2  Institutions and economic activity

Institutions encompass formal rules such as laws and regulations and informal conventions such as mores and customs. These conventions shape the behaviour of members of a society as well as expectations about behaviour. They determine the types of activities that are encouraged or prohibited as well as the rewards and sanctions associated with undertaking these activities. Institutions govern activities in all spheres of society, including economic activity. North (1991) suggests that institutions provide the incentive structure of an economy and that, as the structure evolves, it shapes the direction of economic growth towards growth, stagnation or decline.

2.1  Geography, policies and institutions

Three underlying forces that are thought to drive a country’s economic growth: its geography; its economic policies; and its institutions. There is debate about the relative importance of each in terms of their contribution to economic growth, but there is general agreement that well performing institutions are associated with economic growth.

Geography affects the potential of a country to grow through its location relative to other countries and its endowment of natural resources. Easterly (2003) notes that theories on a country’s geography/endowments suggest that the environment directly influences the quality of land, labour and production technologies. Geographical features may also limit a country’s opportunities for accessing large economic market, such as, in New Zealand’s case, its distance from its markets.

The economic policy view does not consider historical legacies to be particularly important, believing that historical settings can be easily reversed. It emphasises current knowledge about economic development and political forces rather than history or factor endowments. This view holds that sound macroeconomic policies, openness to international trade and the absence of capital account controls will tend to foster long-run economic success.

Proponents of the importance of institutions hold that the formal and informal practices that a country has developed to guide interactions between the members of a society affect the ease with which economic activity can take place. Institutions that are seen to support a country’s economic development include institutions that protect private property rights and the operation of the rule of law, lead to low levels of corruption and facilitate all private interactions rather than protect a small elite.

The broad environment (including factor endowments, social arrangements and colonial power) has powerful effects on the sorts of institutions that evolve. Historically, geographic characteristics have often had an impact on the nature of a country’s institutions. Countries with hospitable climates often led to settlement by colonists and attendant institutions that supported the economic development of a country (Easterly and Levine 2003). Countries that were less geographically hospitable instead tended to see “extractive” institutions implemented that supported the removal of economic resources from the country to the colonial power. The quality of a country’s institutions, as introduced by European colonisers, tended to be lasting or exploitative depending on the suitability of the country for European settlement (as measured by mortality rates) (Acemoglu et al 2001). A study by Engerman and Sokoloff (2003) found that geography seems to have played a greater role in determining the institutions adopted by colony countries than the particular country they were colonised by.

In considering the effects of geography, Easterly and Levine (2003) conclude that geography/endowments explain cross-country differences in economic development but only through their impact on institutions. Policies do not explain cross country differences once the impact of endowments on institutions and on economic development have been controlled for. Thus, correcting bad policies without correcting the institutions will bring little long-run benefit.

The IMF (2003)[1] notes that there are important interactions between institutions and economic policies, with the quality of institutions influencing the strength and sustainability of policies and vice versa. The interplay between these two drivers is important for economic growth but it makes it difficult to identify their individual contributions.

Rodrik, Subramanian and Trebbi (2002) found that the quality of institutions is most important in driving economic growth, with geography and policy having, respectively, weak and negative effects on economic growth. Sachs (2003) disagrees in regard to geography. He notes the direct effects of geography on production systems, human health and environmental sustainability and looks specifically at the relationship between the prevalence of malaria and GNP per capita. He concludes that “there is good theoretical and empirical reason to believe that the development process reflects a complex interaction of institutions, policies and geography.” (2003: 9).

2.2  Firms and institutions

There are four principal categories of institutions that shape the economic activity of firms (Williamson 2000). They are conventions in the social environment such as customs, norms, and social networks; formal institutions such as the polity, judiciary, bureaucracy; the “rules of the game”, especially those related to property; institutions governing the “play of the game” such as transactions between firms and the governance of transactions, especially contracts; and institutions related to resource allocation and employment within firms.

Both formal and informal institutions provide the underlying environment in which economic activity takes place. The effect they have is broad, affecting all aspects of economic activity, and long term, as they change very slowly. By shaping the environment for economic activity, these institutions influence the level of income a country can attain.

Specific institutions govern the activities carried out by firms in the course of producing output and engaging in transactions with others. The institutions associated with these activities affect firm decisions about using resources and undertaking transactions. These introduce structure into the operation of markets in order to improve the way in which they function. Institutions at these levels directly affect economic activity and therefore economic growth.

This paper considers in turn the underlying institutional environment, institutions affecting firm resource allocation decisions and institutions influencing firm decisions about entering into transactions. The relationship between institutions and firms are illustrated in Figure 1.

Figure 1 – Institutions and economic activity