The other day I was describing my honours research to someone (namely James Farrell), which started me churning some of the frustrations I have had with the empirical institutional literature of the past 10 years and I stumbled upon another issue I hadn’t considered before – if institutions can increase the output of a society, who can claim this increased output?
The link above covers it in slightly more detail, but to recap: The fact that institutions – that is the “rules of the game”, both formal laws and how they are enforced and social convention and practice – matter in economics has been known since the times of the hero ancestor Adam Smith. Difficulties in formalising them in mathematics, testing them empirically or giving policy recommendations meant they had limited influence in published work (with some marvelous exceptions). The experiences of the 1990s, especially the transition and developing economies that failed to prosper when first best, Washington Consensus policy was implemented, led some (mainly US) economists to adapt institutional rhetoric, but also to attempt to empirically test the influence of institutions, with many flaws.
What I chewing over today is one particular flaw – the tragically limited views of what institutions are. Take this excerpt from Hall and Jones (1999) – a paper which seeks to explain differential output per worker between countries and which is a mandatory citation amongst the literature I described.
A social infrastructure favorable to high lev-
els of output per worker provides an environment that supports productive
activities and encourages capital accumulation, skill acquisition, invention,
and technology transfer. Such a social infrastructure gets the prices right so
that, in the language of North and Thomas (1973), individuals capture the
social returns to their actions as private returns.
Social institutions to protect the output of individual productive units
from diversion are an essential component of a social infrastructure favor-
able to high levels of output per worker.
Institutions “get the prices right”. The institutions, “social infrastructure” they describe don’t create or productivity in any way, they just make sure that the return on factors of production is what theory says it should be so that people have enough incentive to be or become productive. The institutions merely prevent returns to factors of production being appropriated rather than actually contributing to their growth. They stop brigands and crooks, but they do not invent or generate.
Think about this a bit more. This implies there is some kind of ideal set of institutions that ensures that the prices are perfect. Each (land, labour capital) gets payment that reflects exactly what they contribute to output and are thus motivated correctly. Humanity was wallowing around in a huge variety of bad instutional set up until Britain and The Netherlands got close enough to this ideal set that output could start increasing via fundamental markets. Once we get to this ideal set, we can no longer improve institutions – they are doing all they can – only increasing or improving the productivity of the factors of production can increase output. This ideal state is where institutions result in the absence of a wrong (distorted prices) rather than any actual good.
[I freely admit I partially fell into this trap (albeit somewhat consciously) with my own work, where I only attempted to measure a certain type of "bad" institution, rather than any kind of "good one".]
I think they’re probably a bit beholden to their models which has blinded them a bit. With Cobb Douglas in their minds, they can only imagine land, labour or capital increasing output. Anything else can just avoid getting in the way. But I think institutions are rather like technology, with no such upper bound or ideal state. Like technology they can keep evolving, through trial and error, and continually improving the productivity of these factors. In fact the bearer of technology, science, is in itself a large set of institutions and social practices that have evolved over time (I am embracing a rather Kuhnian notion of science here). Markets themselves are deeply embedded in institutions rather than just using them as enforcement mechanism – these include norms that increase trust, or create standards or increase informational flows. Even now we see the development of online social norms such as those in blogging that contribute to the process of informational discovery. They have contributed immensely to the increased output of our societies without any notion that they are just “getting the prices right”. They are a plus in their own right, not just the absence of a wrong.
Hall and Jones use interesting terminology without being aware of it’s implications – “social infrastructure”. We often think of infrastructure in terms of public goods like roads and bridges etc. A good with public benefits that will not be provided privately because a private provider will not be compensated can be provided by the public, either informally (through convention and cultural practice) or through a formal agent such as the state. Everyone then contributes, output as a whole is thus increased, but contributers are not directly compensated and they are motivated by other enforcement mechanisms.
Institutions are social infrastructure in this fashion. They are an input that increases productivity and output, and the costs of creating and maintaining them are spread across the public. The public does this by following them themselves and offering approbration and disapprobation, praise and censure when required. This is costly, but is itself rewarded by pro-social tendencies. Those who bear the cost of maintaining this social infrastructure, just like those who bear the cost of maintaining physical infrastructure, are not directly rewarded.
Who is then? If the productivity of a worker is improved through the institutions in which they are embedded, they would roughly speaking see an increased return – higher wages. In fact, if we take a worker from the developing world and put them in Australia, we expect their productivity to increase and they also receive higher wages. There’s no increased virtue on their part. The productivity increase is in the institutional environment they, and previously resident Australians, are lucky enough to be in and which they are now bearing the costs of maintaining. However the virtue of this institutional environment cannot be attributed to any individuals in it even though they all contribute to it.
