Opinions

The Importance of Institutionalism And Economic Behaviour

This week's guest writer Jeroen van Alst writes about the importance of institutionalism and how it affects our economic behaviour, mainly through geography and culture.

Economic as a science is more than rather using mathematical models trying to explain how theoretical ideas are related to each other. Mathematical models could be useful for the visualization of theoretical concepts, but most of these models assume that people are rational. According to these models, people maximize their utility by doing what satisfies their preferences the most. With institutionalism as upcoming mainstream view in economics, the way people behave and their decision making seem to gather more attention through the last years. Institutionalism emphasizes the importance of economic institutions on certain economic outcomes. This article will discuss the importance of institutions and how they could affect economic outcomes.

What is institutionalism?

Institutionalism is an approach which emphasizes the importance of institutions. The study of institutions is based upon multiple disciplines, like economics, sociology, political science and psychology. Institutions are especially important in the provision of a sustainable environment for economic transactions to occur. Transactions are more likely to occur in a safe environment where property rights are well-protected. Property rights are the theoretical and legal ownership of resources, which prevent other people from using the resources you own. Johnson et al. (2002) claim that property rights are very important especially for investments. Entrepreneurs will not invest if they expect to be unable to keep the fruits of their investment. This lack of well-defined property rights could lead to less efficient economic outcomes, which seem to be very undesirable. Acemoglu et al. (2005) argue that differences in economic institutions are the fundamental cause of differences in economic development. Economic institutions provide a safe environment for transactions to occur and make markets more efficient. However, old literature proposes that factor accumulation is the cause for economic growth, however, Acemoglu et al. claim that factor accumulation is economic growth. These factor accumulations are the outcomes of an institutional system designed by economic institutions in a specific country.

As we know institutions protect property rights and provide a sustainable environment for transactions to occur, so we could argue that economic behaviour is closely related to the quality of these institutions. People act upon the rules of the games provided by economic institutions, and thereby affect the economic outcomes of that specific country. So economic development depends on the quality of institutions, but there seem to be more fundamental causes for the creation economic development. The two most interesting fundamental causes of economic growth, for me, are geography and culture. Geography, climate and ecology are all important determinants for the preferences and opportunities of individuals. Infrastructure, distance to capital and population density are for instance very interesting geographical variables, which could affect the economic behaviour of people. During my own research on the effects of ERDF on economic growth, I took a closer look at the importance of the distance to capital. The capital of a country is most likely to be one of the places with a high concentration of economic activities, and therefore you expect that countries with economic activities more spread over the country to face lower economic outcomes. Literature shows that density has a positive influence on total factor productivity. Being co-located provides benefits like knowledge spillovers, thick labour markets and you could attract more customers (Jennen et al., 2010). Therefore, to measure this geographical aspect, distance to capital could be a relevant factor in explaining economic growth.

Secondly, culture can explain choices and economic behaviour through cultural beliefs. Cultural beliefs shape the moral framework through which people make their decisions and decide whether something is good or bad. These beliefs are embedded in society, changes of these informal institutions are nil (Williamson, 2000). Norms and other cultural beliefs affect trust, which seem to be an important part of culture in explaining economic growth. Trust goes with property rights and the quality of institutions, because more trust leads to more efficient transactions contributing to more economic growth. People like people of their own social group, which leads to more ethnic fractionalization. As people act within their own social group, you could argue that trust affects multiple social aspects that influence economic growth.  The relationship between trust and economic outcomes seems to be quite endogenous. However, I argue that trust could be a channel through which culture affects economic outcomes, which is quite interesting.

So, geography and culture are two possible channels through which institutions could affect economic growth. It might be clear that institutions matter, especially in shaping the economic environment. In times of COVID-19, we observe differences in the way countries act upon this pandemic. We see that countries use different ways to prevent an outbreak in their country. I am convinced that the role of institutionalism is essential during this COVID-19 crisis, because this crisis shows that (economic) behaviour is one of the most important elements in the process to certain outcomes. Such a crisis shows the behaviour of people under different and strange circumstances, which is quite interesting for the upcoming years. What will be the economic consequences of this COVID-19 crisis? No one knows and, unfortunately, there is no mathematical model which could predict these outcomes.

Bibliography

Acemoglu, D., Johnson, S., & Robinson, J. A. (2005). Institutions as a fundamental cause of long-run growth. Handbook of economic growth, 1, 385-472. Up to and including section 6.

Williamson, O. (2000). The New Institutional Economics: Taking Stock, Looking Ahead. Journal of Economic Literature, 595-613.

Johnson, Simon, John McMillan, and Christopher Woodruff. 2002. “Property Rights and Finance .” American Economic Review, 92 (5): 1335-1356.

Jennen, M., & Verwijmeren, P. (2010). Agglomeration effects and firm performance. Urban Studies, 47, 2683-2703.

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