3  Underlying institutions

The underlying social environment and formal institutions determine the fundamental conditions that operate in a country, affecting all facets of business. The social environment can shape attitudes towards economic activity, while underlying formal institutions can influence the incentives for investment and exchange.

3.1  Social environment

The social environment includes the values, customs, norms, culture and social networks that exist in a society. These factors are often cultural, religious or moral in origin and as a result are generally longstanding. The social environment can influence the informal rewards and sanctions associated with different behaviours. They can influence economic activity through affecting the aspirations that individuals hold and the attitudes firms take towards risk. Factors affecting social relationships, such as trust, provide the basis on which parties can expect to interact (Klein 1997, Offer 1997).

All behaviour, including economic action, takes place in a network of interpersonal relations. Firms operate in markets where information is exchanged through the price mechanism. Any exchange, however, depends greatly on trust. There is a strong relationship between the general level of trust and economic activity within a society. If people did not trust one another, economic activity would be greatly impeded as firms use more costly methods (sometimes illegal) to ensure exchange. Trust can thus both reduce the transaction costs of exchange and ease the burden on the formal institutional system (New Zealand Treasury 2001).

Granovetter (1985) suggests that the density of networks of social relations amongst business people affects the types of business relationships and activities they undertake. Economic actors avoid malfeasance most effectively by dealing with those they trust. That trust is produced and maintained by social relations, and formal institutions or sanctions that provide assurances against malfeasance are rarely used. In repeated transactions it is reputation, rather than the impersonal legal system, that ensures individuals will deal honestly with one another (Ellickson 1986, 1991). In a wide variety of situations, people not only succeed in resolving their conflicts without recourse to law, they do it by informal mechanisms that work considerably better than the formal legal system.

The social environment influences the accumulation of human capital in a number of ways. It can influence the value placed on acquiring education and training, the extent to which knowledge is transferred between people and the ability of individuals to adopt new technology. People’s social environment (consisting of their family, friends, neighbourhood and colleagues) largely determines their abilities to adopt new knowledge (Delsen and Schonewille 1999).

An individual’s relationships with friends, family and acquaintances and associated norms of reciprocity can be viewed as an asset, social capital, that has value both for the people in the network and often for those outside it (Putnam 2000). It can be called on in a crisis, enjoyed for its own sake and/or leveraged for material gain but may also involve costs such as nepotism and peer pressure (Woolcock 2001).

Social capital can contribute to economic growth by making it easier to create new knowledge (ie, augment human capital) and to transmit ideas and information, particularly information that is tacit (Grafton, Kompas and Owen 2003). The greater the degree of interchange between social groups the more adaptable, resilient and productive the community is likely to be. Social barriers that inhibit communication between groups will tend to raise the costs of interchange of knowledge and ideas, and lessen the ability of the society to withstand adverse shocks. Rodrik (1999) suggests that countries with low levels of social conflict and with institutions that are able to mediate social conflicts experience more resilient economic growth than countries with weak institutions of conflict management.[2] At the same time, the level and type of social capital in a community can be influenced by existing formal institutions and the role of government, influencing the contribution social capital can make to economic growth (Woolcock 2001).

The institutional setting both underpins the development of social relationships such as trust, and is formed in the context of the social relationship between people. Values, customs, norms and culture influence both the nature and effectiveness of formal institutions. Formal institutions are most effective when they reflect what is seen to be appropriate behaviour and are well adapted to the underlying culture and ethics of a society (Haucap 1998). As a result, institutions that are effective in one country do not always translate well in another. In particular, picking up institutional arrangements that work in one country and applying them in another will not necessarily lead to economic growth (IMF 2003).

Social cohesion, the commitment of members of a society to its institutional arrangements, is also promoted when formal institutions reflect social norms (Petrie 2002). A particular set of values, customs and norms are not necessarily held by all members of a society, particularly where distinctive groups exist within the society. For example, different ethnic groups within a society may operate with different social structures. Petrie points out that norms can be established by a dominant group as a means of promoting behaviour that serves their interests. Where formal institutions align more with the social conventions of one group than with those of other groups, broad social cohesion will be more difficult to achieve.

A country’s formal institutions reflect its social institutions, its history and other factors peculiar to that country. Differences in what is valued by countries will thus lead to variety in institutions. Very different institutional settings, even where they reflect first order economic principles such as security of property rights, can be reasonable substitutes for each other and there are no particular institutions, narrowly defined, that are indispensable for economic growth (Engerman and Sokoloff 2003). At the same time, institutions are not the only factor important for growth – countries with similar institutions can do quite differently in any given time period (Freeman 2000).

As well as determining the underlying social context within which economic activity takes place, the social environment can also have more direct effects on firms. They can influence transaction costs through reducing search costs (through social capital) and monitoring costs (through trust) (Rupasingha, Goetz and Freshwater 2000) and shaping firm attitudes towards risk taking and uncertainty (Baptista 2004) and entrepreneurship (Beugelsdijk and Noorderhaven 2004). They can influence the level of innovation taking place in firms by encouraging the diffusion of knowledge and best practice between firms (through social capital) (New Zealand Treasury 2001). Culture and values can also influence the degree to which a country regulates economic activity, for example controlling new firm entry, and therefore the investment opportunities available to firms (Baptista 2004).