Institutions and Incentives: A Guide for Policy Practitioners

Have you ever thought what stops some places from developing? Why is it hard for some places to implement progressive policy? What stops people from being more entrepreneurial? Well it can often be the institutions, the “legal and administrative organizations” that underpin society and they predict the ability of a place to prosper (World Economic Forum, 2015).

Institutions are a “consistent and organized pattern of behaviour or activities (established by law or custom) that is self-regulating in accordance with generally accepted norms” (Business Dictionary, ND).

Institutions “are the rules of the game in a society, […] the humanly devised constraints that shape human interaction. […] They structure incentives in human exchange, whether political, social or economic” (North, 1990, p. 4).

Why are institutions important?

Institutions are important because they form what is called the ‘enabling environment’ (World Economic Forum, 2015). Institutions move beyond the concept of an organisation to encompass social structures that guide “human interaction and activity” and include formal and informal rules. Institutions are important social structure as they “create stable expectations for the behaviour of others,” and create the incentives for economic and political development (Hodgson, 2006). Institutions therefore provide a framework for social cohesion and long term prosperity Bakir, 2009).

The four key sectors where institutions play the most effective role in promoting growth are “finance, education, justice, and public administration” and as a result, Institutions need to be a consideration for in policy and program design in both the developed and developing world (Paul, 2017).

In particular, strong institutions support economic development by:

  • reducing the costs of economic activity by lowering transaction costs such as search and information costs, bargaining and decision costs, policing and enforcement costs;
  • promoting a return on investment through common legal frameworks (e.g. contract terms and contract enforcement, commercial norms and rules);
  • reducing oppression, corruption and encouraging trust by providing policing and justice systems; and
  • Encouraging collaboration between public-private sectors to increase social capital (Bakir, 2009; Ferrini, 2012; World Economic Forum, 2015).

More specifically, institutions affect the level of production, adoption of new technologies, entrepreneurship and venture creation, environmental protection, ability to attract investment, property ownership, law enforcement, and levels of bureaucracy and red tape. Thus, institutions need to be a key consideration when designing policy and programs.

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Institutions and Policy

Often when transformational policy is required, consideration of the institutional framework is paramount. There are four different types of influences on institutions that practitioners should be aware, these include:

  1. Rational choice: where intuitions are influenced through ‘feedback’ that reinforces the decisions and actions to become norms. For example increasing returns on investments is a positive feedback that reinforces the norm;
  2. Organisational the adoption of common practices (i.e. imitation) and norm from other successful organisations and leaders;
  3. Discursive institutionalism is when self-interests and cognitive ideas are pushed until adopted as norms; and
  4. Historical institutionalism is a mix of the above three where logic and idea have amalgamated over time to become norms (Bakir, 2009).

Practitioners should examine the changes they wish to achieve against identifiable institutions.  Incentives or more specifically, pigouvian penalties can then be designed to help shift behaviours and actions in line policy positions.

Incentive: a moral, coercive or remunerative motive behind an individual’s particular course of action (Johnson, 2005). Incentives do not have to provide positive motivations.

 Pigouvian penalties: is a tax to deter or counterbalance market activities that generate negative externalities (the Economist, 1017).

 Examples:

  • Public transport: Policies to promote public or physical transport uptake may only become effective when society recognises that cars have a negative impact on the environment and are willing to change their behaviour to protect the environment. Policy practitioners may needs to consider the individual rational choice, self-interests and historic institutions that support people to drive cars. For example, if parking was increased in the CBD to support institutional change around driving, does it just push people in to suburban areas where driving is still more cost-efficient? Is advertising to change values and perspectives (self-interests) on driving required? Are additional services or upgrades required to change the efficiency of public transport in addition to car and parking taxes?
  • Welfare: Income welfare that supports disadvantaged people can be relatively ineffective in enabling long term dependents to transition into the mainstream economy when the alternative is low skilled and repetitive work. Thereby dis-incentivising people to transition to employment. Policy practitioners may need to consider if the community, formally or informally, agrees that welfare is a right? If individuals have intergenerational dependency and therefore share similar aspirations? And what are the real incentives that encourage employment and discourage unemployment? Otherwise actions that just consider capabilities will have limited impact.
  • Innovation and technology adoption: for societies wishing to promote innovation and technology adoption, it is also important to look at existing intuitions that may disincentive action. For example what are the red tape barriers (costs) to setting up a business and commercialising ideas? Are there any Government Trading Enterprises that crowd-out the private sector innovations? Are technology rebates and R&D subsidies promoted widely and easily accessed? Does the government have a consistent view and is their machinery (departments and agencies) progressive in their policies?

Finally, strong institutions may not ensure robust growth in the short term but in the long term, a society cannot expect to prosper without them. Thus the policy practitioners need to consider institutional environment when designing interventions.

North, D. C., 1990. Institutions, Institutional Change and Economic Performance, New York, Cambridge University Press.

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