In Defence of Institutions

Why Institutions Matter and Why You Should Care

Within the fields of political economy, economic history and development, the new institutional synthesis is the water we swim in. A combination of neoclassical economic theory and it’s application around questions of the non-market forces that influence behaviour has become the discipline standard, whether or not we recognise it as such. After all, the broad combination of power, interests, and cultural influences, constraining the standard incentives and tradeoffs of economic reasoning sounds reasonable enough as a model for understanding the role of institutions in the economy. Nevertheless, the term has been taken to refer to a narrow strain of the literature concerned with the long-run advancement of ambiguously “good” or historically progressive institutions.

Institutionalism (new and otherwise) is more nuanced than critics will often admit.

I maintain a healthy skepticism towards whiggish institutionalism and the opaque “black box” approach to economic outcomes, but there is a common generalisation of the institutionalist school of political economy as an ill-defined input-output function that remains a persistent and overstated criticism applying primarily to a series of papers from the early 2000s. Institutions matter, that much is obvious, but there is room for debate with respect to the practicality of widening the causal scope from isolated policies towards a more systematic approach to the political economy of comparative development.

And yet, a universal definition of institutions remains difficult to pin down, presenting a dilemma for causal identification and development in practice. Many are remiss to accept the framework explicitly and instead focus on narrower observable questions that implicitly accept the assumptions of basic institutional conditions, vis-à-vis abstractions like state capacity or an independent judiciary. Endogenous institutional structures will affect the outcome of a given policy in practice, regardless of how granular your analysis, so this approach often means taking relevant institutional features as given.

Causal analysis of institutions and institutional change represent an empirical puzzle, but any policy that aims to achieve more than simple incremental adjustments on the margins must contend with the political economy of institutional formation and change as currents that shape implementation and enforcement. In this essay I want to emphasise the value of an institutionalist framework in practical development contexts and discuss why practitioners should care about institutions as not simply state variables or even useful abstractions, but the fluid environment in which policy operates.

Why Institutions?

Before diving into the definition of the term and how we ought to understand institutions, I want to first outline why we should care. The simplest case for institutionalism in economics is that ‘counterintuitive’ empirical evidence, defying the basic ‘Econ 101’ logic, is often by comparative institutional construction and the result of frictions or other constraints on market behaviour. The canonical Card and Krueger (1994) paper on minimum wage is an excellent example, in a familiar context.

Contrary to the basic supply-and-demand model of minimum wages, the paper shows employment in neighbouring areas is not negatively impacted by a rising wage floor. However, this cross-state result is conditional on local monopsony power, firm price setting, and employee mobility relative to the control state. The conclusion as such should not be that basic economics ‘fails’ and the demand for labour is in fact upwards sloping. Rather, there are larger institutional conditions that interact with a minimum wage policy to produce different and unexpected consequences. While geography may play a role, it is the humanly devised norms and expectations, prevailing laws and regulations, and the built environment, subject to change, that represent the institutional constraints that shapes economic behavioural outcomes.

Other international examples arise along these lines. Why does land reform succeed in parts of the world but not others, how do nascent industrial policy efforts eventually lead to trade liberalisation in some economies and autarky in others, what is it about the institutional structures surrounding near identical policies that can produce such disparate outcomes?

This is the basic analytical framework I hope that you, the reader, take away from this piece. A given policy is nested within a social-political-economic context which may produce unexpected results, and thus yield unintended consequences. Firm size, state and local regulation, transportation infrastructure, human capital, cultural preferences, etc. will interact with a policy as simple as raising the minimum wage. As such, understanding these interactions is crucial for achieving your stated policy goals, and effective policy thus requires a rigorous understanding of the institutional environment as it exists, and further how said environment evolves in response to these policy developments over time.

What are Institutions?

Now, I want to discuss two important questions; what is an “institution”? and what do I mean when I say that, “institutions are significant and endogenous”?

