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A Note On Institutions

Joan McDonald, a home-schooling mom, writes to ask if I can explain what we economists mean when we say that “institutions matter.”  I’ll give it a shot.

First of all, not all economists appreciate the role of institutions.  Economists who most ardently insist that institutions matter typical do so in order to counter the impression left by other economists – as well as by the many other people who are keen on guiding the economy less through market forces and more with central direction – that the economic problem is merely, or mainly, an engineering one.  Given all people’s tastes and preferences – given some known existing stock of capital, resources, and inventories – and given the current state of technology, the manner in which capital, resources (including labor), and inventories can be allocated in order to satisfy as many consumer desires as possible can be described mathematically.

Of course, the inconceivably immense number of such variables in reality means that no actual mathematical description – one with real quantities throughout – can in practice be written down.  What can be written down, though, is a description of the logic by which all the actual and given resources, inventories, and bits of capital must be allocated in order that the result is the satisfaction of as many as possible of the existing and given consumer preferences.

Such mathematical (or geographical, or even plain-word) depictions of the logic of ‘the economic problem’ makes this problem appear to be an engineering one.  Such depictions make central direction of the economy appear to be not only a plausible, but a preferred, method of ‘solving’ the economic problem.

Although there’s nothing inevitable in such engineering depictions of the economic problem that turns analysts’ attention from the role and reality of change, uncertainty, discovery, dispersed knowledge, and – most importantly – incentives, there seems to be something psychological in such depictions that has this attention-diverting effect on those who obsess over getting correct the formal mathematical description of the economic problem.

Those who ‘see’ the economic problem chiefly as an engineering challenge typically don’t think deeply enough about the available real-world conditions that can with the greatest likelihood of consistent success not only (1) approximate the best solution that can in principle be described mathematically with a set of given variables, but also (2) encourage and accommodate real and beneficial changes in the variables – changes such as occur, in the real world, in consumers’ preferences and in production techniques.  “Institutions” is the summary term for the set of real-world conditions that in fact govern how existing resources are allocated and the extent to which change is encouraged and accommodated.

Institutions can be “formal” – such as a particular government’s tax policy and occupational-licensing dictates.  Most institutions, however, are informal.  These are the rules of behavior that people generally obey even though these rules are not written down in the sovereign’s rule book and imposed formally.  They include the vast and intricate ‘constraints’ and expectations that are the evolved law and social customs and norms.  Some of these informal institutions reflect purely cultural happenstance (say, the fact that people today typically greet each other by shaking hands), while others reflect hard-wired human nature (such as the fact that each of us cares more about ourselves, our loved ones, and our friends than we care about strangers).

These formal and (mostly) informal ‘rules’ governing behavior combine with each other to influence the ways that each person in the multitudes of people in society act.  Some patterns of actions will produce ‘good’ overall economic outcomes; others will produce ‘bad’ overall economic outcomes – regardless of the formal details of the mathematical description of how resources can be ‘best’ allocated.  In other words, what actually happens in an economy is the consequence of institutions and not of the engineering problem that the economy faces.  The challenge – and it is a monumental one – is to get the institutions right; the challenge is not to describe in principle how best to allocate resources.  The latter task is child’s play in comparison to the former.


Pardon me if the above is unclear or too airy-fairy.  Let me end with a simple thought experiment.

Suppose that the rules of the economic ‘game’ are changed so that each household in America gets to spend, not the income that it earns, but only the income earned for it by some other household.  Each household is paired at random with another; no paired households know each other; they remain strangers to each other.  Let this be the only change in America’s institutions and economic landscape.

What do you predict will happen?  I predict that productive activity outside of each household will fall dramatically.  People will work fewer hours earning incomes at their jobs; they’ll invest far less in businesses and in financial markets; and they will display far lower levels of entrepreneurship in the market.  In turn, people over time will become much poorer materially.  People also will likely become less cosmopolitan as their engagement in commercial markets declines.  I predict also that there will be lower levels of formal schooling.

Note that in this hypothetical example the formal description of the ‘best’ way to ‘solve’ the economic problem isn’t changed.  People’s tastes and preferences are unchanged, and at the start of this social experiment America’s stock of resources, capital, and inventories is the same as it would have been had this social experiment not been launched.  Yet make this one change – which is an institutional and not an engineering one – and the economy’s performance changes greatly.

Of course, most institutional changes aren’t as dramatic as the one hypothesized here.  Therefore, the results of changes in institutions – good and bad – are more difficult to detect and to distinguish from other changes.  But even small changes institutions, we can be sure, affect the way the economy performs.