Why institutions matter

A while back at university, after having completed thorough research in Eastern European transition economies I acknowledged the importance institutions play in a country’s cultural and socio-economic development. At this point I do not wish to delve into the subject area too much as I would rather introduce some terminology to make my next posts more interesting and understandable to the reader.

Q: What are institutions?

A: Douglass C. North provided a great working definition for us in his book about Institutions, Institutional Change and Economic Performance. Institutions are the rules of the game in a certain socio-economic eco system. These rules can be both formal such as a legal regime of a country, and informal such as norms enforced over time that are in turn embedded in a country’s culture.

Q: Who creates these rules?

A: The major players of a given economy, industry or international community. Identification of the major players can be a difficult process because their hierarchy and decision making powers are guided by networks of overlapping and complex relationships.

Q: Are institutional rules good for the wellbeing of the economy?

A: This depends greatly on the interests of those creating the rules and how has history shaped them. Although it may be easier to adjust formal laws, it is incredibly difficult if not impossible to change cultures. The objective of any institution is to survive in the long term and they will continue to enforce that objective even when harmful to other actors in the economy and society.

Q: Does this mean that institutions are path-dependent?

A: Let us first elaborate on the term “path-dependent” which is derived from North’s book on institutions and institutional change. Path dependency simply means that certain events that happened in the past are going to shape decisions and actions made in the present time. Because institutions are created in the past their change will be gradual and path-dependent on prior events and decisions. Hence yes, institutions are indeed path-dependent.

Q: What does this mean for social and economic development?

A: It means that, whatever path a country, economy, industry, business or any other type of organization has taken will adjust gradually at most. Contextual threats, by challenging major players’ current status, will force them to adapt in order to survive. So unless major actors are challenged by a competing group of actors they will continue to impose their power and interests onto the remainder of the ecosystem and the outcome can be ofcourse good or bad, depending on the interests. However, I tend to think that competition and continuous challenges to a position of a major player encourages positive change because actors will need to justify their position in order to maintain their power.

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