Institutions Research Paper

1. The Concept ‘Institutions’

In everyday language and in the social sciences, the term ‘institutions’ is often used in a broad and sometimes amorphous way. It is quite common to denote organizations and other corporate actors such as business firms, political parties, schools, and public administrations as ‘institutions.’ On the other hand, the term also, more specifically, refers to rules and other constraints of human interaction. ‘Institutions’ in this sense include conventions (for example, traffic rules), as well as informal and formal social norms. Furthermore the term is often used to describe complex systems of interrelated norms. For example, modern law can be considered as a set of formal norms proscribing or prescribing certain actions. Another aspect of the law is that it employs (mainly negative) sanctions to punish and prevent deviant behavior. In accordance with Max Weber’s terms (1978), the law induces stable regularities of nondeviant behavior via (threats of ) sanctions that are employed by a specialized staff of actors. In this sense, the law may be conceived as an organization that enforces certain formal norms.

The concept ‘institutions’ is thus used in a dual way. First, it denotes rules, constraints, or norms of human interaction. Second, it describes the resulting stable patterns of interaction among a set of agents and the social mechanisms generating this outcome. This latter aspect is sometimes also expressed in the concept ‘institutionalization’ which plays a central role, for instance, in Talcott Parsons’ theory of social systems. ‘Institutionalization’ means that certain cultural norms become elements of the actors’ motivational dispositions, and that norm conformity is rewarded and deviant behavior appropriately punished by the application of sanctions. In Parsons’ (1982, pp. 117–18) words, ‘institutionalization is an articulation or integration of the actions of a plurality of actors in a specific type of situation in which the various actors accept jointly a set of harmonious rules regarding goals and procedures.’

To allude to the modern choice theoretic framework of game theory, institutions are first represented by the rules of the games actors are playing. These rules define, among other aspects, the set of possible actions (strategies) of the agents. They also specify the consequences of the actions (payoffs) and the available amount of information. Given these rules or constraints, agents choose an action (strategy) that is individually optimal. The optimal choices will, under general conditions, yield an equilibrium. An equilibrium is a combination of actions (strategies) such that no agent has an incentive to deviate from her chosen actions unilaterally, that is under the condition that the other actors choose their equilibrium actions. The stability of an equilibrium is due to the fact that no (rational) actor could gain by shifting to another strategy unilaterally. Consider now a population of actors who recurrently interact in a social situation governed by the rules of the game. Then it may happen that a certain equilibrium will eventually evolve. In other words, a stable pattern of social interactions may emerge under the constraints of the rules of the game.

An ‘institution’ can thus be conceived to be the set of constraints or rules which determine the opportunities and incentives of the relevant actors in a given situation. Second, interactions within these rules generate equilibria, which may be stable over time if the situation is recurrent. These equilibrium outcomes can be considered an integral component of the institution. To illustrate, consider a coordination situation. Imagine a time with considerable road traffic (e.g., horse-drawn carriages in the seventeenth century) but no universally accepted rules with respect to keeping left or right. If a central authority (the government) were to create the rule that pedestrians use the right side of the road and horse-drawn carriages use the left side, one source of potential accidents could be avoided, namely, inconsistent mutual reciprocal expectations with regard to the usage of public roads. The rule would, so to speak, ‘solve’ a coordination problem. A coordination problem can roughly be defined as an interaction with multiple equilibria. In the absence of any rules or ‘focal points’ (Th. C. Schelling), there would be ambiguity with regard to the different courses of action available to road users: should one use the right or the left side of the road? The actors probably do not have intrinsic preferences with regard to the direction of the rule, that is, whether to go right is better than to go left. But they prefer to adopt a rule that gives clear and unique prescriptions and prevents accidents if universally acknowledged, rather than ambiguous rules or rules which are not easily implemented (e.g., the rule that one should determine by chance whether to go right or left). Given that the government has publicly announced a rule, the participants easily form convergent expectations with regard to each other’s behavior. In other words, an equilibrium of universal rule-oriented behavior emerges as a consequence of individually adaptive or optimizing behavior under the constraints of the rules of the game and of external constraints created by the government. This gives rise to a ‘convention.’ Following Lewis (1969), a convention may be defined as a behavioral regularity R in a population of agents who recurrently interact in a coordination situation if R is an equilibrium of the recurrent situation and if almost every member of the population prefers to conform to R on the condition that almost every other member of the population conforms to R too.

