Institutions and Economic Growth | Free Essay Example

Institutions and Economic Growth

Words: 4338
Topic: Business & Economics


Governance in the community must be performed through institutions that dictate the specific behaviour of the people and groups of people in the community. The power held by specific institutions depends on the mandates that they are granted by the law and their ability to compel other organisations to make decisions parallel to the law. It is vital for governments to develop institutions that consider decisions that are in the best interests of the community. The fundamental responsibilities of the government must be pursued simultaneously; hence, the government needs to develop mechanisms to handle its different courses simultaneously.

It is, therefore, crucial for the government to develop political, economic, and social institutions to handle specific roles. Managing institutions and integrating their efforts provides an opportunity for the government to pilot the community into growth. Economic development should be the primary goal of any government; hence, its institutions must be geared toward helping the community to attain economic growth. It follows that most institutions must keep changing to adapt to the political, economic, and social pressures of the community. The efficiency of the institutions in promoting economic development in a community is dependent on their ability to adapt effectively to the prevailing pressures in the community. This paper looks into institutions and economic growth with a close focus on how the institutions affect development in a community.


Institutions in the community are regulative elements of the government, which are charged with various responsibilities. Institutions utilise government resources to push the community. To understand the effects of institutions on economic development, it is essential to understand the main components of an institution and how the components work. The key components of an institution are its structure of power and the processes of the institution. The structure of an institution is determined by the nature of its course and the distribution of power across its formative departments. Institutions can assume either of the two power structures.

These include a decentralised or centralised structure. In a decentralised institutional structure, the institution works closer to the community to establish the changes that must be made to influence growth in the economy. This structure compels the institution to become more responsive to the needs of the community, rather than pursuing changes blindly. Institutions using this structure are flexible, and they can easily adapt to the changing situations in a community.

They are open to innovation, and they welcome feedback and suggestions from the members of the community. Centralised structures in an institution have a standardised policy; thus, they are rigid in nature. There are fewer conflicts in such institutions because the leaders hold all the power in decision-making. Institutions engage in clear action because their leaderships are anchored in their legal mandates. The second component is the processes within an institution. The processes include the policies governing the activities of the institutions, their routines in handling issues, and the schemes adopted by the institutions (Rodrik, 2008).

How institutions affect economic performance

Institutions influence the attainment of economic goals in a community by developing regulations that must prevail in the quest for developments. Institutions are instrumental in protecting the economy against abusive leadership. Political institutions in government or in the firms help in the development and implementation of the most desirable policies to keep the leaders in check; hence, eliminating predatory behaviour. In democratic states, the presence of institutions provides citizens with avenues to compel the government to undertake local and foreign investment (Polterovich & Popov, 2007).

The institutions also play a major role in protecting the returns of government investments against corrupt political leaders. Economic growth in a country can only be achieved if the government and its institutions strive to protect the national property, and utilise the resources available in the respective nations to expand the financial performance of the countries. In democracies, economic performance depends on the nature of the political regimes in the nation.

The institutions in a given regime must understand the political climate of the nation and compel the government to protect the interests of the people. Institutions work as regulators of the political systems in a nation by ensuring the political leaders do not jeopardise the economic development of the nations. The political systems in a nation do not necessarily have to have a linear relationship with the nature of the institutions in the nation. The only requirement for effective economic performance is the institutions to develop and implement policies that catalyse economic growth (Rodnik, 2000).

Political and economic institutions in a nation are instrumental in the development of the business environment. Economic growth is dependent on the business environment fostered by the policies advocated by government institutions. The policies developed by the institutions are key factors in determining how business is done by the local and international investors within the nation. Regulations, market predictability, and transparency levels in a nation are determined by the goals set by the institutions, and their ability to actualise their objectives (Nikoloski & Commander, 2010).

Investors are particularly interested in operating in a supportive business environment; hence, the ability of the relevant institutions influences economic performance by altering the nature of the business environment. Institutions affect economic performance because they are mandated to respond to the changing business environments locally and internationally. Depending on the effectiveness of the laws developed by government institutions, economic growth can be slower or faster.

It is clear that nations with long-term supportive business environments achieve better economic performance. The institutions of a nation are also charged with the responsibility of measuring the economic performance of the nation through various instruments. Economic performance at the nationwide level can only be measured on a long-term basis; hence, the institutions have to collect data and information longitudinally to evaluate growth.

