It’s very hard to think of decisions we make that are not affected in some way or another by the presence of institutions. I used to have a very simple mental model where institutions were loosely part of two groups: cultural and formal. The cultural group captured the societal norms; or more ‘specifically’ the part of life that would not be regulated by law, and the formal group sort of aligned with the legal apparatus (set of laws and organizations enforcing them). For a while, this was good enough. But when you start thinking about why do institutions exist and how they evolve, or whether individuals and companies can also be institutions, a better mental model is needed.
What are institutions?
Douglass C. North, who won the Nobel Prize in Economics for his work on the economics of institutional change, defines institutions as “the rules of the game”, or less tersely:
humanly devised constraints that shape human interaction [1]
Geoffrey M. Hodgson, the editor-in-chief of the Journal of Institutional Economics, defines them as:
kinds of structures that matter most in the social realm: they make up the stuff of social life [2].
Acknowledging the work done by a plethora of distinguished authors that dedicated years to the study of institutions, from Aristotle to Webber to Durkheim and North, the lack of a generally applicable definition that goes beyond context, is hard. John R. Searle points this out writing that a well-defined, worked-out theory of institutions, does not exist. He proposes that one must first look at what he calls institutional facts, that is facts that can exist only in the presence of a certain observer-related context and which have a subjective nature of being or as he puts it, ‘facts that have a subjective ontology’. In this light, an institution, according to Searle, is:
any collectively accepted system of rules (procedures, practices) that enable us to create institutional facts [3].
Every attempt of defining institutions is subjected to different political and economic systems, degrees of formality, relations with culture and religion and a variety of contextual variables, but I think viewing institutions as North suggests, as rules of the game is helpful.
Why do institutions exist?
If institutions are the rules of the game, then we already have an intuition for why they exist: to make the game fair, … or easy to play.
Manztavinos in his book Individuals, institutions and markets [4] provides two main classes of reasons about why institutions exist, one related to the motivational, and the other to the cognitive architecture of humans beings. He explains the main motivational characteristics of humans is that of trying to increase one’s utility. In this context, the conclusion that there shall be interindividual conflict follows logically. Manztavinos therefore proposes the main reason for the existence of institutions, is to provide the means necessary to overcome conflict, reduce friction and promote collaboration among agents.
The second class of reasons why institutions exist are cognitive ones. The environment is very complex for the human mind, which has limited computational capacity, as well as imperfect information. Thus making systematic deductions to choose suitable behaviours a hard problem. The existence of the institutions can be justified as a solution to recurrent complex issues that may lead to friction, and to which some simplified, systematic rules can be applied. North suggests the ’major role of institutions in a society is to reduce uncertainty by establishing a stable (but not necessarily efficient) structure to human interaction’ [1:1]. This is very interesting as it allows a line of reasoning where inefficient outcomes are possible.
Another seemingly different perspective is offered by Searle, who suggests that the reason for the existence of institutions is mainly to collectively assign status functions, which he explains logically by ’X counts as Y in context C ’, where X represents certain features of an object, person or state of affairs (entity), Y assigns a special status to that entity in a given context C [3:1].
Organizations are not institutions
If institutions are the rules of the game, according to North, individuals and organizations are the players of that game. Their objective is to ‘win the game - by a combination of skills, strategies and coordination; by fair means and sometimes by foul means’.
Organizations include political, social, educational bodies, among which firms, trade unions, universities etc. More specifically, North defines organizations as ’a body of individuals bound by some common purpose to achieve objectives’. Any theory of institutions, North says, must clearly separate 'the analysis of the underlying rules from the strategy of the players’. In this context, organizations are created to exploit opportunities that emerge from the existing set of constraints induced by institutions and economic theory, and it is in doing this that they become agents of institutional change, through a perpetual interaction between institutions and organizations.
Note: Institutions and institutional change are part of the foundations of evolutionary economics, which I’ll hopefully soon have a brief introduction post for.