Conventions arising in so-called pure coordination situations (with no conflict of interest) are self-enforcing. This is so because any individual who deviates from R would punish himself. There is no incentive to break the rule. In other social situations, for example of the prisoner’s dilemma type, there is an incentive to defect. A prisoner’s dilemma is a social interaction such that universal cooperation is profitable to everyone, but it is even more profitable to defect unilaterally from cooperation. Cooperation is not an equilibrium situation in the single-shot prisoner’s dilemma. In a population of agents who recurrently interact in a prisoner’s dilemma, an institution of mutual cooperation may emerge if there is a policing mechanism such that members of the population of agents expect that nonconformity will be punished by (negative) sanctions. The policing or enforcement of cooperation could be achieved under appropriate social conditions due to sanctions that are created by the agents themselves. Of course, intervention by external, third parties (in the sense of Hobbes’ Le iathan) would be another mechanism to enforce an institution. Generalizing Lewis’ concept of convention, a social institution can be defined as a regularity in the behavior of the members of a population that ‘specifies behavior in specific recurrent situations, and is either self-policed or policed by some external authority’ (Schotter 1981, p. 11; italics omitted). The self-enforcement of an institution may be due to the fact that the regularity is an equilibrium of a coordination problem. If the recurrent situation has similarities with a prisoner’s dilemma, however, an equilibrium of cooperative behavior may result from self-created sanctions (e.g., of the ‘tit for tat’ type, cf. Axelrod 1984) or from policing by an external authority. The concept ‘social institution’ in this sense includes conventions as a special case, and also formal and informal social norms (see Lewis 1969, Schotter 1981, Young 1998 for sophisticated elaborations of this line of reasoning).

2. Some Types Of Institutions

There are many different kinds of institutions. First, adopting the intuitive meaning of institutions as rules or constraints of behavior, it is useful to make the following distinctions. There are rules that regulate the personal life of human agents. These personal rules (e.g., the rule to go early to bed every night) resemble individual habits and individual routines. Some of these rules may be interpreted as attempts of individuals to bind themselves. Personal rules may be motivated by individuals’ long-term interests to achieve self-control. But they are not social institutions in the proper sense. In contrast to personal rules, social rules affect social interactions, that is, recurrent situations of social interdependence. For example, it can be argued that social institutions typically regulate social dilemmas. Social dilemmas are situations where interdependent agents are faced with choices for which individual rationality does not yield a socially optimal outcome. The prisoner’s dilemma and public good situations are cases in point. Furthermore, there are formal and informal institutions. Informal institutions do not rely on an external authority’s monitoring and policing of the participants’ behavior. These institutions include, for example, social norms of self-help among residents in rural communities (see Ellickson 1991). Other informal institutions are conventions. Though conventions are defined as self-enforcing, they often become codified in formal rules (e.g., time standards or traffic rules). Formal institutions are generally created and arranged by agents who are able to rely on third parties for monitoring and enforcement. Among the most elaborate formal institutions in modern societies one should mention the law. There are also complex formal institutions regulating political committees in political systems and collective decisions in large capitalist firms. However, it is important to notice that formal rules are embedded in informal norms. Committee power in democratic political bodies is determined to a large extent by informal norms that foster vote exchange (logrolling) (Coleman 1973, Shepsle and Weingast 1987) and only to a minor degree depends on formal rules. Thus, formal institutional constraints are often supplemented by informal rules and vice versa.

Second, it is useful to point out the different levels of rules that can be relevant in institutional analysis (see Ostrom 1990, Chap. 2). There is first the constitutional level. Constitutional rules define the most general context of the games agents are allowed to play. They determine the set of eligible actors and the principles used in crafting or changing more specific rules of the system. Constitutional rules are not only relevant in the arena of international and national politics but also in regional and local contexts. Second, there is the level of Collective choice. Collective choice rules specify principles of policy-making. They help to generate unique collective decisions. Third, there is the operational level. Operational rules help to implement the decisions of the higher levels. They determine dayto-day decisions, for example decisions related to the monitoring and sanctioning the participants.

Third, institutions may be classified by the spheres of the society to which they belong and contribute. There are economic institutions regulating economic exchange, for example, property rights institutions. Other economic institutions include conventions with regard to media of exchange or the specific rules and constraints affecting economic behavior between and within firms (see Williamson 1985). Political institutions provide basic rules and procedures to achieve collective decisions. The most important political institutions in contemporary societies are, of course, the constitutions of nation states, for example, the constitution of the United States of America. There are also international political institutions. Besides these basic ground rules of international and national politics there are more specific institutions and laws dealing with the operation of the democratic system. Every human society has developed institutions shaping family life and kinship relations. Modern societies have created a differentiated system of educational institutions. There are also cultural and religious institutions of different kinds.

3. Explaining Institutions

The analysis of institutions has always been considered to be one of the most important tasks in social theory. For example, Emile Durkheim (1978, pp. 82–3) emphasized that sociology’s subject was ‘social facts,’ in particular social institutions. A desideratum of sociological analysis, according to Durkheim, is the discovery of the mechanisms, causes, and effects of institutions in the diverse spheres of societal life.

