UNIT 1: INTRODUCTION TO INSTITUTIONAL ECONOMICS

📘 Objective:

To understand the role and types of institutions, their influence on economic systems and
outcomes, and the development of institutional economic thought.

🔹 1. Meaning and Role of Institutions

 Institutions are structured systems (formal or informal) that regulate behavior and
interactions in society.
 They provide stability, order, and predictability in social, political, economic, and
cultural contexts.
 Types:
o Formal: Enforced by law (e.g., government, banks, judiciary).
o Informal: Based on customs and traditions (e.g., family, religious practices).

🔹 2. Types of Institutions

Type Examples
Social Family, marriage, caste, religion
Political Government, parliament, judiciary
Economic Markets, banks, trade unions
Educational Schools, universities
Legal Courts, police
Religious Temples, mosques, churches
Healthcare Hospitals, clinics

🔹 3. Formal vs. Informal Institutions

Feature Formal Institutions Informal Institutions

Origin Legislated by public authority Spontaneous/customary
Enforcement By government or judiciary By social pressure/self-interest
Examples Constitution, contracts Cultural norms, habits

 Public vs. Private Institutions: Not always aligned with formal/informal distinction.

🔹 4. Institutional Environment

 Refers to all formal and informal rules that affect economic transactions.
 Hierarchy includes: values → norms → conventions → laws/rules.
  Douglas North and Williamson emphasize institutions as crucial to economic
performance.

🔹 5. Components of Institutional Structure

 Values: Deep-rooted cultural beliefs about what is "good" (e.g., justice, peace).
 Norms: Expected behavior to uphold values (e.g., fairness, competition).
 Conventions: Practical rules (e.g., driving rules, measurement units).
 Laws: Formalized, enforceable rules.

🔹 6. Institutionalization as a Process

 The development of institutions involves conflicts and choices among values.

 Institutions evolve based on societal consensus, political influence, and historical context.
 Example: Conflict between freedom of speech and religious sentiments.

🔹 7. Effectiveness of Institutions

 Two key conditions (Kasper and Streit, 1999):

1. Widespread acceptance by individuals.
2. Credible sanctions to enforce compliance.
 Requirements for effective rules:
o Generality: Apply equally to all.
o Certainty: Clear and predictable.
o Openness: Allow for adaptation.

🔹 8. Institutions as Enablers and Constraints

 Institutions:
o Reduce uncertainty.
o Facilitate economic transactions.
o Enable contracting and cooperation.

🔹 9. Economic Systems and Governance Structures

 Pure Market Economy: Privately owned production, guided by markets.

 Centrally Planned Economy: State-owned resources and planning.

🔹 10. Subject Matter of Institutional Economics

 Explores both:
o Descriptive: How institutions work.
o Normative: How they should be structured.
 Concerned with designing institutions that promote: Efficiency, Equity, Sustainability
🔹 11. Development of Institutional Economics

📚 A. Old Institutional Economics

 Pioneers: Thorstein Veblen, John Commons, Wesley Mitchell.

 Rejected neoclassical individualism.
 Focused on: Evolution of habits, Conspicuous consumption (Veblen), and Institutions
as social habits of thought.

📚 B. New Institutional Economics

 Key Concepts: Transaction Costs, Property Rights, Contracts

 Emphasis on how institutions reduce market friction and improve efficiency.
 Oliver Williamson and Ronald Coase are key figures.

🔹 12. Marxian Economics (Background Context)

 Karl Marx emphasized: Exploitation of labor, Surplus value, Class conflict

 Marxism critiques capitalism for: Wage suppression, Unequal distribution of resources,
and Institutional reinforcement of capitalist interests

🔹 13. Interrelationship between Legal and Economic Processes

 Legal institutions protect rights, enforce contracts, and regulate markets.

 Economic activity is shaped by: Property laws, Competition laws, Labor laws, and
Environmental regulations

🔹 14. Policy Perspectives and Outcomes of Institutions

 Institutions influence:
o Efficiency of resource allocation
o Equity in distribution
o Stability of governance
 Outcomes depend on: Quality of governance, Degree of corruption, Trust in institutions

📚 References & Thinkers to Remember

 Douglas North – Institutions as humanly devised constraints.

