institutions: what they are, why we need them and how they shape our everyday lives

It is a common practice in the United States to sing Happy Birthday to a person when they survive another year on this planet. However, in China, birthday celebrations commonly take the form of elaborate banquets and are reserved for the very young or very old. Despite being obviously divergent practices, they are both considered forms of institutions.

According to North (1990), “institutions are the humanly devised constraints that shape human interactions”. In other words, they are the rules of the game of life. These rules can be both formal and informal, and serve to address the interdependence of human actors on the planet by providing guidelines or requirements for conflict, cooperation and coordination. Formal institutions are de jure and legislated, e.g. common law or statutes. Contrastingly, informal institutions are, for example, norms of behaviors, conventions and internally imposed rules of conduct, e.g. customs and traditions. The implementation of institutions serves to safeguard people against opportunistic behaviors.

In this respect, formal institutions combine a particular situation with a required or forbidden act that is governed by a third party. The purpose of such institutions is to solve situations with conflicting interests. Property law, liability law or even regulations on water pollution can be considered a form of formal institution. As conventions and norms are informal in nature, there is no official third-party regulator, rather it is society, that enforces these institutions. For instance, norms combine a given situation with a required act or solution as a means to support the underlying value, indicating that norms are a protection of human values or ‘proper’ human relations, with the giving and receiving a birthday gift serving as an example. Similarly, but not as severe, conventions like language or dress codes combine a certain situation with a certain act or solution as a means to simplify life in a complex world, establish and maintain regularity, solve coordination problems or provide a tool for creating identify.

The foundational assumptions of Institutional Economics are based on several assumptions about individuals:

  • They are bounded and also intendedly rational, but not always successful in this intention
  • They are interested in a means to a given ends
  • They engage in opportunistic behavior
  • They are faced by transaction and information costs as well as variations in the quality of goods and services received
  • They are dependent on institutions to overcome information costs and safeguard them against negative behavior

Such assumptions are essential to understand, as they must be considered in the design of institutions and contracts. In this respect, it thereby becomes relevant in the comparison of the relative benefits of various institutional arrangements. Is also important to note that those who establish institutions should not independent from the rules that they implement, e.g. politicians adhering to the laws they implement, albeit this is unfortunately often not the case. Common subjects addressed by IE include:

  • Markets: Which type of contracts to use based on a given situation? How should an alternative energy market be designed?
  • Organization: How can employees be controlled or incentivized? How shall departments/subunits be organized.
  • Politics: How should utilities be regulated? How will the commons be managed?

North, D. (1990). Institutions, institutional change, and economic performance. Cambridge University Press.