Understanding the role of institutions in the economy: A mathematical approach

Over the past couple of decades it has become more and more recognised in economics that socio-economic institutions are essential for the functioning of the economy. This research has emanated from the seminal work of Douglas North in his study of various economic systems throughout economic history and of Ronald Coase in the understanding of hierarchical organisations and mechanisms in market economies.

This reasoning has recently been extended by Daron Acemoglu to a wide variety of environments, the main one being the influence of political institutions on economic performance in his work with James Robinson. (I refer here to the very accessible account of this work in their book Why Nations Fail: The Origins of Power, Prosperity and Poverty.)

Together with Emiliya Lazarova and Pieter Ruys, I have been working on a mathematical theory that gives expression to the essential nature of institutions. We interpret institutions mainly as guidelines or rules that people apply to build socio-economic relationships. These rules should provide economic stability in the sense that the economy tends to a stable state in which prosperity can be achieved regardless of how exactly the production technologies or preferences in the economy change. Thus, while production technologies and preferences evolve, the institutions are in some sense timeless and provide the possibility to achieve stability regardless of these changes.

Our mathematical analysis shows that the institutional structure of the economies that humans devised throughout history are indeed the ones that provide stability. There are three major institutional structures that provide such stability:

  • The creation and assumption of socio-economic roles through specialisation of human capital. By assuming professional roles in the economy and following certain well-established rules of how one should act in these professional roles, all of us together provide a stable foundation for economic development. This started out as hunters and gatherers in the most primitive, tribal economies and it evolved into our highly complex 21st century global economy in which we assume a multitude of diverse socio-economic roles through professional specialisation.
  • The second major institution is that of social hierarchy. By assigning individuals to positions of authority over other individuals, the economy is stabilised and is able to prosper. Social hierarchies have been around from the dawn of mankind. Political leadership usually coincides with economic power and control. Kings, knights, bishops and monastic priors used to exercise control over large groups of productive individuals, resulting in wealth creation in the medieval, feudal economy. This evolved into capitalist systems of democratic governmental authority and hierarchical social production systems in which leaders control subordinates. Our conclusion is that social hierarchies are very effective institutional structures that provide stability irrespective of the productive abilities of these individuals.
  • Finally, the role of market makers and platform entrepreneurs is crucial in the functioning of the economy. By binding the economy across differentiated local markets and creating a global economy, the economy again provides a foundation of stability and the accommodation of wealth creation through a wide variety of socio-economic processes. It is recognised here that “markets” do not emerge naturally, but are explicitly created by market makers and platform providers. (These platforms include markets as centralised trading places, operating systems, chain stores and systems of laws and rules that conduct how we interact with each other.)

Our mathematical theory shows that these three fundamental forms of socio-economic institutions are effective stabilisers of the processes that occur in any economy. This points away from the point of view promoted in traditional neoclassical economics that wealth creation is driven only by markets and the incentives emanating from market institutional arrangements. It is also an indication that we still are far away from a deep understanding of how the economy functions and that lessons for our ongoing economic crisis should be drawn from an institutional perspective.

A preliminary draft of the paper can be found on my economic theory page.

The paper has now been published in the Journal of Economic Behavior & Organization.