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Institutions coordinating human behavior
Institutions are the rules, organizations, and social norms that facilitate
coordination of human action (figure 3.1). On the
informal end, they go from trust and other forms of social capital (including
deeply rooted norms governing social behavior) to informal mechanisms and
networks for coordination. On the formal end, they include a country's codified
rules and laws, and the procedures and organizations for making, modifying,
interpreting, and enforcing the rules and laws (from the legislature to the
central bank).
Because institutions govern behavior, they are social assets (or liabilities,
when bad or weak). So are the elements of social capital, such as trust and
personal networks. The distinction between social capital and institutions can
sometimes be blurred, and there are strong influences between the various
social assets (see chapter
2, note 14). For example, the exchange of goods and services may be
based on personal networks and other forms of social capital in the village,
but on formal institutions in the city. Similarly, general trustworthiness in a
society can be strong either because of strong personal networks-or because of
good laws and judicial systems that are generally accepted. In fact, as
societies become more complex, trust in individuals (based on knowledge of
character and frequency of interpersonal contacts) is supplemented by trust in
institutions (rules and organizations) when dealing with strangers.
Two very important dimensions of coordination are others and future.
Markets are institutions with coordinating functions (box 3.1).
A market coordinating the transactions of individuals and firms enables them to
serve others and invest for the future (as when a baker builds an oven in
response to greater demand). But markets need the support of other institutions
to ensure confidence, control, and the right incentives. Economic agents face
transaction costs, and institutions can coordinate to lower those costs.
Traders may want to cheat each other-or to renege on their promises. But social
capital and modern institutions-such as the rule of law and the enforcement of
contracts-reduce this probability (a transaction cost), facilitating mutually
beneficial transactions. Particular challenges for these other institutions are
to commit to protect and nurture people and assets-and to serve dispersed
interests.
Box 3.1
The market as a coordination mechanism
Adam Smith, 1776, captures well how market forces coordinate human behavior for
the common good with his famous "invisible hand" formulation: "It is not from
the benevolence of the butcher, the brewer or the baker that we expect our
dinner, but from their regard to their own self interest." Going beyond this,
Friedrich von Hayek lucidly depicts the market as a discovery device. Through
voluntary exchange, the market generates price signals, conveying information
about scarcity. When markets are competitive and decentralized, the "knowledge
of the particular circumstances of time and place" will help guide
decisionmaking (Hayek 1945, p. 526). Hayek uses the example of a rise in the
scarcity of tin. Users of tin will receive a signal through the higher price
that "some of the tin they used to consume is now more profitably employed
elsewhere, and that in consequence they must economize tin." Simultaneously
producers receive a signal to seek new supplies. The system operates with
remarkable economy of knowledge and gathers dispersed interests.
"The marvel is that in a case like that of scarcity of one raw material,
without an order being issued, without more than perhaps a handful of people
knowing its cause, tens of thousands of people whose identity could not be
ascertained by months of investigation, are made to use the material or its
products more sparingly; i.e., they move in the right direction" (Hayek 1945,
p. 527).
Markets can perform these functions even when there are important public
concerns, of course, but they need the support of other institutions to handle
those concerns. For instance, an environmental protection agency issuing
tradable pollution permits or charging for emissions (as with sulfur in the
United States, or water pollution in Colombia), can use markets to find cheap
ways to abate pollution. More typically, emission regulations fail to use
markets as much as they could to challenge firms to find cheaper and more
environmentally friendly ways to produce.
Source: Authors.
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World Development Report 2002: Building Institutions for Markets,
looked mainly at human-made assets, and its focus was narrower than this
Report's. But it looked deeper into what sustains investments and transactions.
This Report builds on that foundation but expands the discussion to aspects of
well-being that are not limited to income or easily amenable to markets,
including services from environmental, natural, and social assets. The actors
in society partly play under a given set of rules and they partly shape those
rules. Firms, government, and civil society are positioned to act and to
influence the actions of others, playing complementary roles in coordination.
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