The standard definition of institutions, in the most general terms, is that they represent “the rules of the game in a society” or rather are the “humanly devised constraints that structure political, economic, and social interaction” (See the first paragraph of North 1990; 1991). But what does this mean in practice? Examples of institutions extend from formal laws and legislation to informal customs and traditions, more akin to what we might consider culture. This definition is helpful, but risks overstating the scope of institutions, falling back into the “black-box” trap where institutions is everything that occurs between an input and an output, with limited formal explanatory power beyond “behaviour, therefore institution.”

Institutions (plural) are broadly the set of behavioural norms that structure our political, economic, and social lives, informing social choice and individual decisions. An institution (singular) is a specific, observable arrangement that contributes to the aforementioned bundle. For example, private property as a general norm is part of the broader institutional environment, while a land registry system or property court represents a discrete institutional form. The former absorbs most of the critiques outlined, while the latter presents a better specified research agenda. The two are often used interchangeably, and some of the more interesting work in this particular corner of the literature aims at disaggregating the features of these arrangements, and identifying their discrete impact of specific institutions on the margins.

In the context of the economy and economic relationships, institutions can be best understood in terms of what collectively informs expectations, or what an individual can reasonably expect in terms of the outcome of a given action or transaction. Effective economic institutions thus aim to facilitate economic activity by reducing uncertainty between economic agents in their various interactions. This can be seen in the creation of social-reputational norms around property and exchange and through the development of common-law jurisprudence and the doctrine of precedent, having historically been introduced and revised to resolve property disputes and impose costs on anti-social behaviours like cheating or stealing that run counter to the collective interest.

To complicate matters, institutions do not always mean legal intervention. Enforcement of contracts or the terms of a transaction can occur through informal social channels like reputation, not just formal judicial sanctions (Milgrom, North & Weingast 1990; Greif, 2000). Much like common law evolves over time, so too do social expectations and sanctions, representing a latent institutional force in addition to the state. However, the role of political and governmental institutions, in terms of both structure and policymaking, are a common topic of research considering these discrete formal institutions are more clearly defined, easily observed, and subject to measurable change.

The tension between the state and the economy is a reoccurring theme in the discussion of institutional formation, where capacity and constraint present a sort of balancing act when it comes to enforcement without infringement (North & Weingast 1989). The state can represent both a force for expropriation or credible commitment to property rights, with much of popular liberal institutionalism emphasising the countervailing checks and balances that uphold secure markets and rights without fear of overreach. Credible commitment in this context referring to whether political or legal authorities can reliably demonstrate they will not arbitrarily violate rules or property claims. The debate regarding institutions and economic performance from this literature is thus, which kinds of institutional arrangements are best able to promote growth, development, and welfare? And how are these “good” institutional arrangements reliably achieved?

This is where things get tricky empirically. Institutions are determined by interests within a group, constrained by factor endowments and topology, but fundamentally determined endogenously, alongside the variables like income or social welfare that we are trying to maximise. A common question of institutional reverse-causality whether democracy promotes growth, or is it economic growth that enables democracy? The issue of endogeneity means that over time institutions and institutional change do not just occur randomly, they instead represent a process of feedback between institutions and the outcomes they produce making it difficult to quantify said relationships. There may be some shocks on the margin of either variable, but a simple cross country regression identifying the correlation between liberal democracy and some human development index fails to reliably identify the true causal relationship.

Even if we were to look at clear changes in the law or legislation as institutional breakpoints, these may be simply a reflection of the latent social, political, and economic forces shaping the formal institutional environment. If we understand legislation as a process of bargaining between interested parties, rather than a purely exogenous process, a change in the written law may represent a formal breakthrough, but is nevertheless the outcome of an unobserved set of social, political, or economic factors that have also undergone some change. Thus we need some kind of framework to decompose the endogenous and exogenous components of institutional change if we ever hope to identify the causal effects on development indicators like economic growth.

Institutions, Inclusive and Extractive

The spectre haunting this discussion is, of course, Why Nations Fail by Daron Acemoglu and James A. Robinson. Published in 2014 this is often the first (and too often last) book that many practitioners will read on the role of institutions in development. Reductive to the point of near monocausality and build on a literature subject to intense methodological criticism, it is both a practical introduction to institutional thought and a whipping post for anti-institutional arguments. I do not mean to come off as glib in my dismissal of these arguments, but I have a hard time internalising myself the criticisms of a text that I myself have many criticisms of.