 Oliver Williamson – Transaction Cost Economics.
 Ronald Coase – Nature of the firm, property rights.
 Thorstein Veblen – Habits, conspicuous consumption.
 Karl Marx – Critique of capitalist institutions.
 UNIT 2: PROBLEMS OF INFORMATION ASYMMETRY

📘 Objective:

To understand how asymmetric information leads to market failure, and to explore theoretical
models like adverse selection, moral hazard, and principal-agent problems using tools like game
theory and efficiency wage theory.

🔹 1. Introduction to Asymmetric Information

Asymmetric Information: A situation where one party in an economic transaction possesses

more or better information than the other. This imbalance often leads to inefficient outcomes or
market failures. It is very common in the sectors of Insurance markets, Financial markets,
Labor markets, and Used car markets

🔹 2. Adverse Selection

 Definition: A situation where one party has more information before a transaction takes
place, leading to the selection of poorer-quality goods or high-risk individuals.
 Example: In health insurance, sick people are more likely to buy insurance, driving up
prices and pushing out healthy buyers.
 Akerlof’s Lemon Theory (1970):
o Describes how quality uncertainty in used car markets causes sellers to push
poor-quality cars ("lemons").
o Result: Good quality cars exit the market, leaving only lemons.
 Consequences: Market collapse, Mispricing of products, Hidden risks to buyers

✅ Solutions to Adverse Selection:

 Warranties and guarantees

 Third-party certifications
 Government regulation (Consumer Protection Act, 2019)
 Reputation systems (e.g., online reviews)
 Signaling: Sellers provide credible signals (like maintenance records)
 Screening: Buyers ask for information proactively

🔹 3. Moral Hazard

 Definition: When one party takes on excessive risk because the cost is borne by another.
 It occurs after a transaction.
 Example: An insured person may drive recklessly because the insurer bears the loss.
 In labor markets: Employees shirk responsibility knowing employers can’t constantly
monitor them.
✅ Solutions to Moral Hazard:

 Monitoring systems
 Incentive-based contracts
 Co-payments in insurance
 Performance-linked bonuses
 Transparency and audits

🔹 4. Principal-Agent Problem

 Principal: Person who delegates authority (e.g., shareholders).

 Agent: Person who acts on behalf of principal (e.g., CEO).
 Problem: Agent may not act in the best interest of the principal.
 Agency Costs: Costs incurred to align agent behavior with principal interests.

✅ Solutions:

 Well-designed contracts (link pay to performance)

 Regular reporting
 External monitoring (e.g., auditors)
 Stock options to align interests
 Performance incentives

🔹 5. Efficiency Wage Theory

 Employers pay above-market wages to boost worker productivity and reduce turnover.
 Helps solve moral hazard by reducing shirking and increasing loyalty.

📌 Reasons to Pay Efficiency Wages:

 Attract and retain skilled workers

 Increase productivity
 Reduce absenteeism
 Prevent theft and dishonesty
 Boost morale

🔄 Efficiency Wages vs. Involuntary Unemployment:

 Firms may avoid wage cuts even in recessions, leading to layoffs and higher
involuntary unemployment.

🔹 6. Game Theory and Strategic Interaction

Prisoner’s Dilemma
Two rational players may choose to not cooperate, even if cooperation yields better results. Self
interest leads to sub-optimal outcomes in absence of trust or enforcement mechanisms.

Player B \ Player A Cooperate (C) Defect (D)

Cooperate (C) -2, -2 -10, 0
Defect (D) 0, -10 -5, -5

Nash Equilibrium

A state where no player can improve their outcome by changing strategy unilaterally. Often, in
Prisoner’s Dilemma, (Defect, Defect) is the Nash Equilibrium—even though mutual cooperation
is better.

Dominant Strategy

A strategy that provides a better outcome regardless of what the other player does.In the
classic Prisoner’s Dilemma, defection is the dominant strategy.

🔹 7. Case Studies and Real-World Examples

 Insurance industry: Moral hazard & adverse selection.

