The Central Role of Institutions  1.1 Institutions: Keys to Development?

A good starting point for understanding how institutions and transaction activities can affect development within a community is provided by the work of Douglass North. North argues that wealth is created through trade (including all forms of exchange) since this allows different individuals, groups or regions to specialise in production activities according to comparative advantages in access to and use of assets. Trade, however, requires co-operation between the trading parties, and the transaction activities associated with this are costly. Aside from the physical costs of transport, buyers and sellers have to communicate to establish contact and then to bargain, agree and execute a transaction, with mechanisms to check and enforce the delivery and quality of goods, services and payments.

The costs involved in communicating and enforcing transactions and the property rights on which they are based are known as transaction costs and these are incurred in order to reduce the risks of loss from transaction failure. If transaction costs and/or the risks of loss from transaction failure are too high, greater than the margin of revenues over physical transformation costs, then they will cancel out the cost savings and other benefits possible from trade. The result is market failure and trade will not then occur, with consequent loss of its wider benefits to society as a whole. Critical to our understanding of economic development, therefore, is an understanding of transaction costs and risks of transaction losses.

Davis and North (1971) identify two major influences on transaction costs and on the risks of transaction failure: the institutional environment, and institutional arrangements.

‘Institutional arrangements’ are the particular forms of contract or arrangement that people and organisations are set up for particular transactions (share cropping and commission sales are examples for land and commodity transactions respectively).

The institutional environment (sometimes known as the institutional framework) is the broader set of institutions (or ‘rules of the game’) within which people and organisations develop and implement specific institutional arrangements.

Formal institutions (such as by-laws, national laws, policies, the national constitution, and international laws and treaties) are clearly part of the institutional environment and distinct from institutional arrangements. The distinction may not always be so clear, however, for informal institutions (such as social customs and conventions) widespread acceptance of particular institutional arrangements as the norm can mean that in effect they become part of the institutional environment.

North argues that in a close traditional village community, transaction costs between villagers are low: people know about each others’ activities and reliability while social relations and structures both encourage people to keep agreements and also provide mechanisms for enforcing agreements and resolving disputes. For development to proceed, however, people need to trade between communities and with the wider national and international economies. This requires institutional environments and institutional arrangements that are effective in reducing the transaction costs and risks of increasingly complex and distant forms of trade and property rights.

North argues that the development of the institutional environment is central to economic development, through its effects on transaction costs and risks, and hence on trade. Productive economic activity, with specialisation and complex forms of exchange, is thus stimulated in countries with a highly developed institutional environment. Countries with an under-developed institutional environment, on the other hand, have transaction costs and risks that are too high for actors to engage in complex forms of exchange, and they therefore remain relatively undifferentiated and cannot realise gains to be made from specialisation and economies of scale. North concludes that "the inability of societies to develop effective, low-cost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment in the Third World."

Our summary of NIE analysis provides three entry points to reduce transaction costs and risks: development of the institutional environment, development of more effective institutional arrangements within the existing institutional environment, and development of infrastructure and services to improve communication and reduce its costs. These are very relevant to sustainable livelihoods analysis, and to household, meso, macro and international scales of analysis. (See Box 1)

We conclude this section by noting that fundamentally NIE involves a recognition that holistic analysis of economic activity requires explicit reference to institutions. It is also recognised, however, that institutions exist for a wide variety of reasons, and in analysing them and their development, their varied and often multiple roles will not be understood by economic analysis alone.