Economic Institutions

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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....
    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?
    Political Behavior, from the Concise Encyclopedia of Economics
    The fact of scarcity, which exists everywhere, guarantees that people will compete for resources. Markets are one way to organize and channel this competition. Politics is another. People use both markets and politics to get resources allocated to the ends they favor. Even in a democracy, however, political activity is startlingly different from voluntary exchange in markets.

    People can accomplish many things in politics that they could not accomplish in the private sector. Some of these are vital to the broader community's welfare, such as control of health-threatening air pollution from myriad sources affecting millions of individuals or the provision of national defense. Other public-sector actions, such as subsidies to farmers and restrictions on the number of taxicabs in a city, provide narrow benefits that fall far short of their costs....
    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....
    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....
    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....

In the News and Examples

    Peter Leeson on Pirates and the Invisible Hook. Podcast 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.
    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.
    Eminent Domain: Debate Pits Private Property Against Powers of the State, from Econoblog at the Wall Street Journal
    The closely watched case centers on a New London, Conn., economic development plan. The city wants to use eminent domain to build offices, a hotel, condominiums and parking where houses now stand, arguing that its plan has economic benefits in new jobs and property-tax revenue. But opponents maintain that the project isn't a legitimate public use, saying it unjustly takes private property for a project that will benefit other private interests....
    Government agencies (that is, institutions) collect and provide a variety of economic data: Economic Statistics Briefing Room, from the official government website
    The purpose of this service is to provide easy access to current Federal economic indicators. It provides links to information produced by a number of Federal agencies. All of the information is maintained and updated by the statistical units of those agencies.

A Little History: Primary Sources and References

    Eminent Domain, from Lalor's Cyclopedia of Political Science
    EMINENT DOMAIN, an original ownership retained by the sovereign, or remaining in the state, whereby land or other private property can be taken for the public benefit. This is the most definite principle of fundamental power of the government with regard to property, and the most striking example of the sovereignty of the people as a corporate body to resume original possession of the soil, where its use is essential to their mutual advantage and the welfare of society....
    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 Use of Knowledge in Society, by F. 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....
    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.
    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.

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