To create a better understanding of how institutions impact economic performance, the United States and Canada present a good example. During the European invasion period in North America, the European settlers took over the Canadian and United States’ region, and they established their governance in the areas. For a long time, the growth and development of the two regions were parallel to each other, but in the wake of the industrial era, the United States made a big gap between the two regions (Easterly & Levine, 2012).

The two countries took different paths in their economic development, and the United States has emerged in the lead for a long time. Some of the conventional economic elements like the availability of resources have been used to explain the difference in economic growth. It is, however, clear that institutional approaches provide a comprehensive explanation of the difference in growth between Canada and the U.S.

The institutions in the U.S. concentrated on securing property rights, elimination of corruption in the government, and developing efficient financial structures in the nation. Institutions in the U.S. have since developed a strategy for the growth of social capital alongside its promoting entrepreneurial ideas (Sokoloff & Engerman, 2000). In a nation like India where the rights to land ownerships were granted to landlords, investments in agriculture have historically been low; thus, the nation has lower economic growth despite the availability of the resources to influence growth (Banerjee & Iyer, 2004).

Differences between political and economic institutions

Economic growth is dependent on the relationship between the political and economic institutions of the government. The political institutions are responsible for the development of the environment in which economic institutions implement their growth strategies. The economic variables required to influence growth in the economy depend on the political climate fostered by a regime (Flachaire, Garcia-Penalosa & Konte, 2011). To understand the relationship between the political and economic institutions in economic growth, it is important to look at the two institutions individually. Political institutions in a nation comprised of the formal and informal rules and values that guide the political system in making decisions about the country.

The line of action for the political institutions varies from one regime to another, and the decision made by the politicians directly affects the economic development of the nation. Political institutions normally make decisions based on the constraints they face, and their desired goals for the economy and the society. Political institutions in a nation operate with reference to the provisions of the Constitution to achieve lawful decisions on the part of the leaders. The political institutions of a nation assume a hierarchical structure that places the fundamental components of the political system at the top of the structure.

This includes government bodies and their individual rights and powers in decision-making are clearly spelt out in the constitution. The second-highest political institutions in a government operate under the policies made by the arms of the government, and they depend on social factors. For instance, the electorate is a political institution that is developed by the government, but it provides the society with an avenue to decide who rises to the decision-making positions in the arms of the government. Special interest groups in the nation also form political institutions that could be formal or informal. Their work is to ensure the arms of the government are kept in check with relation to their efficiency in implementing the desirable policies (Borner, 2005).

The political institutions are not only dependent on the social factors in a nation, but also the economic approaches used by the government and the private investors. For instance, if private investors develop a new entrepreneurial strategy, political institutions are compelled to react by developing policies that protect new economic activities. Political institutions tailor laws that apply to local and international investors. In so doing, the political institutions must look into the national, regional, and international trends that affect the nation’s economy. The fundamental character that distinguishes political institutions is the concept of power.

In the political institutions, the different systems do not have to collaborate in their decision making; rather, the most powerful institutions make decisions, and the rest follow by force. Political power can influence the political leaders to foster losses or gains for the society as they pursue private interests; hence, the political institutions are empowered by different laws to constrain the power. Political institutions are charged with the responsibility to shape the business environment in a nation in a feasible dimension that enhances economic performance. The ability to attain this depends on the competencies held by the most powerful political institution in the nation (Borner, 2005).

Economic institutions in a nation emerge formally and informally. The formal institutions are developed by the government, and they are mostly constitutional, whereas the informal institutions are developed by private or public entities after long-term business ties. Unlike the political institutions, which must be developed to run a nation effectively, the economic institutions of a nation are developed as a response to economic uncertainties.

Institutions are always changing with the changes in interactions between the business entities in the local and international markets. This character means that the efficiency of the economic institutions in improving economic performance lies in their ability to adapt to the changing business environments. Unlike political institutions, economic institutions gain their power over society by attracting more recognition by the people. Institutions that develop economic policies that are recognised by the government as legally binding have more power to influence economic performance.

