Institutions

Overview of Individual Rules and Enforcement

Rules without obligatory sanctions are useless. When sanctions are no longer applied, institutions collapse. It should also be noted that institutions are man-made, not physical constraints on human action.

Human nature is such that self-seeking individuals will all too often make promises, but later forget them or shirk on fulfilling them.

Our instincts play a big role in this sort of opportunism Opens in new window, and institutions support the control of our innate instincts in the interest of effective cooperation between people over the longer term (Hayek, 1979a, pp. 165 – 173; 1988, pp. 11 – 28).

Institutions and Trust

Institutions are rules of conduct, a means of channeling people’s actions. By channeling the structure of pay-offs, incentives Opens in new window and disincentives, institutions effectively rule out certain actions and narrow the range of possible reactions.

Thereby they make the actions of others more predictable and give social interaction a certain structure. Institutions provide a kind of ‘external scaffolding’ for human choice and learning (Drobak-Nye (eds) 1997, pp. 269 – 290; Leibenstein, 1984).

Indeed, by facilitating predictability and preventing chaos and arbitrary behavior, institutions establish trust and allow people to economize on the costly search for knowledge. Even if rule-bound behavior (behaviour) does not offer 100 percent certainty, it can be perceived as more probable and plausible than chaos.

Institutions normally reflect what has proven useful in the past and what is needed for people to interact with others in pursuit of their diverse individual objectives. In that respect, institutions are storehouses of knowledge acquired by past generations.

In the face of ever-present knowledge problems Opens in new window, institutions give people a degree of confidence that the interactions in which they are engaged will occur as expected. This lowers the costs of information search, a difficult and risky business. Appropriate rules of conduct reduce the costs of transacting business or cooperating within an organization Opens in new window.

Without trust in the wider framework, individuals would often not be able to concentrate on exploiting knowledge Opens in new window in their specialization or to find knowledge in new areas. Numerous useful actions would simply never take place (Hazlitt, 1988/1964, pp. 53 – 61).

Humans often try to cope with the knowledge problem by thinking through an overall strategy that sets a framework of rules for individual actions before they act. Lest people be overwhelmed by ad hoc decisions and mal-coordination in the heat of battle, all bind themselves in their tactical day-to-day decisions by this strategy and keep necessary tactical changes within the overall strategy.

Given cognitive and other limitations of human nature, institutions to be effective have to be easily knowable.

This is not the case when rules proliferate, when they are purpose-specific, rather than abstract, or when rule systems become inherently contradictory. Nor should institutions discriminate between different people, giving some groups as preference over others.

In that case, institutions would be less likely to be obeyed and would less effectively serve their function of economizing on transaction costs. Institutions that are anchored in a community’s fundamental values Opens in new window are more likely to be effective than institutions that are foisted on the community from outside or contradict its fundamental mores.

There is also an inter-temporal dimension to effective institutions:

The advantage of stable institutions is that people have adjusted to old institutions to the best of their ability and have acquired a practice of following them almost automatically.

Stability Opens in new window reduces enforcement costs, improves reliability, and hence facilitates human interaction. However, excessive stability can become a vice. It may lead to institutional rigidity, even when circumstances change and make institutional adjustment desirable.

Hence, there must be some scope for adjustment. Hayek made this argument incisively in his essay ‘Why I am Not a Conservative’ (Hayek, 1960, pp. 395 – 411). When rules are open, that is, when they apply to an indeterminate number of future cases, rigidity is less of a problem than if the rules are case-specific. Nonetheless, even open rules may require adaptation if coinditions evolve.

To illustrate how appropriate rules establish trust and why this is essential for effective interaction, we can look at football rules:

• They stipulate certain types of behavior (behaviour) of the players and obligatory sanctions for rule infringements.
• The rules are simple and certain (no ifs, ands or buts!), hence knowable.
• They are abstract in that they do not apply only to one particular game or one player, and they are open-ended in that they apply to an infinite number of future games.

Thanks to these qualities, the rules shape the behavior (behaviour) of the players, or—as institutional economists would say—are normative of their behavior (behaviour), making it predictable.

Now imagine if these qualities are suspended: the referee rules on every move and goal in a discretionary manner. Instead of abstract rules, he decides case-by-case, giving preference to some players, possibly on the basis of expediency, and changes the implicit rules all the time.

The football game would at best end in conflict and total confusion, and at worst could not be played at all. Even a deluge of directives from the referee would not coordinate the players on the two sides.

Likewise, case-by-case regulation and intervention in civil and economic interaction destroys trustworthy rules and leads to disintegration of a healthy society and economy. It was a great contribution of the ancient Romans to Western civilization that the praetors of the Roman Republic (the law enforcers) Opens in new window announced rules under which they would act. From this initiative, transparent, stable law evolved, on which people could rely.

Institutions may also be categorized as to how they are framed:

1. They may be prescriptive, instructing people precisely what actions they must take to achieve a specific outcome, for example to move from point A to point B so as not get a speeding ticket.
2. They may be proscriptive, ruling out certain classes of unacceptable behavior (behaviour), for example not to exceed a speed limit or not to steal.

Examples for proscriptive institutions are many of the Ten Commandments Opens in new window, which rule out certain classes of action — ‘ thou shalt not …’ .

Another example is the well-known Hippocratic oath (named after Greek doctor Hippocrates, fifth century BC) Opens in new window, which instructs medical practitioners not to harm the patient.

Both types of institutions coordinate peoples’ actions.

Prescriptive rules are an essential part of a planned, coercive order, whereas rule-bound behavior (behaviour), which is guided by proscriptions, is typical of spontaneous orders, such as the rules that coordinate people active in markets by an invisible hand (Sudgen, 1986).

One important difference between proscriptive and prescriptive institutions needs to be underscored.

Those who prescribe from the center (centre) what others must do—those who give instructions and directives—need much more specific knowledge than those who only rule out certain types of action. If one prescribes, one has to be aware of the means and capabilities of the actors, as well as of possible conditions for, and consequences of, the prescribed actions.

Those who rule out—proscribe—certain types of behavior (behaviour) only need to know that certain actions are undesirable, but those at the center (centre) are able to leave the specific details and the evaluation of consequences in the field to the actors who are directly involved.