 Financial services: Insider trading & misaligned agent incentives.
 Used car market: Lemon problem.
 Corporate governance: Principal-agent conflicts in CEO compensation.

🔹 8. Policy Implications

Regulation is necessary to correct market failures from asymmetric information. Used in:
Consumer protection laws, Disclosure norms, Licensing and certification, and Incentive-
compatible contracts

📚 Key Thinkers & Theories

Thinker Contribution
George Akerlof "The Market for Lemons", Adverse Selection
Michael Jensen & William Meckling Principal-Agent Theory
Joseph Stiglitz Information asymmetry and market inefficiency
Carl Shapiro Game theory applications
John von Neumann Foundational work on game theory
Early observations of trust and wage differences
Adam Smith
(e.g., goldsmiths)

🧠 Summary of Core Concepts

 Concept Definition Example
Asymmetric
Unequal access to information Seller knows car is a lemon
Information
High-risk individuals buy
Adverse Selection Hidden information before transaction
insurance
Moral Hazard Risky behavior after transaction Insured driver speeds
Principal-Agent
Agent's interests diverge from principal CEO misuses company funds
Problem
Wages above market level to boost Google pays engineers high
Efficiency Wages
productivity salaries
Two firms compete rather
Prisoner’s Dilemma Best collective strategy is not chosen
than collude
No player can benefit from changing
Nash Equilibrium Defect-Defect outcome in PD
strategy unilaterally
Best strategy regardless of opponent’s
Dominant Strategy Always defect in PD
move

UNIT 3: EXTERNALITIES AND PUBLIC GOODS

📘 Objective:

To understand how externalities and public goods cause market failures, the importance of
property rights, and the institutional mechanisms that address these issues.

🔹 1. Externalities: Meaning & Types

✅ Definition: An externality is a side effect or consequence of an economic activity that affects

other parties without being reflected in market prices.

Type Meaning Example

Positive Externality Benefits others Education, vaccination
Negative Externality Harms others Pollution, smoking in public

🔹 2. How Externalities Cause Market Failure

Market failure occurs when the private costs or benefits of an action diverge from the social
costs or benefits. In the presence of externalities, the market fails to allocate resources
efficiently. Examples: 1) Factories not paying for air pollution they cause. 2) People under-
consuming vaccines because they ignore the benefits to society.
🔹 3. Ways to Correct Externalities

🔧 A. Government Solutions

1. Regulations/Standards
o Set legal limits (e.g., emission caps)
2. Taxes and Fees (Pigouvian Tax)
o Tax equals marginal social cost (e.g., carbon tax)
3. Subsidies
o For positive externalities (e.g., solar panel incentives)

🔄 B. Market-Based Solutions

1. Tradable Pollution Permits (Cap-and-Trade)

o Firms buy/sell emission rights.
o Creates financial incentive to pollute less.
2. Property Rights Allocation
o Clear rights help private bargaining (Coase Theorem).

🔹 4. The Problem of Social Cost (Ronald Coase, 1960)

Coase Theorem: If property rights are well-defined and transaction costs are negligible,
parties will negotiate to reach efficient outcomes regardless of initial allocation of rights.
For Example: If a factory pollutes a river, it can negotiate with fishermen to reduce pollution if
the rights are clear.

Limitations: High transaction costs, Lack of enforceable rights, and Large number of
affected parties

🔹 5. Concept of Property and Property Rights

✅ Definition: Property rights define the legal ownership and control over resources, goods, or
services.

🔑 Significance: They incentivize proper resource usage, Reduce conflicts over usage,
Encourage investment.

🔹 6. Institutions of Property Rights

Good Property Rights Institutions must have:

1. Clarity: Clearly defined boundaries.

2. Enforceability: Rights must be legally protected.
3. Transferability: Ability to transfer rights.
 4. Exclusivity: Owners can exclude others.
5. Durability: Rights last over time.

🔹 7. Problems of Ill-Defined Property Rights

 Overuse and depletion of resources.

 No incentive for conservation.
 Example: Overfishing in oceans (no ownership = overuse).

🔹 8. Public Goods

✅ Definition: Goods that are:

 Non-rivalrous: One person’s use doesn’t reduce availability for others.

