Institutional Structure and Economic Growth

“True forms of government will of necessity have just laws, and perverted forms of government will have unjust laws,” said Aristotle in Politics. “…The form of government is best in which every man, whoever he is, can act best and live happily” (Aristotle, 1905).

New Institutional Economics (NIE) postulates that the determining factor of the performance of a country is the nature of its institutional structure – which is defined as “a set of formal rules and informal norms, which together with their enforcement mechanisms structure human interaction” (Hussain, 2011). National economic independence, we argue, is realized through an efficient institutional structure that is founded on the principles of equality of opportunity, just competition, and academic freedom.

Types of institutional structures

Institutions are the “constructs of human mind.” They are an abstract set of rules that structure the way humans and organizations behave (North, 1990). The purpose of institutions is to reduce uncertainty, bring order, and if they are efficient institutions, stimulate growth. An organization is defined as “a group of individuals bound by some common purpose to achieve objectives.” They can be social, economic, political, and educational (Benham, n.d.). Organizations operate based on their institutional framework. Simply put, institutions are the rules of a game while organizations are the players who participate.

An efficient institutional structure – that is, efficient rules and norms – allows open entry of organizations based on the principles of meritocracy and competition. On the flip side, an inefficient institutional structure limits access to various types of organizations. Therefore, by definition, a country characterized by an efficient institutional structure is called an Open Access Social Order, or Modern State. While a country characterized by an inefficient institutional structure is called a Limited Access Social Order, or Natural State (North, Wallis & Weingast, 2009).

The institutions of a natural state are designed to generate rents for the dominant coalition, which are elite groups of the country such as industrialists, landlords, military, bureaucracy, religious leaders with political agendas, and others. Rent in New Institutional Economics is defined as the “return to an economic asset that exceeds the return the asset can receive in its best alternative use” (North, Wallis & Weingast, 2009). In other words, it is the unearned income by the elite coalition.

Rent generation is made possible when the institutional structure of a state is made to restrict competition, both in economic and political spheres. Constrained competition results in low productivity and efficiency by participants. The aftermath of an inefficient institutional structure is a rise in nepotism, bribery and corruption, work avoidance, lethargy, and lack of innovation. As a result, the idea of human development through equality, and transformation of the lives of the people is critically suppressed. The sole beneficiaries of such a system are the elite groups. Rent-seeking is normally rooted in a nation that is dominantly driven by greed.

The institutions of a modern state, on the other hand, are founded on the principles of equality of opportunity for all citizens. For this purpose, the institutional structure – the underlying rules and norms – enables open entry of organizations and encourages competition in economic and political circles to induce greater productivity and efficiency.

Competition in the political domain implies the ability to form impersonal or perpetually lived organizations. Impersonality implies “treating everyone the same.” A perpetually lived organization is, therefore, founded on impersonal relationships and “is independent of the lives of its members” (North, Wallis & Weingast, 2009).

Competition in the economic sphere is based on the pursuit of innovation rents. It is to be noted that ‘innovation itself is a source of rents’, but these rents are different from those in a natural state, as they are continually replaced by persistent competition and stream of new innovations (North, Wallis & Weingast, 2009).

Innovation, academic freedom and institutional structure

The work of Philippe Aghion, a French economist, shows that “greater the depth and range of innovations, the higher the long-term economic growth of a country” (Hussain et al, 2017). Through a culture of competition, innovation is fostered in a wide range of fields, especially in knowledge and skill-intensive goods and services. Innovative products, services, and business models start to emerge that bolster an economy’s competitiveness in the global demand for these products (Hussain, 2019). Open access to the formation of economic organizations is a prerequisite “for creative destruction and a dynamic economy” (North, Wallis & Weingast, 2009).

Innovation demands creative thinking and cutting-edge research; whereas “creativity requires freedom” (Hussain, 2018b). Therefore, an institutional structure that is conducive to creative thinking and produces an environment of academic freedom is a prerequisite for innovations to transpire. Academic freedom is “the freedom of teachers and students to teach, study, and pursue knowledge and research without unreasonable interference or restriction” (Britannica, 2020). It incentivizes individuals to think freely and creatively. The formal laws and informal norms of society – together forming its institutional structure – must be synchronized to promote creative thinking and cutting-edge research.

The organizations of academic freedom include universities, research centers, and think-tanks. The institutional framework of these organizations and the whole society need an “innovation infrastructure” that can determine long-term economic growth by tapping into the creative minds of people (Hussain, 2018b). According to Dr. Akmal Hussain, a world-class university – which is essentially a “key element” in building an innovation infrastructure – is an “emblem of a learned civilization.”

Adaptive efficiency and institutional structure

So far, we have established that an open access social order is founded on an efficient institutional structure which – through equality of opportunity, competition and innovation, and academic freedom – enables sustained growth in per capita income. It is noteworthy that the process of sustaining an efficient institutional structure itself depends on the ability of the system to evolve by adapting to changes and challenges over time. For this purpose, an institutional structure must embody adaptive efficiency.

Douglas North, the economist who introduced New Institutional Economics, describes the meaning, role and purpose of adaptive efficiency:

“(It) is concerned with the kinds of rules that shape the way an economy evolves through time. It is also concerned with the willingness of a society to acquire knowledge and learning, to induce innovation, to undertake risk and creative activity of all sorts, as well as to resolve problems and bottlenecks of the society through time” (North, 1990).

Adaptive efficiency in an institutional structure develops dynamism in society for the formation of new institutions, organizations, and solutions.

The state should primarily work for the well-being of its people. The formal laws and societal norms, together with their enforcement mechanisms, should revolve around this very incentive: to increase the welfare of the people. By unleashing the collective abilities and latent potential of human beings, countries can sustain economic growth in per capita income, develop worthwhile solutions and innovations, and produce advanced knowledge that unravels the mysteries of existence and the universe. Such a desirable vision for human civilization can be pursued under equality of opportunity, freedom of self, and an efficient institutional structure.

References

Aristotle. (1905). Politics. Oxford: Clarendon Press.

Benham, Alexandra. (n.d.). Glossary For New Institutional Economics. The Ronald Coase Institute.

Hussain, Akmal. (2011). Norms, values and democracy. The Express Tribune.

Hussain, Akmal. (2017). Policy Issues in Economic Growth, Equality and Sustainable Development. In Inclusive and Sustainable Development: Analytical Basis and Policy Framework (pp. 21–30). Islamabad: UNDP Pakistan.

Hussain, Akmal. (2018a). Capitalism, Consciousness and Development. In Development Policy in a Globalized World: Recent Trends, Theories and Lessons. Routledge.

Hussain, Akmal. (2018b). Economic development and the university. The News International.

Hussain, A. (2019). Pakistan: Charting a New Course to Development. In Rethinking Pakistan: A 21st Century Perspective. Lahore: Folio Books.

North, Douglass. (1990). Institutions, Institutional Change and Economic Performance. Cambridge: Cambridge University Press.

North, D. C., Wallis, J. J., & Weingast, B. R. (2009). Violence and social orders: A conceptual framework for interpreting recorded human history. Cambridge: Cambridge University Press.

The Editors of Encyclopaedia Britannica. (2020). Academic freedom. Encyclopædia Britannica: Encyclopædia Britannica, inc.

Featured image by Muaaz Saeed