How do you build effective institutions that support growth and poverty reduction? This chapter from the 2002 World Development Report sets out a diagnostic framework for building effective institutions. It argues that improvements in living standards and in the lives of poor people depend on institutions that support markets and poor people’s access to them.
Market opportunities are limited by the transaction costs resulting from inadequate information, incomplete definition of property rights and barriers to entry for new participants. Institutions support markets by helping to manage the risks of market exchange, increasing efficiency and raising returns. The positive relationship between economic development and institutional success is widely documented, but not all institutions lead to growth, nor is there one set of institutions which guarantee growth.
Institutions have three main functions:
- They channel information about market conditions, goods and participants. They can affect the production, collection, analysis, verification and dissemination of information. There is a need to identify who needs information on what.
- They define and enforce property rights and contracts, determining who gets what and when. Knowing one’s rights and being able to defend them are essential for successful market development, and institutions need to help reduce potential disputes.
- Institutions increase or decrease competition in markets. Competition gives people incentives to perform better, makes it more likely that resources are allocated on the basis of merit, and increases innovation. However some institutions may impede competition, for example by overregulating.
The first step in building effective institutions is to identify any institutional ‘gaps’ in these three areas. The next step is to design appropriate institutions, taking account of demand and supply and aligning the incentives of market actors to produce the desired outcome. There are four key approaches to institution building that hold across all countries and sectors:
- Complement what exists: There may be a need for complementary institutions, for example laws promoting transparency and law enforcement. Several other factors need to be considered, such as the costs of institutional arrangements, the quality of human capital and how technical standards should be applied.
- Innovate to identify institutions that work: In transferring institutions, innovations can make up for the differences between countries. Policy makers can adopt local innovations but need to flexible enough to drop unsuccessful ones.
- Connect communities through information flows and trade: Trade openness can create demand for strong institutions to support markets, and is significantly correlated with institutional effectiveness. Improving information flows can improve the quality of institutions and increase the demand for strong institutions.
- Promote competition among jurisdictions, firms and individuals: Competition makes institutions more or less effective by changing the incentives of agents. Sometimes institutions that limit competition may be desirable, for example to promote stability or aid the adoption of a new technology.
- Finally it is important to take into account political forces, social pressures and shocks. An institution exists partly because certain constituencies benefit from it and therefore support it. Economic analysis may argue for a certain design but political and social realities need to be considered.
