Why Economies Need (Strong) Institutions

Institutions are essential to facilitating exchange and sustaining economic growth

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Developed economies are profoundly defined by institutions whose objective is to promote fairness and codify its meaning into law. Institutions have been created to establish order and reduce uncertainty through their informal constraints and formal laws. Therefore, they are central to economic growth because they reduce transaction costs by a) providing a safe environment that allows productivity, b) establishing order and facilitating exchange in large markets, b) and substantially decreasing information asymmetry between players (North, 1991).

Transaction costs

Weber, in his treaty on bureaucracy, emphasized the importance of rules for the reduction of transaction costs. According to his definition, transaction costs are “the [hidden] costs of deciding, haggling (bargaining), arranging, and coordinating” the transaction. To reduce transaction costs we need clear rules that reduce uncertainty and allocate rewards and punishments by explaining to society what is right and what is wrong (Di Maggio, 2001).

To understand the positive effect of rules, we should consider the enormous disparity between developed (rich) countries, where institutions are strongly established, and developing (poor) countries, where institutions are almost non-existent or very corrupted. This disparity is caused by high transaction costs, which arise due to the lack of an efficient political system that enforces laws. Therefore, as history has proved, the development of institutions creates a reduction in transaction costs that allows firms to enhance productivity and growth by exchanging products and services in a safe environment (North, 1987).

Order and Exchange

The ancient Greek agora was one of the first internal markets with a complex social structure that needed political and legal regulation. Since people tried to violate the system, merchants and buyers agreed to exercise more control through a third party. Therefore, communities nominated the agoranomoi to establish order within the agora by inspecting weights, measures, employment relations, quality of the coins, and quality of the products (Smelser and Swedberg, 2005).

As markets grew and specialized merchants saw the opportunity to trade outside of the community, they began traveling to new destinations and participating in foreign markets, which were bigger in size and stricter in regulation. In those markets, they had to abide by the international law of the merchants that was established to create order and facilitate exchange with buyers. Moreover, a third party was escorting their merchandise and protecting them against robbers (Smelser and Swedberg, 2005).

All laws and informal constraints were enforced by institutions to lower the costs of defection that merchants and buyers would have had to pay. Therefore, rules were set to reduce transaction costs and render exchange more feasible. As in ancient times institutions protected the merchandise of merchants, nowadays they protect the intellectual property of firms by enforcing property rights. Apple, Google and Facebook are perfect examples of firms that have been able to scale and become market leaders thanks to the protection of intellectual property.

Information asymmetry

Governmental intervention increases welfare and diminishes the economic costs of dishonesty in large markets. When there is substantial information asymmetry between buyers and suppliers, the latter will try to maximize profit by selling low-quality products at the price of high-quality ones. In this case, the cost of dishonesty does not affect just the buyer, but also honest suppliers since “dishonest dealings tend to drive honest dealings out of the market” (Akerlof, 1970). Therefore, institutions play a big role in enforcing guarantees that fight quality uncertainty.

The certification conferred by the International Organization for Standardization (ISO) is a very good example that supports Akerlof’s argument. Firms that seek and achieve the ISO certification assure buyers of the quality of their products and services through a quality management system, which is evaluated by the ISO (ISO, 2013). This explains why major corporations require their suppliers to obtain the certification and abide by their supplier code of conduct. The certification released by the ISO reduces transaction costs of major corporations, which are assured of the quality of the product or service they buy.

Institutions can fail

Institutions are not always the panacea to economic instability and the reduction of transaction costs. The 2008 financial crisis has shown that institutions may fail to establish flawless regulation because they are involved themselves in the trap of information asymmetry. On the opposite side, the now boycotted austerity plan implemented by the European Union reveals that excessive regulation does more harm than good. Hence, we can argue that when institutions do not reduce transaction costs or create economic growth or stability, their role should be reconsidered and adapted to reshape economic welfare.

Now, more than ever, institutions must show their adaptation skills by preserving order and economic stability. In such a turbulent situation, transaction costs and information asymmetry will definitely increase and compromise exchange. In addition, citizens may begin to question the role of institutions in our society and violent movements may quickly become the start of civil riots (like in Lebanon).

Conclusion

Institutions are central to economic growth because they establish order and facilitate exchange in large markets. Since the ancient Greek empire, institutions were adopted to protect merchants and buyers from unfair deals or robbery and to control exchange within the agora. Moreover, institutions substantially reduce information asymmetry between players by providing product or service certifications and by allowing firms and buyers to better understand the quality of a product.

Also, institutions enforce rules that regulate markets and create a safe environment that allows productivity and growth. Indeed, the enormous disparity between rich and poor countries can be explained by a simple analysis of their institutions. The power of institutions reduces uncertainty and, therefore, transaction costs. However, sometimes institutions fail to create the right balance between regulation and economic stability. In this case, their role should be reconsidered.

References

• Akerlof, George A. (1970) The Market for “Lemons”: Quality Uncertainty and the MarketMechanism, Quarterly Journal of Economics, 84: 3, Aug., pp. 488–500.
• Di Maggio, P. (2001) Introduction: making sense of the contemporary firm and prefiguring its future. Ch 1. in di Maggio, Paul ed. (2001)The Twenty-first-century firm: changing organisation in international perspective. Princeton University Press, Princeton.
• International Organization for Standardization (2013) ISO 9000-Quality Management. International Organization for Standardization.
• North, D. C. (1987) Institutions, transaction costs and economic growth. Economic inquiry. [Online]25 (3),419–428.
• North, D. C. (1991) Institutions.Journal of Economic Perspectives. [Online] 5 (1), 97–112.
• Swedberg, R. (2005) Markets in society. Ch 11 in Smelser J., and Swedberg R. eds.The Handbook of Economic Sociology, Princeton University Press, Princeton NJ. Pp. 233–253.
• Williamson, O. (1985)Economic institutions of capitalism, Ch. 4: Vertical integration: theory and policy, pp. 85–102, and Ch. 6. The limits of firms: incentive and bureaucratic features, pp. 131–162