Humans have an inherent tendency to reduce uncertainty by structuring their environment. Uncertainty in human interactions is reduced by creating structures that allow people to expect a certain behaviour from others in a specific situation. For example, in a football match, one can expect the players to adhere to the formal and informal rules. The rules of the game constrain what behaviour the players are expected to adopt. They may not, for example, pick up the ball with their hands and run with it to the goal. In the social sciences, the persistent structures that reduce uncertainties in human interactions are called institutions.
Through people’s continuous efforts to reduce uncertainties in their lives, institutional constraints accumulate over time and an elaborate structure of informal and formal institutions emerges. Institutions are ‘the rules of the game’ both on the level of personal interactions but also on the level of interactions among organisations, firms and government. The academic discipline of New Institutional Economics (NIE) is concerned with the institutions, formal and informal, that govern human interactions and exchanges in the economy.
According to North (2005:49), the institutional framework in a society generally consists of:
- the political structure that specifies the way we develop and aggregate political choices
- the property rights structure that defines the formal economic incentives
- the social structure – norms and conventions – that defines the informal incentives in the economy.
More concretely, common institutional arrangements include (Menard & Shirley, 2008:1, in revised order to mirror North’s list above):
- constitutions, laws and rules that govern politics, government, finance and society more broadly
- written rules and agreements that govern contractual relations and corporate governance
- unwritten codes of conduct, norms of behaviour and beliefs.
Scholars differentiate between informal institutions that emerge from human interactions and are not codified but are rather part of the culture in a society and formal institutions as consciously designed and codified governance structures. Informal institutions include social values and norms as well as, for example, informal ways to enforce a contract. Formal institutions include written laws and rules, processes, etc. Institutions are complemented by, and their effectiveness is dependent on, enforcement mechanisms.
At the same time as reducing uncertainties for actors, institutional structures determine how the competitive environment is shaped and, consequently, whether an economy is competitive. Institutions reduce transaction costs and create positive externalities, for example through the coordination of available knowledge in a society, which allows the specialisation of production. North (2005:2) asserts that “The evolving structure of political and economic markets is the key to explaining performance”.
In a sense, institutions perform the function of second-order context-sensitive constraints. They have emerged through the interaction of people, forming the systemic whole of a society or an economy. They enable the economy to work but at the same time constrain the options of each actor within the economy. An example of such a constraint would be a social norm in a specific community only to trade with people of the same religion. The constraint is enabling in as far as it builds trust between a potentially large network of people who do not know each other personally but have the same beliefs. At the same time it constraints the options of each individual.
MENARD, C. & SHIRLEY, M.M. 2008. Handbook of New Institutional Economics. Springer Berlin Heidelberg.
NORTH, D.C. 2005. Understanding the Process of Economic Change. Princeton, N.J.: Princeton University Press.