1 Introduction
Institutions include all the formal and informal conventions that shape the political, economic and social behaviour of the members of a society. They encompass not only basic institutions such as social norms and the rule of law, but also more specific institutions such as governance arrangements for entities such as firms, and regulations applying to various markets (IMF 2003). Political and economic institutions are underlying determinants of the incentive structure and economic performance of a society (North 1990, 1994).
Institutions based on first order economic principles (such as the protection of property rights, competition, and appropriate incentives) underpin long run economic growth (Rodrik 2003). While it is possible for such economic principles to be reflected in many different types of institution across countries, the empirical evidence suggests that the quality of economic institutions affects the level of GDP per capita, the growth of GDP per capita and the volatility of growth (Acemoglu, Johnson and Robinson 2001, Easterly and Levine 2003, Hall and Jones 1999, New Zealand Treasury 2004, Rodrik, Subramanian and Trebbi 2004). The evidence suggests that the quality of institutions has a robust and significant indirect relationship to growth via its effect on the volume of investment. In particular, better quality institutions reduce red tape and rent-seeking activities and (more weakly) improve the efficiency of investment by enforcing well-defined property rights (Aron 2000).
One route through which institutions can influence economic growth is through their effects on firms and the efficiency with which they operate. Institutions, such as property rights and contract law, shape the regulatory and economic environment within which firms operate. They also influence the firm’s internal decisions and its productivity. Financial market regulation, for example, can affect the availability and price of capital while intellectual property regulation can affect the design and price of products. Institutions also affect firms’ decisions on their use of inputs, including human capital. Labour market regulation designed to protect workers can encourage investment in the human capital workers but can also reduce the incentives for firms to hire new workers.
Institutions and the ways they can affect economic activity are described in section 2 of the paper. The fundamental social, political and economic institutions that underlie all relationships are discussed in section 3. The remainder of the paper covers institutions that are specific to particular activities of firms. Section 4 describes how these institutions can affect firm decisions and productivity. Sections 5 and 6 describe the key institutions and discuss their implications for human capital and firm productivity. Conclusions are drawn in section 7.