3.1 Effects Of Institutions

A starting point of many explanations is the study of the effects or consequences of institutions. Not only functionalist analyses in the proper sense, but also contributions from diverse theoretical perspectives in the social sciences argue that institutions may have beneficial consequences.

Institutions regularize social life. Rule-oriented behavior reduces uncertainty and increases the predictability of others’ actions in situations of social interdependence. The institutionalization of social norms in Parsons’ sense is a key to the solution of the Hobbesian problem of order. In a ‘state of nature’ without an enforcing agency, mutual cooperation, for example, the recognition of private property rights, would be profitable, but there are strong incentives to defect from mutual agreements. The institutionalization of social norms of reciprocity and solidarity via their internalization into the actors’ motivational systems would be, according to Parsons, a solution to the Hobbesian problem (Parsons 1937). Thus, institutions and the institutionalization of appropriate social norms may foster cooperation and increase efficiency (in the Pareto sense of making agents better off without harming anyone in society).

Institutions such as exclusive private property rights with respect to economic resources are prone to enhance a society’s aggregate welfare because they reduce transaction costs (North 1990). If transaction costs within an economic system decrease, the economy will generally become more productive, provided the costs of creating and enforcing these institutions are not too high (see Eggertsson 1990 for a survey of the literature). To allude to a recent institutional innovation, it seems plausible to argue that global communication networks (Internet) constitute an institutional framework that reduces some kinds of transaction costs (in particular costs of acquiring information) in long-distance economic relations. Many institutions, such as property rights, can be said to be part of a society’s social capital (Coleman 1990, Chap. 12). In this sense, institutions are a productive asset because they enhance the efficiency, the welfare or, in other words, the well-being of most members of a society. Furthermore, they can have the properties of public or collective goods. That is, they are goods such that it is not feasible easily to exclude agents from their consumption if these goods are available to anyone. In other words, institutions with collective goods properties can be profitably ‘consumed’ by all those actors who wish to benefit from them, not only by those agents who contributed to the costs of their ‘production.’

This public-good characteristic of many institutions makes it clear that the potential beneficial effects of institutions cannot sufficiently explain the emergence and change of institutions. This is so because public goods create incentives to a free ride. If the formation and maintenance of an institution is costly, the amount of voluntary contributions to these costs will generally be too low, that is suboptimal (Olson 1971). At least for this reason, simple functionalist accounts of efficient institutions are incomplete.

3.2 Mechanisms Of Institutional Change

There are many different types of processes that are prone to generate or change social institutions. First, there is the extreme type of institutional change by conscious design. In particular, formal institutions such as legal norms are in many cases designed purposively. Parliamentary committees in modern democracies regularly propose such changes. However, many of these changes are accompanied or supplemented by changing informal institutions in the larger society. These informal rules generally change more incrementally.

Second, institutional change may be due to evolutionary forces of an ‘invisible hand’ (Adam Smith). In this case, the goal-oriented actions of a large number of actors may in the long rule unintentionally produce results that seem to be due to conscious planning by a central authority. But, in fact, the institution is a byproduct of each individual’s activity to locally adapt to its circumstances. Institutions of this kind are called ‘spontaneous orders’ (F. A. Hayek). It can be argued that many conventions have emerged as spontaneous orders (Sugden 1986, Young 1998) in the first place. Once adopted, they may be included in a cultural tradition and will be taught to children by their parents (e.g., table manners).

Invisible-hand processes of institutions and their explanation (Ullmann-Margalit 1978) are attractive because they may yield theoretical arguments with some ‘depth.’ They explain facts on the collective level of social institutions by principles of purposive action and by a ‘generating mechanism’ (Boudon 1979). Work in the tradition of evolutionary game theory has expressed these mechanisms more explicitly. It can be shown that certain institutions emerge as special kinds of (stochastic) equilibria in games played by members of a population of agents who recurrently interact in the ‘long run’ (Young 1998).

Obviously, most empirically observable institutions will not be explicable exclusively by one of these two extreme or ideal types of mechanisms but are probably complex combinations of different types of processes. However, the study of theoretical models representing some aspects of a complex reality in an idealized way may be understood as a theoretical ‘thought experiment’ (Gedankenexperiment). Such thought experiments enhance the clarity of theoretical arguments and provide an antidote against simplistic and empirically dubious ‘conspiracy theories’ of institutions (K. R. Popper) which argue that most social institutions are explicable in terms of the joint efforts of some group of powerful actors who want to foster their material interests.

