Institutions and efficiency

Institutions are the rules of the game. Some are upheld by law, others by mutual and spontaneous consent and a few by the (brute) force of privileged elites. Some institutions are informal, such as trust and commitment, while others – say, the limited liability corporation – needed co-ordinated action by lawmakers to get established as they did by the end of the nineteenth century.

Modern economic historians tend to explain institutions by pointing at their efficiency-enhancing effects. That works well for a large number of institutions and this is how we shall explain the emergence and persistent use of money as well as the evolution of banks in Chapter 7. Welfare state institutions are explained by the way they resolve potential market failures in private insurance and capital markets (Chapter 10). Private property rights can be seen as solving the inefficiencies of communal property rights; this is known as the tragedy of the commons. The tragedy of the commons is a metaphor for the waste of resources that may occur if there are no restrictions on the use of resources. If all have access to a resource – a forest, say – it will be over-exploited unless there are centrally planned restrictions on its use. The over-exploitation stems from the fact that each individual user generates a cost to others, what is technically known as an externality*.