Most economic institutions appeal to the government to help them implement their policies through legal backing. This dependent nature of the economic institutions indicates that the economic institutions are predictable in their decision-making. The main goal of the economic institutions is to provide advantages to some business entities to influence growth in social capital. Economic institutions remain predictable for a long time, but their policies are constantly reinforced to adapt to the changing economic environment (Wiggings & David, 2006).

Economic institutions are categorised into three groups depending on their functions. The first category is property rights institutions. These institutions are in charge of developing rights and making decisions on the best policies for the economy. The second category is made by the reciprocal institutions, which primarily deal with facilitating transactions through the implementation of trading rules. They reduce economic risks for the public and private sectors in the nation.

The third category is made by the institutions in charge of managing co-operations and organisation in the economy. They register companies and establish employment tribunals to protect the citizens. The different categories do not have to collaborate in their decision making, but their respective functions form a correlation with the political environment to foster the development of an economic environment that can lead to faster or slower growth depending on the resultant climate (Wiggings & David, 2006).

Impact of institutions on economic growth and development

The outcomes that follow the development of institutions to pilot economic growth can either be positive or negative depending on the efficiency of the institutions. Institutions may propagate or eliminate corruption in political institutions. Corruption is the leading cause of poor economic performance in nations; hence, its elimination would ultimately lead to an increase in the economic performance of a nation. In a corrupt nation, political leaders are likely to place their private interests first in their decision-making, and they tend to gain while the members of society lose economically (Aidt, 2009).

Institutions are erected to keep the political leaders in line with the desired behaviour. Institutions eliminate corruption by improving transparency in government processes. Whether they are formally or informally formed, institutions have the power to probe into the issues facing the government and mobilise the people to influence the leaders to make the most appropriate decisions that enhance the chances of higher economic performance. The economic institutions and political institutions must attain high cohesion in any regime to ensure the political leaders are futuristic in the development of a stronger economy (Lee & Kim, 2009).

Institutions increase the economic performance in a nation by improving the efficiency of the government. The government is constantly faced with economic challenges nationally and internationally, and its institutions come in handy in the development of the best countermeasures. For instance, the financial institutions have the mandate to determine the best way to allocate national funds to various development projects in the national budget. The efficient allocation of government revenue to the most profitable development projects leads to economic growth.

Institutions also impact economic growth by influencing the nature of the policies developed by the government. The economic and political environments in a nation are important because they determine the number of investors willing to operate in the nation. The emergent economies in the world can attain sustainable growth through the efficiency of their political and economic institutions, especially in the implementation of policies (Siddiqui & Ahmed, 2009).

The correlation between institutional quality and economic growth shows a linear relationship between the two variables. When the institutions in a nation are high-quality with relation to their functionality and ability to implement the appropriate policies, economic growth is guaranteed. Institutional quality is transmitted to economic development through complex relationships that are developed on a cause and effect basis.

Both economic development and institutional quality are subject to other factors, but it has been observed that if the institutions influence the development of a good business environment, growth is achieved in a nation. It is important to understand that institutional quality and economic growth have a linear relationship only when other factors affecting economic growth are held constant. It is also important to understand that the quality of the institutions may eliminate the negative factors affecting economic growth; thus, the sentiment that when the institutions are efficient in their work, economic growth is guaranteed (Docquier, 2014).

When considering the GDP performance of the emerging economies in the world, it is apparent that most of the nations have similar resources. Despite similar resources, some of the emerging markets are recording faster growth in their economies than their counterparts. While many explanations have been developed through literary works, it is clear that the quality of their political and economic institutions is the main reason for the gap in growth.

The analysis of the quality of institutions in a nation may save many countries economic performance because there is sufficient evidence that growth and institutional performance go hand-in-hand. The difference between the developed and the developing nations is the quality of the institutions because both groups attain economic development but in varying quantity. The developed nations have high-quality institutions that influence faster growth in the economy, whereas the weak institutions in the developing nations struggle to foster economic growth (Valeriani & Peluso, 2011).

Determining institutions

Institutions in a nation are developed formally on informally. Political institutions are formed formally, and their operations are determined by the provisions of the Constitution and other rules developed by the arms of the government. Institutions are normally developed with the aim of influencing the development of specific policies, and they ensure the policies are implemented accordingly. In essence, political institutions are normally rigid in their advocacy, but they can alter their approaches to influence the politicians to take responsibility.

