Economic Institutions

PRINT

Introduction

    The term "Economic Institutions" refers to two things:
    1. Specific agencies or foundations, both government and private, devoted to collecting or studying economic data, or commissioned with the job of supplying a good or service that is important to the economy of a country. The Internal Revenue Service (the IRS—the government tax-collection agency), the U.S. Federal Reserve (the government producer of money), the National Bureau of Economic Research (a private research agency) are all examples of economic institutions.

    2. Well-established arrangements and structures that are part of the culture or society, e.g., competitive markets, the banking system, kids' allowances, customary tipping, and a system of property rights are examples of economic institutions.
    Economists are interested not only in understanding specific existing institutional agencies, but also in the more exciting question of why some institutions evolve and others don't. Why do institutions differ in one country to the next? Why do some institutions take centuries to get started while other spring up in a few years? Why do some institutions evolve spontaneously in general society? When does government get involved in supervising societal institutions? Does the wording of a Constitution or the structure of a country's legal or religious background influence the economic institutions that arise in a country?

Definitions and Basics

    Institution, from Dictionary.com
    institution:
    • 1. an organization, establishment, foundation, society, or the like, devoted to the promotion of a particular cause or program, esp. one of a public, educational, or charitable character: This college is the best institution of its kind....
    • 4.Sociology. a well-established and structured pattern of behavior or of relationships that is accepted as a fundamental part of a culture, as marriage: the institution of the family....
    Law and Economics, from the Concise Encyclopedia of Economics
    A legal system should provide clear definitions of property rights. That is, for any asset, it is important that parties be able to determine unambiguously who owns the asset and exactly what set of rights this ownership entails. Ideally, efficiency implies that, in a dispute regarding the ownership of a right, the right should go to the party who values it the most. But if exchanges of rights are allowed, the efficiency of the initial allocation is of secondary importance. The Coase theorem--the most fundamental result in the economic study of law--states that if rights are transferable and if transactions costs are not too large, then the exact definition of property rights is not important because parties can trade rights, and rights will move to their highest-valued uses.
    Free Market, from the Concise Encyclopedia of Economics
    The market, then, is not simply an array, but a highly complex, interacting latticework of exchanges. In primitive societies, exchanges are all barter or direct exchange. Two people trade two directly useful goods, such as horses for cows or Mickey Mantles for Babe Ruths. But as a society develops, a step-by-step process of mutual benefit creates a situation in which one or two broadly useful and valuable commodities are chosen on the market as a medium of indirect exchange. This money-commodity, generally but not always gold or silver, is then demanded not only for its own sake, but even more to facilitate a reexchange for another desired commodity. It is much easier to pay steelworkers not in steel bars, but in money, with which the workers can then buy whatever they desire. They are willing to accept money because they know from experience and insight that everyone else in the society will also accept that money in payment....
    The Use of Knowledge in Society, by Friedrich A. Hayek
    We have developed these practices and institutions by building upon habits and institutions which have proved successful in their own sphere and which have in turn become the foundation of the civilization we have built up....

    The price system is just one of those formations which man has learned to use....
    Corporations are economic institutions: Corporations, from the Concise Encyclopedia of Economics
    Corporations are easier to create than to understand. Because corporations arose as an alternative to partnerships, they can best be understood by comparing these competing organizational structures.

    The presumption of partnership is that the investors will directly manage their own money rather than entrusting that task to others. Partners are "mutual agents," meaning that each is able to sign contracts that are binding on all the others. Such an arrangement is unsuited for strangers or those who harbor suspicions about each other's integrity or business acumen. Hence the transfer of partnership interests is subject to restrictions.

    In a corporation, by contrast, the presumption is that the shareholders will not personally manage their money. Instead, a corporation is managed by directors and officers who need not be investors. Because managerial authority is concentrated in the hands of directors and officers, shares are freely transferable unless otherwise agreed. They can be sold or given to anyone without placing other investors at the mercy of a new owner's poor judgment. The splitting of management and ownership into two distinct functions is the salient feature of the corporation....
    Federal Reserve System, from the Concise Encyclopedia of Economics
    Several monetary institutions appeared in the United States prior to the formation of the Federal Reserve System, or Fed. These were, in order: the constitutional gold (and bimetallic) standard, the First and Second Banks of the United States, the Independent Treasury, the National Banking System, clearinghouse associations, and the National Reserve Association. The Fed was the last such institution founded. Although it has endured, the present-day Fed would be unrecognizable to its founders....
    Council of Economic Advisers (CEA), from the official government website
    The CEA was established by the Employment Act of 1946 to provide the President with objective economic analysis and advice on the development and implementation of a wide range of domestic and international economic policy issues....