In summary, Why Nations Fail sets out a comprehensive thesis on institutions and development. There are inclusive institutions, a bin containing property rights, representative democracy, liberalisation, and other historically progressive forces, representing a status quo where each economic unit has some stake in the prosperity of society and stands to benefit from development. There are extractive institutions, concentrating economic and political power, and thus the benefits of growth, in a small elite, resulting in minimal societal buy-in, and thus limited incentives for entrepreneurship, innovation or growth. This basic dichotomy sits at the centre of the literature, and frames much of the debate around the role of institutions in development.

The problem with the book, as with any introductory text, is that it remains fairly surface level in it’s case studies, and remains largely blind to the illiberal or nominally “extractive” developmental states that have succeeded at raising income and living standards. China, being the most relevant case of state-led development of the last half century, is mentioned in passing as an exception. The high-level framework is questionable when scrutinised at this level, so what about the empirics?

From the general arguments book I want to move towards the specific papers that it is built on; the actual contributions towards a theory of institutionalism that earned the authors the 2024 Nobel Price in Economic Sciences. Through the early 2000s Acemoglu, Johnson, and Robinson, repeatedly tackled the empirical problem of measuring institutions. Again, because of the endogenous nature of institutional formation and persistence, it becomes necessary to measure the effect of intuitional variables on economic performance through some kind of instrument, separating exogenous variation from joint economic-institutional development. In the most famous of these papers, Acemoglu, Johnson, and Robinson (2001) leverage settler mortality as a plausibly exogenous determinant of the quality of colonial institutions, institutions that persist and impact present economic performance.

The Colonial Origins of Comparative Development: An Empirical Investigation is motivated by the theory that colonies facing high settler mortality are unlikely to see significant migration from the colonising country, and are thus less likely to extend property rights and other legal guarantees to the population, the same way they would in a settler colonial context, resulting in an elevated risk of expropriation today.

The innovation of the paper was methodological. Since institutions are endogenous, the authors identified an exogenous, historical variable that could plausibly explain institutional variation without being directly caused by present income levels. This type of identification strategy tends to demand monocausal explanations, and in this case, the burden falls on settler mortality as an instrument for extractive institutional arrangements as being responsible for long-term development trends.

Decomposing institutions into an endogenous and exogenous component offers an empirical framework for a more robust understanding of how institutional development has impacted long-run incomes. This provides insight into the role of institutions but runs the risk of abstracting complex systems of institutions to a few features; inclusive (good) and extractive (bad) institutions require further unbundling (Acemoglu and Johnson 2005).

Further, this simplified account fails to recognise the agency of the indigenous population and institutional reforms undertaken taken after decolonisation, and that the institutions preceding colonisation were heterogenous and necessitated variation in the construction of colonial institutions, relevant features of a practical development agenda.

There are also numerous technical issues with the paper, data issues emerge as we begin to interrogate the cases used in the study, settler mortality as an instrument for institutional variation hardly meets the exclusion restriction, and replication accounting for spatial variation finds the model specifications insufficiently robust.

These papers were a significant contribution to the literature on institutions but upon interrogation of the premises, we find that there are a number of discrepancies between the historiography of European colonialism and motivating theory. Institutions are characterised by a broad set of descriptors that fail to capture the nuanced channels through which development varies across a multitude of contexts, with issues of agency, sorting, and preceding institutions all applicable to the broader literature on institutions and persistence.

The problem of this misconceived notion of institutionalism in the context of practical development can be largely attributed to the fact that the standard-bearing book was written 15 years ago and has no meaningful explanation of the most relevant case studies of the last decade. Any grand theory of institutions, institutional change, and economic performance must explicitly contend with the success of China, which occupies exceedingly little space in the book, and falls largely outside the theory outlined.