 Non-excludable: People can’t be prevented from using them.

Examples: National defense, Public parks, Street lighting, Clean air

Free-Rider Problem: People benefit without paying → under-provision of public goods.

Market fails to supply these efficiently → government intervention needed.

🔹 9. Common Resources vs. Public Goods

Feature Public Good Common Resource

Rivalrous? ❌ No ✅ Yes
Excludable? ❌ No ❌ No
Example Lighthouse Fish in the ocean

🔹 10. The Tragedy of the Commons (Garrett Hardin, 1968)

✅ Concept: When individuals act in their self-interest, shared resources get overused and
depleted. Example: If everyone grazes cattle on common land, the land becomes barren.

Institutional Solution:

 Privatization: Assign ownership.

 Community management (Elinor Ostrom).
 Government regulation

🔹 11. Case Study: Transfer of Ownership & Disinvestment

Privatization of public enterprises aims to improve efficiency.

  Challenges:
o Loss of social control
o Need for accountability and regulation
 Institutional perspective: Must define ownership, control rights, and regulatory
frameworks.

🔹 12. Theory of Property Rights

Property rights are central to market efficiency. In a world of scarce resources, property rights
enable efficient resource allocation.
Demsetz (1967): Property rights evolve to internalize externalities.

🔹 13. Institutional Role in Externalities & Public Goods

🌐 Institutions Must:

 Set and enforce property rights.

 Provide public goods.
 Regulate usage of common resources.
 Create platforms for negotiation (e.g., pollution trading markets).
 Design laws to address the free-rider and overuse problems.

📚 Key Thinkers & Theories

Thinker Contribution
Ronald Coase Coase Theorem – social cost and property rights
Garrett Hardin Tragedy of the Commons
Elinor Ostrom Community governance of commons
Harold Demsetz Evolution of property rights
Arthur Pigou Pigouvian taxes to correct externalities

🧠 Summary Table

Concept Problem Solution

Externality (−) Over-pollution Taxes, permits
Externality (+) Under-supply Subsidies, public provision
Public Good Free rider problem Government provision
Common Resource Overuse Regulation, privatization
Ill-defined Property Legal frameworks, community
Resource mismanagement
Rights institutions
Depletion of shared
Tragedy of Commons Institutional or private control
resources
 UNIT 4: TRANSACTION COST AND BOUNDED RATIONALITY

📘 Objective:

To understand how transaction costs and cognitive limitations (bounded rationality) affect
economic decisions, contracts, and governance structures.

🔹 1. Transaction Costs: Meaning, Scope, and Nature

✅ Definition: Transaction costs are the costs incurred during an economic exchange, other
than the price of the product or service itself.
Coined by Ronald Coase (1937) in “The Nature of the Firm”.

✅ Types:

1. Ex-ante costs:
o Search and information costs
o Bargaining and contract negotiation
2. Ex-post costs:
o Monitoring, enforcement, dispute resolution

✅ Scope: Present in all markets and organizations. Can determine whether firms choose
markets, hierarchies, or hybrid structures.

🔹 2. Rationale for Transaction Costs

⚙️ Why Transaction Costs Matter:

 Markets are not frictionless.

 People and firms expend resources to: Gather information, Protect property rights, and
Negotiate and enforce contracts

Coase: If market transaction costs are high, firms emerge to internalize transactions.

🔹 3. Issues Related to Transaction Costs

Issue Description
Uncertainty About future outcomes and other parties’ behavior
Asset Specificity When assets are tailored to specific transactions
Frequency How often the transaction occurs
Opportunism Self-interested behavior that exploits the situation
Bounded Rationality Limited ability to predict all contingencies
🔹 4. Identification and Measurement of Transaction Costs

🔍 Difficult to Measure Directly, but observable via:

 Legal and regulatory fees

 Time and resources used in: Contract drafting, Dispute settlement, Negotiations
 Costs of establishing trust and compliance mechanisms

Williamson (1985): Transaction Cost Economics analyzes how transactions are governed in
practice.