In the News and Examples

    Cultural institutions form the basis of societal interactions. Peter Leeson on Pirates and the Invisible Hook. Podcast episode on EconTalk. May 25, 2009.
    Peter Leeson of George Mason University and author of The Invisible Hook talks with EconTalk host Russ Roberts about the economics of 18th century pirates and what we can learn from their behavior. Leeson argues that pirates pioneered a number of important voluntary institutions such as constitutions as a way to increase the profitability of their enterprises. He shows how pirates used democracy and a separation of powers between the captain and the quartermaster to limit the potential for predation or abuse on the part of the captain. He explains the role of the Jolly Roger in limiting damages from conflict with victims. The conversation closes with a discussion of the lessons for modern management.
    Munger on Sports, Norms, Rules, and the Code. Podcast episode on EconTalk. July 1, 2013.
    Michael Munger of Duke University talks with EconTalk host Russ Roberts about the role of formal rules and informal rules in sports. Many sports restrain violence and retaliation through formal rules while in others, protective equipment is used to reduce injury. In all sports, codes of conduct emerge to deal with violence and unobserved violations of formal rules. Munger explores the interaction of these forces across different sports and how they relate to insights of Coase and Hayek.
    Cultural institutions tell us about the different fabric of different societies. Boettke on Elinor Ostrom, Vincent Ostrom, and the Bloomington School. Podcast on EconTalk.
    Peter Boettke of George Mason University and author of Challenging Institutional Analysis and Development: The Bloomington School (co-authored with Paul Dragos Aligica), talks with EconTalk host Russ Roberts about the Bloomington School--the political economy of Elinor Ostrom (2009 Nobel Laureate in Economics), Vincent Ostrom, and their students and colleagues at Indiana University. The discussion begins with the empirical approach of Elinor Ostrom and others who have studied the myriad of ways that actual communities have avoided the tragedy of commons. Boettke emphasizes the distinction between privatization vs. informal norms and cultural rules that prevent overuse. The conversation also looks at urban development and the benefits and costs of multiple municipalities vs. a single, large city. Throughout, Boettke embeds the conversation in the Ostroms' interest in how the citizenry can be self-governing and the challenges of implementing local knowledge.
    The Rule of Law. YouTube video, LearnLiberty.org.
    Why is the rule of law so important? Chapman University School of Law professor Tom W. Bell explains how the rule of law is a critical part of a free and tolerant society. The rule of law means that people are not subject to the arbitrary will of others. It means they can engage in activities that others might disapprove of without fear of persecution. When there is rule of law, people can buy property, plan businesses, and otherwise plan for the future with confidence. As Bell explains, the rule of law provides a necessary framework for civil society. To make his argument, Bell draws from such thinkers as Aristotle, John Locke, Thomas Paine, James Madison and Friedrich Hayek.
    Government institutions are a type of institution formalized by law. For example, what is the Federal Reserve? Meltzer on the Fed, Money, and Gold. Podcast on EconTalk.
    Allan Meltzer of Carnegie Mellon University talks with EconTalk host Russ Roberts about what the Fed really does and the political pressures facing the Chair of the Fed. He describes and analyzes some fascinating episodes in U.S. monetary history, discusses the advantages and disadvantages of the gold standard and ends the conversation with some insights into recent Fed moves to intervene with investment banks. This is a wonderful introduction to the political economy of the money supply and central banks.
    Arnold Kling on Freddie and Fannie and the Recent History of the U.S. Housing Market. Podcast on EconTalk. Sep. 29, 2008.
    Arnold Kling of EconLog talks with host Russ Roberts about the economics of the housing market with a focus on the role of Fannie Mae and Freddie Mac. The conversation closes with a postscript on the current financial crisis.
    With so many institutions, how do we get information? Sunstein on Infotopia, Information and Decision-Making. Podcast on EconTalk.
    Cass Sunstein of the University of Chicago talks about the ideas in his latest book, Infotopia: How Many Minds Produce Knowledge. What are the best ways to get the information needed to make wise decisions when that information is spread out among an organization's members or a society's citizens? He argues that prediction markets can help both politicians and business leaders make better decisions and discusses the surprising ways they're already being used today. Deliberation, the standard way we often gather information at various kinds of meetings, has some unpleasant biases that hamper its usefulness relative to surveys and incentive-based alternatives.
    Institutions can be created or maintained by violence. Weingast on Violence, Power and a Theory of Nearly Everything. Podcast on EconTalk.
    Barry Weingast, Senior Fellow at Stanford University's Hoover Institution and the Ward C. Krebs Family Professor in the Department of Political Science at Stanford University, talks about the ideas in his forthcoming book with Doug North and John Wallis, A Conceptual Framework for Interpreting Recorded Human History. Weingast talks with EconTalk host Russ Roberts about how violence shapes political institutions, the role of competition in politics and economics, and why most development advice from successful nations fails to lift poor nations out of poverty.
    David Rose on the Moral Foundations of Economic Behavior. Podcast on EconTalk. January 23, 2012.
    David Rose of the University of Missouri, St. Louis and the author of The Moral Foundation of Economic Behavior talks with EconTalk host Russ Roberts about the book and the role morality plays in prosperity. Rose argues that morality plays a crucial role in prosperity and economic development. Knowing that the people you trade with have a principled aversion to exploiting opportunities for cheating in dealing with others allows economic actors to trust one another. That in turn allows for the widespread specialization and interaction through markets with strangers that creates prosperity. In this conversation, Rose explores the nature of the principles that work best to engender trust. The conversation closes with a discussion of the current trend in morality in America and the implications for trust and prosperity.
    Firms--businesses--are private institutions. But what exactly is a firm? Coase on Externalities, the Firm, and the State of Economics. EconTalk Podcast, May 2012.
    Nobel Laureate Ronald Coase of the University of Chicago talks with EconTalk host Russ Roberts about his career, the current state of economics, and the Chinese economy. Coase, born in 1910, reflects on his youth, his two great papers, "The Nature of the Firm" and "The Problem of Social Cost". At the end of conversation he discusses his new book on China, How China Became Capitalist (co-authored with Ning Wang), and the future of the Chinese and world economies.
    Seidman on the Constitution. EconTalk Podcast.
    Louis Michael Seidman of Georgetown University talks with EconTalk host Russ Roberts about the United States Constitution. Seidman argues that the we should ignore the Constitution in designing public policy, relying instead on the merits of policy regardless of their constitutionality. Seidman defends his position by citing examples in the past where constitutionality has been ignored and says it would be better to recognize our disdain for the Constitution in a transparent way. In this lively conversation, Roberts pushes back against these ideas, citing the limits of reason and the dangers of using popular sentiment to determine policy.
    Glenn Reynolds on Politics, the Constitution, and Technology. EconTalk Podcast.
    Glenn Reynolds of the University of Tennessee and blogger at Instapundit talks with EconTalk host Russ Roberts about the political malaise in America, whether it could lead to a Constitutional Convention, and what might emerge were such an event to occur. Reynolds also gives his thoughts on the suggestion advanced in a recent episode of EconTalk that we should ignore the Constitution. The conversation concludes with Reynolds's views on the decentralizing power of technology and Reynolds's music career.