In summary, norms, expectations, and the outcomes they produce are the subject of institutionalist research. Acemoglu, Johnson, and Robinson made important methodological contributions that may help with the causal identification side of the institutions problem, but this only represents a starting point in the literature on institutions with lots of other formulations, empirical methods, and paths of research on the subject.

A “Newer” Institutionalism?

While moving away from an inclusive-extractive framework of institutions and development, the literature on the “exceptions” broadly expands on a theory of uncertainty-reducing constraints on the exercise of arbitrary power, which is ultimately not all that dissimilar, but offers a greater insight on the role of expectations in developmental outcomes.

A relevant distinction in institutionalism is the separation of formal and informal constraints on behaviour, property rights may exist, de jure, but credible commitment to said law remains the pivotal factor with respect to the observed outcomes. These are ultimately two sets of institutional features, jointly determined, but subject to different developmental paths. Under this framework, institutions matter primarily because they shape expectations. Economic development depends not only on incentives, but on whether individuals, firms, and officials can reliably anticipate how others, particularly the state, will behave.

That is to say, expectations of enforcement can be achieved by non-state or extra-state means, looking towards uncertainty reducing arrangements in contexts where the state itself may be a threat to property rights, but historically, legal centralism has served to facilitate economic activity because it expands certainty in transacting agents at a scale not sustained by pre-legal or proto-legal informal arrangements like reputational coalitions. There are time and context varying consequences of specific institutional regimes. It’s important not to discount the differential effect of formal institutional continuity under changing economic, social, and political conditions, particularly as they give rise to new norms of enforcement or forbearance under existing written law.

The China question that plagues the “inclusive” versus “extractive” framework is readily answered by the fact that the Chinese state, despite it’s illiberalism and incomplete property rights, represents an uncertainty-reducing institution. The typology of corruption outlined by Yuen Yuen Ang in China’s Gilded Age (2020) is a good example of how apparently under-constrained authority that is not exercised arbitrarily can thus reduce uncertainty and facilitate economic activity. The Private Sector in Public Office (2019) by Yue Hou provides another interesting study on the practical construction of property rights and institutional arrangements leveraged by entrepreneurs to secure business interests, namely holding local political office.

What we understand as a corrupt or illicit activity is a sound institutional equilibrium, secure enough so as to facilitate investment and promote economic activity. Essentially, some forms of corruption function to support or even enhance market and private enterprise under conditions of insecure or incomplete property rights. This does not imply corruption is socially desirable in the long run, but rather that predictable informal arrangements may sometimes reduce uncertainty more effectively than weak formal institutions.

In that respect, there are many cases where people give authoritarianism the wrong credit for China’s success. Too much credit with respect to economic mobilisation under a quasi-“command” economy, not enough credit to the regime as a credible uncertainty-reducing institution. High state capacity under conditions of imperfect or incomplete property rights is a narrow developmental corridor maintained by deliberate restrictions on arbitrary expropriation. Many developmentalist regimes have consolidated executive power, but the growth ‘miracles’ are often defined by the disciplined exercise of that power such that the state response or outcome of an interaction can be expected by the participants.

It’s a kind of institutionalist ‘theory of the second best’ where distortions like incomplete markets might be addressed more efficiently in the short-run through state allocation and interventions than a top-down imposition of an insecure property rights regime, by virtue of the state reducing uncertainty. Industrial policy in South Korea, land reform in Taiwan, and export-oriented development in China all relied on institutional arrangements that differed substantially from the liberal ideal-types often presented in institutional development theory.

This would resemble something more like “arbitrary” and “definite” institutions over “extractive” and “inclusive”. This seems a little more practical when we consider the fundamental role of institutions is to reduce uncertainty. Thinking mostly in terms of expectations, where a stable, self-reinforcing institutional equilibrium will reduce uncertainty, as opposed to regimes with unchecked authority producing inconsistent outcomes and increasing relative risk.

I would urge practitioners to therefore consider a framework of uncertainty and risk in institutional construction as a better framework for situating the effects of development policy. This means asking whether a policy, first reliably produces the expected outcome under these conditions, and second can itself contribute to reducing individual or household uncertainty in the long run.