I’m finding this a bit difficult to describe ( blogging is for discussions and not for theses). Let’s try an analogy. Imagine a society without a basic institution like language – lets call them Ferroneans. When a language appears and becomes a standard the productivity of Ferronean society and any given Ferronean will increase. But no Ferronean can really claim credit for this. A language is only useful when others are using it, and a language needs to be maintained and developed through use by the broader population to be of any use. A Ferronean will lose their productivity when they leave the language society, but a neighbouring non-language Balonean will gain some if they move to Ferronea and start using language.
If some institutions create rather uniform increases in productivity and rather uniform increases in wages, then there’s no real issue. The cost of creating an maintaining the institution is shared across society and rewarded through pro social incentives, but the benefits are also distributed fairly evenly.
But this is rarely the case. A given institution or set of institutions will increase the productivity of a given kind of input, such as workers with certain attributes or character types, more than others. For instance, someone who is a good verbal communicator relies on the institutions or language to have any use – a born orator only has virtue where there is a tradition of public speaking. If the neurodiversity advocates are right, the success of certain neurological types is contingent on the social setting institutions have created (such as our current schooling system) and the internet may well create institutions in which ADHD or autism has greater productivity than “normal” neurology. The productivity of the physically infirm is far greater under the institutions that provide an informational society than they are in a farming society.
The benefits of an institutional set up that requires public maintainence can be privately appropriated if the increased productivity increases wages for that group.
This isn’t a problem in the Tragedy of the Commons fashion or public goods problem fashion, since maintaining the institution is being rewarded by pro social tendencies already. It’s not strictly speaking a rent either. But “getting the price right” for these wages also doesn’t make much sense, since the differential features that are resulting in differential productivity did not require incentives to be produced. They existed naturally, the institutions are what are increasing output, and they were provided already.
But there is obviously an equity issue. If society at large contributes by maintaining institutions but in which no individuals can claim credit, by some moral considerations society at large should reap the reward, and the fact that the features rewarded differentially are not provisioned based on price means that a tax system is fairly capable of doing this efficiently.
But there is a long term dynamic. If an institutional set up increases the productivity and reward to a certain group, even if this increases productivity overall, they then have the resources to create an institutional set up that cements their relative position. For instance, take later form Samurai in Japan. Institutional set ups towards the beginning of the Tokugawa shogunate rewarded a type I would describe as a martial bureaucrat over sheer warrior talent or the patience required from a farmer. This did increase overall productivity (by creating stability), but rewarded the martial bureaucrat type who then began to create institutional developments to prevent institutional developments that would favour further productivity increases that might favour rival groups – namely merchant classes. Thus whilst the immediate result was increased productivity in Japan (reflected in higher living standards than elsewhere), the long run involved the adoption of parts of Confucianism to help keep market institutions undveloped even whilst a merchant class was champing at the bit and thus lower overall productivity than may have otherwise been the case.
A more contemporary example might be the way the groups of social norms and legal practice has created the institution of the company, or corporation. This isn’t a creation of the market, but an evolved institution. It has produced greater productivity by allowing new means of informational discovery and collaboration as well as economies of scale. To this extent society as a whole has benefited. One group it has particularly rewarded has been managers, who thrive in the hierarchal environment and possess enough narcissism to put themselves forwards. But they can, and have, used those resources to promote institutions that promote themselves. This isn’t a conscious plot, it is only natural to believe oneself is virtuous and they are already narcissistic types, but they now have the resources to do so. This can be by the lobbying for laws and formal institutions that favour CEOs and corporations and protect them from legal censure. It is also present in the stories they tell about themselves that are widely distributed not just because the media is controlled by similar people, but because, as Galbraith put it, “Wealth, in even the most improbable cases, manages to convey the aspect of intelligence. “.
This enforces the current corporate institutions in many ways that are damaging to overall productivity only one of which is confusing men (and it’s almost always men) who seem like existing managers for the virtuous and placing them in positions where other people (including many women) would be just or more able. The examples here are legion and well discussed.
So the distribution of returns from an institutional set up may have implications beyond mere equity. It is important in terms of the dynamics that shape further institutional development and further output.
This is a very long and muddled post, so if you’re still here, thanks. There’s a number of “placeholders” for concepts I haven’t really defined (my use of productivity is one example) but I think this is an interesting and somewhat overlooked issue. If institutions do increase output, rather than just acting as an absence of diversion, then they do entail some return as a social investment. The distribution of this is important for both equity reasons and the long term dynamics of a society and economy. Hopefully by throwing this out to the 6 people who will read this far we’ll be able to figure out just how we can think about these implications clearly.