A Little History: Primary Sources and References

    George Selgin on Free Banking. Podcast on EconTalk.
    George Selgin of West Virginia University talks with EconTalk host Russ Roberts about free banking, where government treats banks as no different from other firms in the economy. Rather than rely on government guarantees to protect depositors (coupled with regulation), banks would compete with each other in offering security and return on deposits. Selgin draws on historical episodes of free banking, particularly in Scotland, to show that such a world need not be unduly hazardous or filled with bank runs. He also talks about Gresham's Law and an episode in British history when banks successfully issued their own currency.
    Boettke on Living Economics. EconTalk Podcast.
    Peter Boettke of George Mason University talks with EconTalk host Russ Roberts about his book, Living Economics. Boettke argues for embracing the tradition of Smith and Hayek in both teaching and research, arguing that economics took a wrong turn when it began to look more like a branch of applied mathematics. He sees spontaneous order as the central principle for understanding and teaching economics. The conversation also includes a brief homage to James Buchanan who passed away shortly before this interview was recorded.
    Starting a new country, the social institution of slavery: The American Founding in Practice. YouTube video, LearnLiberty.org.
    History professor Rob McDonald of the U.S. Military Academy at West Point gives a lecture on the conflict between the ideals of the American Revolution, such as individual liberty, and unfortunate realities of the time, such as slavery.
    Economic Freedom and Growth. YouTube video, LearnLiberty.org.
    Economics professor Josh Hall describes how greater economic freedom leads to higher incomes and more economic development over time. When governments allow citizens the freedom to trade, own property, create businesses, and contract with others, the income of average citizens grows over time. This effect can be observed internationally when comparing countries, as well as domestically when comparing states in the US.
    Philosophy of Law, from Lalor's Cyclopedia of Political Science
    We shall now briefly touch on one of the most important questions regarding the nature and character of the state. It was in keeping with the entire Kantian conception of morals, law and the state, that it considered the latter merely as a great institution for the enforcement of the law. The state, according to that conception, established courts, and, if necessary, carried out their judgments by force.... [par. III.55.61]