🔹 5. Coase Theorem (Ronald Coase, 1960)

✅ Statement: If property rights are clearly defined and transaction costs are negligible, then
private bargaining will lead to efficient outcomes, regardless of initial allocation of rights.

✅ Conditions:

 Clear and enforceable property rights

 No or low transaction costs
 Rational behavior and perfect information

✅ Implications:

 Role of law and regulation is to minimize transaction costs.

 Effective institutional design improves efficiency and equity.

🔹 6. Governance Structures

Structure Description
Market Decentralized exchange governed by price
Hierarchy (Firm) Internal coordination via management
Hybrid Contracts and alliances (e.g., franchises, joint ventures)

Firms use governance structures to minimize transaction costs.

🔹 7. Bounded Rationality

✅ Definition: Term coined by Herbert Simon – people make decisions with limited
information, cognitive limitations, and finite time.

💡 Key Points:
  Individuals cannot foresee every contingency.
 Contracts are incomplete because not all future states can be anticipated.
 Decision-making is satisficing (good enough), not optimizing.

🔹 8. Impact of Bounded Rationality on Transactions

Area Impact
Contract Design Leads to incomplete contracts and scope for renegotiation
Decision-making Simplified rules, routines, and heuristics
Organizational Behavior Structure and routines compensate for cognitive limits

🔹 9. Opportunism and Asset Specificity

🔓 Opportunism:

 Parties may act deceitfully if contracts are incomplete.

 Example: Supplier exploits buyer after investment in specific machinery.

🔑 Asset Specificity:

Investments that are specialized and not easily redeployed. Leads to lock-in, making governance
mechanisms (like long-term contracts or vertical integration) necessary.

🔹 10. Transaction Cost Economics (TCE) – Oliver Williamson

🔁 Goal: Choose the most efficient governance structure to minimize transaction costs.

✅ Three Key Determinants:

1. Frequency: More frequent transactions → internalization more efficient

2. Asset specificity: High specificity → contracts insufficient
3. Uncertainty: High uncertainty → governance structure needed

🔹 11. Bounded Rationality and Incomplete Contracts

🧠 Challenges:

 Parties can’t write fully detailed contracts due to unpredictability.

 Leads to renegotiations, disputes, or strategic behavior.

✅ Solutions: Relational contracts, Long-term agreements, Dispute resolution mechanisms, and

Vertical integration (make vs. buy decisions).
🔹 12. Institutions and Organizational Behavior

 Institutions reduce complexity by: Structuring interactions, Enforcing compliance,

and Setting expectations
 Habits, norms, and routines evolve to guide behavior within bounded rationality.

📚 Key Thinkers & Contributions

Thinker Concept
Ronald Coase Transaction Costs, Nature of the Firm, Coase Theorem
Oliver Williamson Transaction Cost Economics, Governance structures
Herbert Simon Bounded Rationality
Elinor Ostrom Institutional design for complex governance
Douglass North Institutions and economic performance

🧠 Summary Table

Concept Definition Relevance

Costs beyond price in an
Transaction Costs Affects whether to use market or firm
exchange
Limited cognitive ability to
Bounded Rationality Contracts are incomplete
decide
Private bargaining leads to
Coase Theorem Only under low/no transaction costs
efficiency
Asset Specificity Resources tailored to one use Increases risk of opportunism
Requires safeguards like contracts or
Opportunism Strategic, self-interested behavior
trust
Governance
Ways to organize transactions Markets, hierarchies, or hybrids
Structures
 UNIT 5: INSTITUTIONS AND ECONOMIC GROWTH
📘 Objective:

To analyze the relationship between institutions and economic growth, including legal and
international institutions, corruption, institutional reforms, and ecological concerns.

🔹 1. Definition and Role of Institutions in Economic Growth

✅ Definition:

Institutions are the formal and informal rules that structure social, political, and economic
interactions.

Douglass North: “Institutions are the rules of the game in a society.”

📈 Role in Economic Growth:

 Institutions determine incentives, trust, and efficiency in markets.

 Good institutions promote: Property rights protection, Rule of law, Policy stability, and
Fair competition

Weak institutions result in corruption, inequality, and low growth.