The legal recognition of the political institutions grants them more power to influence the nature of politics in the nation. The political institutions determine the political constraints in a nation, and the responses employed toward alleviating the adverse effects of the constraints. In so doing, political institutions develop a ground for the establishment of social and economic institutions. Economic institutions are also developed formally or informally, depending on their purposes (Zouhaier & Kefi, 2012).

Their ideas are embraced by the public, and sometimes by the political institutions, and they may foster the development of certain incentives for business. The economic institutions are distinguished by their activities in society. Some institutions are established to protect the rights of business industries and the players in the businesses. Other institutions are developed to influence the development of policies that determine the nature of the incentives offered to investors by the government. There are also institutions developed to make the business environment favourable to the employees. These different institutions are identified on the basis of what they bring to the table in the government (Easterly, 2008).

Understanding/modeling institutional changes

The economic and political variables in a nation are never constant; hence, institutions also never remain rigid. Constant changes in the institutions are influenced by the need for the systems to adapt to the changing economic and political environments. For instance, when a regime is over, the political institutions of the nation in question are bound to change, and this creates a new environment for the economic and social institutions. This relationship indicates that the changes in the political institutions are instrumental in the development of changes in other institutions in a state.

The political institutions in a nation allocate power to the economic and social institutions; hence, for one to understand the institutional changes in the economic institutions, reviewing the political institutions provides a comprehensive explanation. The political institutions, on the other hand, are subject to social pressures, and the people are the determinants of the decisions made by the political institutions. Changes in the economic institutions occur when the political institutions empower them. This power enables the economic institutions to implement their innovative ideas through the alteration of various economic variables (Acemoglu, Johnson & Robinson, 2004).

Institutions are adaptive in nature; hence, any changes that occur in the institutions are normally designed to counter some internal or external pressures. Institutions are used as tools for the society to attain social and economic growth; thus, institutional changes are normally influenced by changes in the society. For instance, economic institutions are designed to develop policies that interact with other economic variables like the budgets and technological capabilities to influence positive growth.

When the economic variables change, the institutions are compelled to make small or fundamental changes to accommodate the new constraints. Modelling institutional changes entails four variables. These include agents, the sources of the changes, the process of change, and the direction of the changes. The agents of change in an institution emanate from the innovative ideas developed by the members of the institutions. The ideas are normally developed as responses to internal or external factors affecting the quality of the institutions. The perceptions of the leaders in the institutions determine the decisions made with respect to changes (Kingston & Caballero, 2008).

Sources of changes in institutions are normally adaptive processes that create better opportunities for the institutions to foster economic growth. Changes in the political system are some of the common sources of changes in the economic institutions. Changes in economic institutions also originate from internal pressures from the entrepreneurs. Entrepreneurs normally protest when the costs of operating in a nation are increased by the policies developed by the institutions, and they may lead to the fundamental changes in how the institutions operate.

Institutions that deal with the development of policies in the economic environment have to respond to the changing demands of the local and international investors. Altering the frameworks of the institutions must be evaluated for viability in terms of the costs to the economy. Changes in institutions may also originate from the need to develop a new structure that enhances the quality of the institutions. For instance, as the developing nations experience faster growth in their economies, their economic institutions start dealing with international constraints, and they may choose to dismantle the existing structures to build stronger structures that can deal with the emerging issues.

Institutions may also implement changes in their policies when new laws affecting their powers are passed. For instance, when there is a new statute, institutions are likely to alter their policies to attain parallelism with the provisions of the new statute. Changes may also emanate from the gradual tailoring of the institutional norms (Kingston & Caballero, 2008).

The process of change entails factors like the resources used by the institutions to influence changes and the time used to achieve the changes. While some changes are revolutionary, others are gradual and unplanned. In most cases, the leaders and the members of the institutions develop changes that guarantee more benefits that the associated costs. This provision means that institutions must develop plans to achieve structural, formal or informal changes that not only benefit them, but the changes should also benefit the entrepreneurs in the local market. The process of change in an institution is a sensitive matter that should be handled with care to achieve the desired goals (Kingston & Caballero, 2008).