3.3 Are Institutions Efficient?

Given the functionalist account, which points out that institutions are beneficial, one may ask whether in fact every institution is efficient. There is indeed some evidence on efficient rules. Wittman (1982) has investigated various rules of thumb in certain road traffic situations and comes to the conclusion that only the most efficient rules will be used. Rules have evolved such that two types of costs are optimized, namely, costs associated with monitoring the rule and inappropriate incentives created by the rule. A similar view is expressed in Ellickson’s (1991) book on informal institutions. However, there is ample evidence on the persistence of inefficient institutions (see Eggertsson 1990, Chap. 8). In the Arab world, inefficient institutions regulating economic exchange have persisted for thousands of years. For example, a form of exchange called the suq (C. Geertz) is characterized by high bargaining and measurement costs. These transaction costs could in principle be reduced by major institutional changes. But such changes have not been observed. Moreover, economic historian North (1990, p. 6) points out that the ‘central puzzle of human history is to account for the widely divergent paths of historical change. How have societies diverged? What accounts for their widely disparate performance characteristics?’ It seems safe to say, according to North, that market processes of competition did not weed out inferior institutions but that inefficient institutions have proved to be highly stable.

There are many different arguments that could explain the persistence of inefficient institutions:

(a) Some social scientists, in particular in anthropology, suggest that institutions are inexplicable by functionalist or rationalist ideas. According to this approach, (cultural) institutions mainly serve ‘symbolic’ functions (Sahlins 1976). A different approach, however, points out the signaling properties of certain behavioral regularities (social norms) that prima facie do not contribute to efficiency. These institutions may be interpreted as consequences of signaling behavior. The conformity to ‘ornaments’ of social life, such as clothing norms, table manners, and others, may be perceived as a signal that the actor is cooperative in the more fundamental interaction problems of family, political, or business life (Posner 2000).

(b) Inequality in bargaining power can have the effect of selecting institutions that primarily serve the interests of the more powerful agents or groups in a society. Thus, new (formal) institutions need not foster the aggregate welfare of a society or efficiency (North 1990, Chap. 6).

(c) There are many recurrent interaction situations with multiple equilibria, for instance coordination games or iterated prisoner’s dilemma games. In cases like these, the outcome may be indeterminate. Further-more, there is ‘path dependence’: Small differences in initial conditions and chance circumstances in structurally similar social interactions yield different paths of historical development and therefore different institutional outcomes (see North 1990, Chap. 11, Greif 1994, Young 1998).

(d) Limited rationality and incomplete information of human agents may be obstacles to attaining efficient institutions (North 1990, Chap. 3).

(e) As far as efficiency gains from institutional change are public or collective goods there may be a lack of appropriate incentives to contribute to the costs (see Olson 1971, Ostrom 1990).

4. The Evolutionary Approach To Institutions

Recent research on the emergence of institutions emphasizes that not all institutions are necessarily efficient. This body of work uses ideas from evolutionary game theory. It is generally consistent with all of the above mentioned arguments on the inefficiency of institutions. Historically, the roots of evolutionary explanations of institutions are ideas from the tradition of the Scottish Moralists (in particular David Hume) and the Austrian School of Economics (Carl Menger, Friedrich A. von Hayek). In constructing an evolutionary approach, one must keep in mind that there are important differences between biological and social evolution. Theories of social evolution must contain appropriate behavioral assumptions of adaptive behavior or learning processes. The evolutionary approach can be characterized by the following core ideas (see Young 1986). Institutions are the products of interactions within large populations of actors over considerable periods of time. These agents are boundedly rational and act under conditions of limited information. This means that actors may fail to figure out responses to other people’s actions which are optimal. However, under appropriate circumstances, the Evolutionary process may in the long run (that is, in the presence of stochastic shocks which correspond roughly with mutations in biological evolution) realize equilibrium outcomes such that efficient institutions persist. But this result may well be an exception rather than the rule. Generally, the evolutionary path will depend on initial conditions. That is, structurally similar social systems may develop qualitatively distinct institutions with considerable differences with regard to the degree of ‘efficiency.’ A particularly important aspect of initial conditions are ‘cultural beliefs’ in Greif’s (1994) sense. These beliefs are embedded into a society’s culture and are a product of history. They are employed as equilibrium selection devices in those interaction situations with multiple equilibria. Therefore, different sets of cultural beliefs may yield different institutional outcomes (at least in the medium run). Greif (1994) illustrates this with the help of a comparison of the cultural beliefs in ‘collectivist’ and ‘individualistic’ societies, using the historical data on Maghribini and Genoese traders in the Middle Ages. An evolutionary approach should, in principle, point out the conditions that generate distinct cultural beliefs (and other equilibrium devices such as fairness norms) and the paths of an evolutionary transition from one equilibrium to another (possibly more efficient) equilibrium. The evolutionary approach is a promising research program, but much further work is needed to fully understand and explain concrete cases of empirically observed institutions.

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