In Conclusion

Yes, institutions represent an empirical puzzle, but any policy that aims to achieve more than simple incremental adjustments on the margins must contend with the political economy of institutional formation and change as currents that shape implementation and enforcement.

There are certainly papers that lean into a tautological institutionalism with respect to the instrumental approach, where the good institutions cause good outcomes and good outcomes indicate the good institutions, but the literature broadly recognises time and geography varying consequences of specific institutional arrangements. It’s not a novel or particularly sharp critique of this school of thought if we expand our scope beyond a few papers from the early 2000s.

In research, institutionalism remains valuable precisely because it forces researchers to confront the limits of narrow policy analysis. Properly specified empirical work still often rests on assumptions about enforcement capacity, judicial independence, or even something as simple as accurate data reporting. The contribution of institutional political economy is not simply that “institutions matter,” but that economic outcomes are embedded within evolving systems of expectations, incentives, and constraints that cannot be meaningfully reduced to independent variables.

With that being said, the literature benefits from moving away from universal institutional templates and towards more context-sensitive frameworks. The strongest contemporary work on institutions increasingly focuses on disaggregation; identifying which specific institutional arrangements matter, through what mechanisms, and under what conditions. This means distinguishing between formal law and informal arrangements, legislation and credible enforcement, and institutional forms that may appear similar on paper but are functionally incompatible.

In practice, institutions matter because policy is not introduced into a vacuum, rather it enters an existing institutional equilibrium shaped by a range of informal norms, local interests, bureaucratic incentives, legal traditions, and state capacity. Ignoring these conditions, even defined broadly as “inclusive” or “extractive” in character risks producing policies that appear sound in abstraction but fail in implementation.

This is particularly important in contemporary development debates where policy transfer has become increasingly common. Programmes that succeed in one country are touted as replicable elsewhere, with the assumption that the policy itself is responsible for the observed outcome. Institutional context will determine whether the same intervention produces the desired outcomes.

This does not mean abandoning normative concerns around democracy, economic rights, or government accountability as an idealised political project. Rather, it means recognising that institutional development is often path dependent, constrained by existing social, political and economic constraints. Durable institutional equilibria emerge through changing expectations and bargaining relationships, not simply through the top-down adoption of some ideal institutional blueprint.

Works Cited

Acemoglu, Daron, Simon Johnson, and James A. Robinson. 2001. “The Colonial Origins of Comparative Development: An Empirical Investigation.” American Economic Review 91 (5): 1369–1401.

Acemoglu, Daron, and Simon Johnson. 2005. “Unbundling Institutions.” Journal of Political Economy 113 (5): 949–995.

Acemoglu, Daron, and James A. Robinson. 2014. Why Nations Fail: The Origins of Power, Prosperity, and Poverty. New York: Crown Publishers.

Ang, Yuen Yuen. 2020. China’s Gilded Age: The Paradox of Economic Boom and Vast Corruption. Cambridge: Cambridge University Press.

Card, David, and Alan B. Krueger. 1994. “Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania.” American Economic Review 84 (4): 772–793.

Greif, Avner. 2000. “The Fundamental Problem of Exchange: A Research Agenda in Historical Institutional Analysis.” European Review of Economic History 4 (3): 251–284.

Hou, Yue. 2019. The Private Sector in Public Office: Selective Property Rights in China. Cambridge: Cambridge University Press.

Milgrom, Paul R., Douglass C. North, and Barry R. Weingast. 1990. “The Role of Institutions in the Revival of Trade: The Law Merchant, Private Judges, and the Champagne Fairs.” Economics & Politics 2 (1): 1–23.

North, Douglass C. 1990. Institutions, Institutional Change and Economic Performance. Cambridge: Cambridge University Press.

North, Douglass C. 1991. “Institutions.” Journal of Economic Perspectives 5 (1): 97–112.

North, Douglass C., and Barry R. Weingast. 1989. “Constitutions and Commitment: The Evolution of Institutions Governing Public Choice in Seventeenth-Century England.” Journal of Economic History 49 (4): 803–832.