Advanced Resources

    The Tradition of Spontaneous Order, by Norman Barry. On Econlib.
    The theory of spontaneous order has a long tradition in the history of social thought, yet it would be true to say that, until the last decade, it was all but eclipsed in the social science of the twentieth century. For much of this period the idea of spontaneous order--that most of those things of general benefit in a social system are the product of spontaneous forces that are beyond the direct control of man--was swamped by the various doctrines of (to use Friedrich A. Hayek's phrase in Law, Legislation and Liberty) 'constructivistic rationalism.' No doubt the attraction of this rival notion of rationalism stems partly from the success of the physical sciences with their familiar methods of control, exact prediction, and experimentation. It is these methods which have an irresistible appeal to that hubris in man which associates the benefits of civilization not with spontaneous orderings but with conscious direction towards preconceived ends. It is particularly unfortunate that the effect of constructivistic rationalism should have been mainly felt in economics. This is unfortunate not merely because attempts to direct economics have repeatedly failed but also because the discipline of economics has developed most fully the theory of spontaneous order....
    Readers' Forum, Comments on 'The Tradition of Spontaneous Order' by Norman Barry. On Econlib.
    James M. Buchanan: I want to argue that the "order" of the market emerges only from the process of voluntary exchange among the participating individuals. The "order" is, itself, defined as the outcome of the process that generates it. The "it," the allocation-distribution result, does not, and cannot, exist independently of the trading process. Absent this process, there is and can be no "order."....
    Boudreaux on Reading Hayek. EconTalk Podcast.
    Don Boudreaux of George Mason University talks with EconTalk host Russ Roberts about the work of F. A. Hayek, particularly his writings on philosophy and political economy. Boudreaux provides an audio annotated bibliography of Hayek's most important books and essays and gives suggestions on where to start and how to proceed through Hayek's works if you are a beginner.
    Don Boudreaux on Law and Legislation. Podcast on EconTalk.
    Don Boudreaux of George Mason University talks about the fundamental principles of economics and civilization: spontaneous order and law. Drawing on volume one of Friedrich Hayek's classic, Law, Legislation and Liberty, Boudreaux talks about the distinction between law and legislation, the appropriate role of judges, and how the fulfillment of our expectations allows us to pursue our goals and dreams.
    The behavior of political institutions. The Reason of Rules: Constitutional Political Economy, by Geoffrey Brennan and James M. Buchanan.
    Since we are ourselves professional economists, we have been particularly mystified by the reluctance of our profession to adopt what we have called the constitutional perspective. Economists in this century have been greatly concerned with "market failure," which was the central focus of the theoretical welfare economists that dominated economic thought during the middle decades of the century. This market-failure emphasis extended to both micro- and macro-levels of analysis. Scholars working at either of these levels showed no reluctance in proffering advice to governments on detailed market correctives and macroeconomic management. In retrospect, post-public choice, it seems strange that these scholars so rarely showed a willingness to apply their analytic apparatus to institutions other than the market; they paid almost no attention to politics and political institutions. Once a policy recommendation seemed to have emerged from their market-failure analytics, there was no subsequent analysis aimed at proving that persons in their political roles, as either principals or agents, would somehow behave as the economists' precepts dictated. Implicitly, economists seemed locked into the presumption that political authority is vested in a group of moral superpersons, whose behavior might be described by an appropriately constrained social welfare function. Initial cursory attempts by a few public-choice pioneers to inject a bit of practical realism into our models of individual behavior in politics were subjected to charges of ideological bias. The myth of the benign despot seems to have considerable staying power, a phenomenon that we examine specifically in Chapter 3....

Related Topics