🔹 2. Types of Institutions Related to Economic Development

Type Function
Legal Institutions Enforce contracts, protect rights (e.g., judiciary, police)
Political Institutions Shape policy and governance (e.g., legislature, election systems)
Economic Institutions Facilitate production, exchange, and innovation (e.g., markets, central banks)
Social Institutions Influence norms and trust (e.g., family, education, religion)

🔹 3. International Institutions and Development

🌐 World Trade Organization (WTO):

 Promotes free trade

 Resolves trade disputes
 Reduces barriers (tariffs, quotas)

💵 International Monetary Fund (IMF):

 Provides financial assistance to countries

  Stabilizes exchange rates
 Offers technical support and capacity development

🏦 World Bank:

 Offers long-term loans for infrastructure and development

 Focuses on poverty alleviation
 Supports education, health, and sustainability

🕊️ United Nations (UN):

 Promotes peace, human rights, and development goals (SDGs)

 Coordinates humanitarian and environmental efforts

🔹 4. Institutional Reforms and their Need

⚠️ Why Reforms?

 To tackle corruption, inefficiency, red tape, and policy unpredictability.

 To create transparent, accountable, and inclusive systems.

🔧 Areas of Reform:

 Legal system: Reduce case pendency, improve enforcement.

 Regulatory framework: Simplify business rules.
 Property rights: Secure land titles.
 Public service delivery: Digitization and decentralization.

🔹 5. Corruption and Institutional Quality

❌ Impact of Corruption:

 Distorts markets and public spending

 Reduces investor confidence
 Misallocates resources
 Hampers development

✅ Controlling Corruption:

 Strong laws (e.g., Prevention of Corruption Act, Lokpal)

 Independent judiciary and media
 Digital governance (e.g., e-tendering, DBT)
 Transparency and audit mechanisms
🔹 6. Institutions and Ecological & Environmental Concerns

🌍 Need for Environmental Institutions:

 Overuse of common resources (air, water)

 Pollution, climate change, deforestation
 Tragedy of the Commons

🛠️ Institutional Solutions:

 Environmental laws: Pollution Control Acts, Forest Acts

 Market instruments: Carbon trading, green taxes
 Global efforts: Paris Agreement, UN SDGs
 Community-based governance: Elinor Ostrom’s approach

🔹 7. Link Between Institutions and Development Outcomes

Good Institutions Bad Institutions

Enforce rights Enable rent-seeking
Reduce uncertainty Create red tape
Foster innovation Discourage entrepreneurship
Protect environment Permit degradation

Acemoglu & Robinson: Inclusive institutions → prosperity; extractive institutions →

stagnation.

🔹 8. IMF’s Capacity Development Programs

📚 Capacity Development Includes:

 Technical training
 Fiscal and monetary policy advice
 Public financial management
 Tax and customs reform
 Data and statistics management

📌 Why It Matters:

 Builds local capacity for self-sustained governance

 Improves efficiency and transparency
 Aligns national policy with global standards

📚 Key Thinkers & Contributions

 Thinker/Body Contribution
Douglass North Institutions and long-run growth
Acemoglu & Robinson Institutions shape prosperity or failure
Elinor Ostrom Commons governance by local institutions
IMF Financial support and capacity building
World Bank Institutional development and poverty reduction
WTO Trade liberalization and dispute resolution

🧠 Summary Table

Concept Description Example

Institutions Rules and structures governing behavior Constitution, contracts
Transparent, accountable, participatory
Good governance Lokpal, RTI
institutions
Corruption Misuse of public office for private gain Bribery, nepotism
Structural changes to improve
Institutional reform GST, IBC, e-Governance
performance
International
Bodies that aid development IMF, World Bank, WTO
institutions
Environmental MoEFCC, CPCB, Paris
Institutions to protect natural resources
governance Agreement

🧠 Case Studies (for application in exams)

 India’s GST reform: Streamlining tax through a common platform.

 Digital India: Reducing corruption through e-governance.
 RERA Act: Regulatory institution for transparency in real estate.
 IMF and Greece (2009): Financial bailout with structural reforms.
 Community forest management in Nepal: Successful environmental governance by
local institutions.