Written by: Claude Ménard and Mary M. Shirley

Advanced Introduction to New Institutional Economics: Institutions and Economic Development
Why are some countries rich and some countries poor? This famous question captivated Adam Smith and still preoccupies economists today. It is one of the many issues analyzed in the Advanced Introduction to New Institutional Economics (Menard and Shirley, 2022, the main source for this blog).
At one time economic development was largely attributed to the accumulation of human knowledge, the discovery of new technologies and the infusion of capital. These three ingredients proved to be insufficient. Foreign aid for advice, technology and investment largely failed to boost poorer countries into sustained economic success.

With the arrival of New Institutional Economics (NIE) in the 1970’s, a missing ingredient – institutions — was added to the mix. Douglass North argued that a country’s laws, rules, norms and conventions – its institutions — determine its economic performance (North 1990). Knowledge, technology and capital all matter, but institutions are crucial in shaping incentives to learn, innovate and invest. Institutions are the rules of the game and determine whether an economy rewards corruption, patronage and monopoly, or innovation, competition and entrepreneurship. This idea was not new. But North’s message was strengthened by meticulous empirical studies showing that institutions played a crucial role in the Industrial Revolution and economic history more broadly, plus extensive statistical evidence that institutions are significantly and positively correlated with economic growth and prosperity.

Simultaneously with these macro discoveries, NIE produced a micro vision of development, founded on Ronald Coase’s insight that whether a firm makes a product or buys it on the market depends on transaction costs (Coase 1937). Coase explained that a transaction is the transfer of the right to use a resource from one holder of that right to another. Transaction costs are the costs of establishing, transferring, and policing those rights, including, for example, the costs of discovering a trading partner, conducting negotiations, drawing up a contract, enforcing the contract, etc. The cost of transacting varies from market to market depending on its institutions, since institutions determine how costly it is to access information, establish and enforce property rights, and the like. Transaction costs are fundamental to development; when they are too high, an exchange will not even occur.

Why do damaging institutions persist? NIE gives several reasons. One is that elites strive to preserve the institutions that empower them and prevent efforts to erode or overturn them. For example, in many places colonial powers imposed institutions that exploited and subjected native peoples and made it hard for them to access education, information, wealth or political power. After the end of colonialism, the post-colonial elites used the same institutions that had sustained and enriched the former colonial powers to exploit non-elites and solidify their position over the long term.

A second reason why institutions persist is path dependency. Over time societies evolve an interdependent web of organizations, norms, beliefs, constraints and laws that are costly to change. For example, Poland and Ukraine share a border, a similar language and a long history of overlapping experience, but developed very different property rights (Hartwell, 2017). In 14th century Poland, peasants had full rights of ownership of movable property and even of land in some cases; rights which were then largely absent in Ukraine. The Polish institutions of broad based property rights supported by diffused political power persisted through partition, occupation, communism, and help explain why Poland became an economic success story after the transition. Ukraine’s history of centralized power and insecure property rights set it back during the transition.

Beliefs are another reason why institutions are hard to change. Over time, people evolve shared beliefs about the right thing to do, leading them to conform to the rules, to expect others to conform and to punish non-conformers. A related reason for institutional persistence is culture. Culture encompasses beliefs, values, norms and conventions that are transmitted largely unchanged from one generation to the next. For example, willingness to trust strangers, central to the impersonal exchanges that characterize modern economies, is not the norm in societies where only members of families, networks, or neighborhoods are trusted.

Given these forces for persistence, how do institutional changes ever occur? One reason is that elites are not cohesive; rival elite factions may favor more representative institutions to gain support against their opponents. For example, struggles between merchants and the Crown were key to institutional changes in 17th century England. Second, numerous, marginal changes in day-to-day rules of the game sometimes build up over time to create a window for change. Third, exogenous shocks, such as invasion or civil war, may overturn institutions. For example, Napoleon’s armies wiped out the aristocracy in the Netherlands and imposed legal and educational innovations that were welcomed by enough people to become permanent. Finally, a large deviation between outcomes and expectations may undermine beliefs and erode cultural resistance to change. For example, the growth and prosperity of China’s increasingly market driven economy helped push the leaders of Taiwan to accept an open access economic and social order that underpinned their later success (Shirley, 2008).

New institutional economics has developed powerful tools for understanding development, organization issues (Williamson, 1985) and many other real world phenomena. NIE has tools to address historical puzzles and such contemporary issues as managing climate change, regulating artificial intelligence, and understanding the changing institutions of China. The Advanced Introduction to New Institutional Economics (Menard and Shirley, 2022) provides a concise and lucid analysis of NIE’s rich and growing body of research.

References
^{Hartwell, C.A. 2017. “Determinant of Property Rights in Poland and Ukraine: The Polity or the Politicians?” Journal of Institutional Economics. 13(1): 133-60.
Menard, Claude and Mary M. Shirley. 2022. Advanced Introduction to New Institutional Economics. Cheltenham, UK and Northampton, MA: Edward Elgar.
North, Douglass C. 1990. Institutions, Institutional Change, and Economic Performance. New York: Cambridge University Press.
Shirley, Mary M. 2008. Institutions and Development. Cheltenham, UK and Northampton, MA: Edward Elgar.
Williamson, Oliver E. 1985. The Economic Institutions of Capitalism. New York: The Free Press.}

Advanced Introduction to New Institutional Economics
Edited by Claude Ménard and Mary M. Shirley is available in paperback now.

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