Informal institutions

What Are Informal Institutions?

Informal institutions are unwritten, socially shared rules, norms, and conventions that guide human behavior and interactions within an economy. Unlike formal institutions, which are codified in laws, regulations, and contracts, informal institutions operate through customs, traditions, ethical codes, and shared beliefs. These deeply ingrained societal elements significantly influence economic governance and decision-making, often impacting the effectiveness of formal rules. They are a core component of institutional economics, a field that examines how institutions shape economic behavior and performance.

Informal institutions can range from universally accepted principles like honesty and reciprocity to more specific cultural practices that dictate business conduct or resource allocation. Their presence, or absence, can profoundly affect everything from transaction costs in markets to the broader landscape of economic development.

History and Origin

The concept of informal institutions gained prominence within economics largely through the work of Nobel laureate Douglass C. North. North, along with Robert W. Fogel, was awarded the 1993 Nobel Memorial Prize in Economic Sciences for their pioneering research in economic history, specifically for applying economic theory and quantitative methods to explain economic and institutional change.⁴ North’s work emphasized that institutions, both formal and informal, provide the underlying structure of an economy, shaping incentives and determining economic outcomes. He argued that simply adopting formal rules from developed economies often fails in developing nations because the underlying informal institutions—the beliefs, norms, and shared mental models—are not aligned.

In his 1992 paper "Institutions and Economic Theory," North highlighted the limitations of neoclassical economics, which often assumes perfect rationality and complete information, by underscoring the role of culturally influenced mental models and the complexities of human information processing. This ³perspective highlighted that informal rules, shaped by history and culture, are critical for understanding how societies function economically.

Key Takeaways

• Informal institutions are unwritten rules, norms, and conventions that guide economic and social behavior.
• They include customs, traditions, codes of conduct, and shared beliefs, complementing or sometimes conflicting with formal laws.
• Nobel laureate Douglass C. North significantly advanced the understanding of how informal institutions influence economic performance and development.
• Their strength and alignment with formal rules are crucial for reducing transaction costs and fostering trust in markets.
• Understanding informal institutions is essential for effective policy-making and fostering sustainable economic development.

Interpreting Informal Institutions

Understanding informal institutions involves recognizing that human behavior is not solely driven by formal laws or economic rationality but also by deeply embedded social and cultural factors. For example, in some cultures, verbal agreements carry significant weight due to strong norms of trust and honor, even in the absence of written contracts. In others, these informal promises might be less reliable, requiring more formal contract enforcement mechanisms.

The interpretation also extends to recognizing the interplay between formal and informal rules. Effective governance often relies on formal institutions being congruent with prevailing social norms and cultural values. When formal rules clash with strong informal traditions, the informal often prevails, potentially leading to inefficiencies or the growth of an informal economy. Analysts interpret informal institutions by observing repeated patterns of behavior, unwritten codes of conduct, and the underlying beliefs that shape collective action.

Hypothetical Example

Consider a small, close-knit community where most business transactions, such as borrowing tools or exchanging goods, are based on handshake agreements and word of mouth rather than formal contracts or written invoices. This is a classic example of reliance on informal institutions. The shared social norms of reputation and community pressure serve as effective enforcement mechanisms.

If a community member, Sarah, borrows a farming tool from John with a verbal promise to return it by week's end, the expectation of timely return is enforced not by a legal document, but by the community's informal institution of trustworthiness. If Sarah fails to return the tool, her reputation within the community would suffer, potentially leading to social ostracization or a refusal by others to engage in future informal exchanges. This fear of reputational damage, an informal sanction, effectively ensures compliance and keeps transaction costs low, demonstrating how informal institutions facilitate economic activity without the need for complex formal legal frameworks.

Practical Applications

Informal institutions manifest in various aspects of investing, markets, and economic analysis. In emerging markets, where formal legal systems may be weak or nascent, informal networks, family ties, and traditional business practices often play a crucial role in facilitating transactions, providing capital, and managing risk. For instance, diaspora networks frequently leverage shared cultural values and trust to fund new ventures or manage trade across borders where formal financial intermediaries are less developed or reliable.

Furthermore, informal institutions like ethical norms can influence corporate governance and investor behavior. While regulations dictate reporting standards, the informal expectation of transparency and corporate social responsibility can motivate companies to go beyond minimum compliance. Research indicates a significant positive relationship between a nation's level of trust (an informal institution) and its per capita real GDP growth, suggesting that societies with higher levels of trust experience stronger economic prosperity. This ²highlights how a robust informal institutional framework can reduce the costs of doing business and encourage greater market efficiency.

Limitations and Criticisms

While informal institutions can reduce transaction costs and foster cooperation, they also present limitations and can face criticisms. One major drawback is their inherent lack of transparency and enforceability compared to formal institutions. As they are unwritten and context-dependent, informal rules can be ambiguous, difficult to ascertain for outsiders, and susceptible to subjective interpretation. This can create uncertainty, particularly for large-scale investments or interactions with unfamiliar parties, increasing risk management challenges.

Another criticism is that informal institutions, especially those based on tradition or social hierarchy, can hinder innovation and equitable economic development. For example, deeply entrenched customs might resist necessary economic reforms or perpetuate practices that limit access to opportunities for certain groups, such as restricting property rights or access to credit based on lineage rather than merit. The field of "Law and Economics" often highlights how formal legal systems aim to overcome such inefficiencies by establishing clear, universally applicable rules and providing mechanisms for dispute resolution, thereby promoting a more predictable and efficient economic environment than what might arise from informal rules alone. When ¹informal institutions are misaligned with the goals of a modern economy, they can lead to corruption, rent-seeking, and a lack of accountability, ultimately stifling growth and reducing societal welfare.

Informal Institutions vs. Formal Institutions

Informal institutions and formal institutions are two distinct but interconnected categories of rules that govern economic and social interactions. The primary difference lies in their codification and enforcement mechanisms.

Confusion often arises because these two types of institutions interact constantly. For example, the formal rule of law relies heavily on the informal institution of trust in the legal system and a shared understanding of justice. Conversely, formal regulations can gradually influence and even alter informal norms over time. A robust economic system typically features a dynamic interplay where formal institutions complement and reinforce constructive informal institutions.

FAQs

Q1: Can informal institutions change?

Yes, informal institutions can change, though typically at a slower pace than formal institutions. They evolve gradually through shifts in societal beliefs, repeated interactions, and the influence of new generations or external factors. For instance, the rise of e-commerce has led to the development of new informal norms around online trust and digital reputation. Behavioral economics often studies how these norms form and influence decisions.

Q2: Why are informal institutions important in finance?

In finance, informal institutions are crucial because they underpin the very concept of trust and expectation, which are fundamental to contracts, credit, and investment. For instance, an investor's decision might not only be based on a company's financial statements (formal institution) but also on the perceived integrity and reputation of its management team, which is an informal assessment. They affect the market microstructure by shaping how participants interact and exchange information, even informally.

Q3: How do informal institutions affect market efficiency?

Informal institutions can significantly affect market efficiency by influencing transaction costs and the level of trust among market participants. Strong, positive informal institutions—like a culture of honesty and reliable business ethics—can reduce the need for extensive formal oversight, lowering costs and increasing the speed of transactions. Conversely, weak or counterproductive informal institutions can raise these costs, reduce participation, and impede efficient resource allocation.