. It supports the internal institutions of the civil society, and fosters an open and just order.

There are several functions of the institutions:

• effective coordination and trust: to make complex processes of human interaction more understandable and more predictable, so that coordination between different individuals occurs more readily in creative and entrepreneurial ways; e.g., monetary system;
• protecting the sphere of individual autonomy: to protect the autonomy of the individual from undue, outside interference; though this is never absolute;
• averting and resolving conflict: to mitigate interpersonal and intergroup conflicts in low-cost, non-violent ways.
• power and openness: to create a power balance between different social groups, such as employers and workers

There are three characteristics, subsumed under the concept of universality:

• should be general, i.e., not discriminate among individuals;
• must be certain, i.e., knowable, transparent and reliable
• should be open, i.e., evolving to adapt to new circumstances.