4  Activity-specific institutions

The formal institutions discussed in the previous section provide the general environment in which business takes place. Once property rights and access to economic resources are defined for a country, economic activity, i.e., production and exchange, can be undertaken with greater confidence.

Formal institutions also exist to support the specific activities involved in firm production and exchange decisions. The types of activities these institutions govern include employment, investment in physical capital and use of land and natural resources (production); competition and corporate governance (exchange).

4.1  Differences between underlying and activity-specific institutions

There are some differences between the underlying and activity-specific institutions that mean they operate somewhat differently, in terms of the scope and longevity of their effects.

4.1.1  Scope

Like underlying formal institutions, activity-specific institutions are introduced to reduce transactions costs or to achieve political objectives. However, activity-specific institutions address outcomes that are specific to particular markets rather than economy-wide. Activity-specific institutions contribute to growth where they reduce externalities or opportunistic behaviour in particular markets. Externalities can arise when people engaged in economic activity do not have to take into account the full costs of their actions. For example, where land users pollute waterways that flow through their land this affects the use that those downstream can make of that water. Opportunistic behaviour may arise where one party has information that is not available to another or where there are imbalances of market power, as can arise in employment relationships.

Like underlying institutions, activity-specific institutions will reflect a country’s social institutions. The form institutions take will depend on factors like a country’s preferences for equity and opportunity, what would work with existing institutions in other areas and the degree to which the country is economically developed (Rodrik 2003). If a country’s preferences for equity and opportunity are not reflected in the institutions adopted this may reduce compliance with the requirements of an institution.

In general, each activity-specific institution deals with a market that is a subset of the economy. There will be interrelationships between different activity-specific institutions where they intersect or overlap. Where a new institution does not fit well with the existing institutional framework it may undermine compliance by creating complexity and uncertainty. Freeman (2000) notes that an institution may affect outcomes differently depending on the other institutions that operate around it. He notes that an institution, eg a trade union, may operate in different ways in different legal and economic environments.

4.1.2  Longevity

Activity-specific institutions change more frequently than underlying institutions. To ensure institutions remain efficient and relevant over time, they need to be able to adapt to changing circumstances. Rodrik (2003) suggests that while institutions matter for economic growth, it is how they adapt to change that is most crucial for economic growth. In this way, he sees the role of institutions in economic growth as similar to that of technology. The capacity for adaptation of settings is be more important than the continuance of any particular settings.

Adaptability may be built into institutional settings to some extent, but will also require countries to change their arrangements when they become obstacles to economic growth. To ensure economic growth is maintained over time and to ensure an economy remains resilient against shocks, a cumulative process of institution building is necessary (Rodrik 2003). Institutional change can be seen as endogenous to the growth process as changes accompanying growth, such as changes in technology and preferences, drive further changes in institutional form (Engerman and Sokoloff 2003).

4.2  Institutions, firm productivity and human capital

Economic growth comes from an increase in the production and exchange activities undertaken by firms. Institutions governing these activities will therefore directly affect a country’s potential economic growth. Improvements in firm productivity drive economic growth and there are three components to firm productivity:

a) productivity gains within firms, owing to more efficient use of existing resources and investment in factor enhancements;

b) firm entry and exit, where new, more productive firms are established and less productive firms leave the market; and

c) more productive firms increasing market share compared to less productive firms.

4.2.1  Productivity gains within firms

Productivity within firms is optimised in two ways: by using available resources in the most efficient way and by being innovative. This involves combining amounts of labour, physical capital, land and other natural resources of appropriate quality to produce the most output possible[12].

Labour productivity (output per worker) is one component of firm productivity. Labour productivity improvements can come through multifactor productivity improvements (the efficiency with which labour and capital are used) or growth in the capital-labour ratio. Improvements in multifactor productivity come through eliminating slack in the use of resources, adopting more efficient technologies and increasing innovative effort. Improvements in the capital-labour ratio mean that more capital is available to individual workers. Labour productivity changes as the quantity and quality of other resources change. Investments in human capital enhance labour productivity where additional skills and knowledge enable workers to produce more with the same level of resources.

Firm productivity can also be increased through innovation. Innovation can be embodied as new physical capital technology, new ideas about production processes or changes to the products being made. Innovation will change the nature of the resources needed by the firm and will lead to changes in the ideal resource mix. Innovation that is embodied in new physical capital will often require less labour in the production process, but requires the labour that is used to be more highly skilled to operate new technologies. Innovations technology may allow greater quantities or higher value products to be produced with the same level of resources, increasing the firm’s productivity. Durbin (2004) notes that studies of firms utilising advanced technologies conclude that such firms tend to employ a more skilled and highly paid workforce and tend to be more productive than other firms prior to the adoption of new technologies. He notes that new technologies are more likely to be used by abler and better paid workers.

As well as assisting with the adoption of new technology, human capital is a factor in the creation of new technologies. Firms that wish to be innovative will invest in human capital to generate innovations within the firm.

Durbin (2004) notes that institutions can affect the levels of innovation arising from entrepreneurial activity. He notes that regulations can influence the availability of business opportunities for entrepreneurs, the costs of pursuing them and the returns from doing so.

4.2.2  Productivity gains through changing industry composition

Economy-wide productivity is optimised in a dynamic market environment that allows and encourages firms to be created, to grow or to shrink depending on their productivity. As noted above, firm productivity is driven by resource allocation and innovation. The pressures present in an industry for a firm to allocate resources efficiently and to be innovative will determine how dynamic the market is. Such pressures stem from the degree of competitiveness in an industry and the extent of discipline that corporate governance exercises over the activities of managers within firms.

The more pressure there is to innovate to gain market share and remain in the industry, the greater the investment in human capital firms are likely to make. Scarpetta and Tressel (2004) find that investment in human capital impacts positively on productivity growth in all industries.