Opinion: Strengthen institutional frameworks
Given the current situation when institutions are deteriorating, the Nobel Prize in Economics couldn’t have been timed better
By Dr Kedar Vishnu and Dr Vaishnavi Sharma
A nation’s success or failure is determined by a number of underlying factors, central to which are the kind of institutions that the country has. The quality of institutions determines the fate of that country in the long and medium runs. The 2024 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel has been awarded to Institutional Economists Dr Daron Acemoglu, Dr Simon Johnson and Dr James Robinson “for their studies on how institutions are formed and their effects on prosperity”.
Acemoglu and Johnson are affiliated with the Massachusetts Institute of Technology (MIT) while Robinson is a Professor at the University of Chicago. It is also worth noting that the Nobel Prize in Economic Sciences was only added to the Nobel legacy in 1968 in honour of the 300th anniversary of Sweden’s central bank, Sveriges Riksbank.
Institutional Economics
The study of institutions and their interactions with organisational structures is known as institutional economics. Humans create institutions — both written and unwritten — to regulate their surroundings and reduce uncertainty. These include unwritten codes of conduct, behavioural conventions and beliefs; written agreements and rules governing contractual ties (or, relationships); and constitutions, laws, and regulations governing politics (Williamson, 2000).
Institutional economics is an emerging branch that has developed over the last five decades, seeking to understand how the world operates without relying on the unrealistic assumptions of neoclassical economists (including Adam Smith). It questions the conventional neoclassical view that individuals have perfect information, face no transaction costs and that they are rational. Humans establish institutions that mitigate asymmetric information and transaction costs to reduce opportunistic behaviour. Previously, Ronald Coase, Douglass North and Oliver E Williamson were awarded the Nobel Prize in Economics for their contributions to institutional economics and property rights. The 2024 Nobel laureates are building upon this foundation.
Their Contribution
Their study shows how formal and informal institutions influence economic outcomes. It aims to address three crucial questions: What exactly is an institution? Why do certain countries succeed while others don’t? And how do the right institutions help lessen inequality and ease the transition of less wealthy nations to prosperity?
Their research underscores that the quality of institutions within a country plays a crucial role in shaping its growth trajectory. By examining the history of colonisation, they illustrate how various institutional frameworks established during colonisation influenced the long-term development of different nations. Countries that adopted inclusive institutions — promoting fair laws and protecting individual rights — often experienced prosperity over time. Conversely, countries that developed ‘extractive institutions,’ where colonisation focused solely on exploiting the indigenous populations for immediate gains, often faced economic and political challenges. These oppressive systems marginalised local communities and concentrated wealth and power in the hands of a few.
Their theoretical and empirical work has shown that the persistent gap between rich and poor countries is rooted in institutional factors. By analysing European colonisers’ political and economic systems, Acemoglu, Johnson and Robinson have demonstrated a clear link between institutions and prosperity. Their research highlights that developing countries remain poor not only because of a lack of natural resources but primarily due to weak institutional frameworks and the absence of effective enforcement. The trio argues that for nations to attain prosperity, it is essential to reform institutions to be more inclusive, thereby empowering all citizens and promoting innovation and growth. Their work offers a distinctive perspective on how economic growth can, in turn, promote strong institutions.
Institutions Today
Improvements in governance factors, such as political stability, the rule of law and government effectiveness, are associated with more inclusive economic growth (World Bank, 2019). For example, after enacting reforms to improve government efficiency and regulatory quality, Brazil and Indonesia have seen significant reductions in poverty and inequality.
On the other hand, despite abundance of natural resources, countries like Nigeria that did not reform their institutional frameworks have experienced erratic growth patterns and entrenched poverty (Martin & Subramanian, IMP paper, 2003). These empirical findings highlight the importance of institutions in achieving economic growth and ensuring that it benefits broader sections of society. Colonialism implanted extractive institutions in regions such as Sub-Saharan Africa, Latin America and South Asia, whereas countries like the US, Canada, South Korea, and Australia embraced inclusive institutions, enabling them to achieve higher levels of progress and development.
Many developing countries in the last decade have recorded higher economic growth without robust institutional mechanisms but such growth is unlikely to be sustained in the long run. Acemoglu argued that worldwide, institutions have been deteriorating over time, and countries need to work on this. Without robust institutions, it will not be possible to achieve inclusive growth targets or reduce poverty and inequality. This is especially applicable to developing countries like India.
In India
The World Inequality Report shows that the top 1% now controls over 33.1% of the nation’s wealth and accounted for 21.7% of the income in 2022-23. In contrast, the bottom 50% of the population holds only 5.9% of the wealth and 13.1% of the income. India needs to increase its per capita income and address the issue of inequality.
Going by According to the theoretical and empirical research of laureates, India has struggled to reduce disparities and improve living standards, primarily due to the declining performance of its institutional framework. This can be reflected in institutional economics variables such as voice and accountability, political stability, the rule of law, government effectiveness and regulatory quality. They emphasise that many developing countries, including India, primarily lack a strong institutional framework and effective enforcement. As a result, many firms and individuals in India face challenges related to asymmetric information and opportunistic behaviour, which adversely affect economic outcomes. Globalisation and privatisation can help India achieve higher per capita income, but only if we focus on improving our institutional mechanisms.
Their empirical findings suggest that the root causes of economic failure are deeply embedded in the institutional frameworks that govern societies. The ground-breaking research will undoubtedly contribute to enhancing economic prosperity in both developed and developing countries.
(Dr Kedar Vishnu is Ronald Coase Fellow and Associate Professor of Economics at Manipal Academy of Higher Education, Bengaluru. Dr Vaishnavi Sharma is a PhD from the Indira Gandhi Institute of Development Research [IGIDR], Mumbai)
