Q: Would you agree with the definition of an institution as a set of rules designed to reduce transaction costs?
A:I believe that some institutions have arisen specifically to reduce transaction costs, usually to solve asymmetric information problems though this is not necessary.
North (1991) defines institutions as those man-made rules that determine transaction and productions costs together with the standard constraints of economics. He also argues that institutions determine the cost of transaction – by raising the benefits of solutions or by increasing the cost of cheating – thus making economic activity possible.
Akerlof’s (1976) paper on the function of the lemons market points to the importance of having an institution exist to solve the lemons problem. Grief (1993) in his study of the Maghribi trading coalition explains the functioning of an institution that arose to solve an information problem. The solving of this information problem in turn guaranteed the existence of economic activity (trading) by reducing the transaction cost that would have otherwise been too high to support the economic activity.
Institutions can, however, also be seen as the end result of an evolutionary process which does not necessarily benefit everyone, or increase overall welfare (Sugden 1989). In such an argument, the reason for the existence of certain rules is not they solve information problems or reduce transaction costs necessarily but simply that enough people follow them. Every individual who obeys these rules stands to gain given the expectation that every other individual will also obey these rules.
Sugden (1989) proposes the idea of institutions as spontaneously arising rules that may or may not be efficient solutions. He argues that certain rules arise in society simply because other people follow it. Also, anyone following this rule expects to do as well, if not better, than anyone else following other competing rules. Viewed this way, institutions as a collection of rules don’t necessarily have to reduce transaction costs. In fact, Sugden argues that in many instances, institutions arise that are not pareto –efficient. They “need not be well adapted to the problems of coordination they resolve”.
So, while the definition of institutions as a means of reducing transaction costs is reasonable, it is not complete. Some institutions certainly do not solve transaction costs (the layout of the keyboard I am typing on for example) – for these rules, one must extend the definition to include the concept laid out in Sugden’s 1989 paper.