The direction of change is normally biased in institutions because the objectives of the existing institutions prevail. The changes are normally positive, but their outcomes may have varying contributions to national changes. For instance, in the developing nations, when the institutions implement changes, the resulting influences do not necessarily boost the economies by any significant margins. The internal economic factors in a nation do not affect the income level of the people, but the institutional adaptations in the nations influence the direction of economic development (Easterly & Levine, 2002).


Institutions are structures developed by the society to pursue social, economic, and political interests. The institutions are instrumental in fostering growth and development in a nation, and their effectiveness in delivering the same depends on their quality. The key components of an institution are its structure of power and the processes of the institution. The structure of an institution is determined by the nature of its course and the distribution of power across its formative departments. In democratic states, the presence of institutions provides the citizens with avenues to compel the government to undertake local and foreign investment.

The institutions also play a major role in protecting the returns of government investments against corrupt political leaders. Political and economic institutions in a nation are instrumental in the development of the business environment. Economic growth is dependent on the business environment fostered by the policies advocated by government institutions. The line of action for the political institutions varies from one regime to another, and the decisions made by the politicians directly affect the economic development of the nation. Political institutions normally make decisions based on the constraints they face, and their desired goals for the economy and the society.

The outcomes that follow the development of institutions to pilot economic growth can either be positive or negative depending on the efficiency of the institutions. Institutions may propagate or eliminate corruption in the political institutions. Institutions increase the economic performance in a nation by improving the efficiency of the government. The government is constantly faced with economic challenges nationally and internationally, and its institutions come in handy in the development of the best countermeasures. Indeed, institutions are the key to positive economic performance.


Acemoglu, D., Johnson, S., & Robinson, J. (2004). Institutions as the fundamental cause of long-run growth. Web.

Aidt, T. S. (2009). Corruption, institutions, and economic development. Oxford Review of Economic Policy, 25(2), 271-291.

Banerjee, A., & Iyer, L. (2004). History, Institutions and Economic Performance: The Legacy of Colonial Land Tenure Systems in India. Web.

Borner, K. A. (2005). Political institutions and incentives for economic reforms. Web.

Docquier, F. (2014). Identifying the effect of institutions on economic growth. Web.

Easterly, W. (2008). Design and Reform of Institutions in LDCS and Transition Economies: Institutions: Top Down or Bottom Up? American Economic Review: Papers & Proceedings, 98(2), 95-99.

Easterly, W., & Levine, R. (2002). Tropics, Germs, and Crops: How Endownments influence economic development. Web.

Easterly, W., & Levine, R. (2012). The European Origins of Economic Development. Web.

Flachaire, E., Garcia-Penalosa, C., & Konte, M. (2011). Political versus Economic Institutions in the growth process*. Web.

Kingston, C., & Caballero, G. (2008). Comparing Theories of Institutional Change. Web.

Lee, K., & Kim, B. Y. (2009). Both Institutions and Policies Matter but Differently for Different Income Groups of Countries: Determinants of Long-Run Economic Growth Revisited. World Development, 37(3), 533-549.

Nikoloski, Z., & Commander, S. (2010). Institutions and economic performance: What can be explained? Web.

Polterovich, V., & Popov, V. (2007). Democratization, quality of institutions and economic growth. Web.

Rodnik, D. (2000). Institutions for High-quality growth: What they are and how to acquire them. Web.

Rodrik, D. (2008). One economics, many recipes: globalization, institutions, and economic growth. New Jersey: Princeton University Press.

Siddiqui, D. A., & Ahmed, Q. M. (2009). Institutions and Economic Growth: A Cross country Evidence. Structural Change and Economic Dynamics, 24(2013), 18-33.

Sokoloff, K. L., & Engerman, S. L. (2000). History Lessons: Institutions, Factor Endowments, and Paths of Development in the New World. Journal of Economic Perspectives, 14(3), 217-232.

Valeriani, E., & Peluso, S. (2011). The impact of Institutional quality on Economic Growth and Development: An Empirical Study. Journal of Knowledge Management, Economics and Information Technology, 1(6), 1-25.

Wiggings, S., & Davis, J. (2006). Economic Institutions. Web.

Zouhaier, H., & Kefi, M. K. (2012). Institutions and Economic Growth. Asian Economic and Financial Review, 2(7), 795-812.