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In civilized society [man] stands at all times in need of Individuals, when deciding to comply, either with
the cooperation and assistance of great multitudes. In taxes or with a contractual obligation, have three rea-
almost every other race of animals each individual, sons to do so. First, because of an individual or “inter-
when it is grown up to maturity, is entirely indepen- nalized” norm, such as honesty, which may be founded
dent, and in its natural state has occasion for the assis- in a shared belief system, such as a religion or in a sense
tance of no other living creature. But man has almost of obligation to one’s peers. Second, because deviant
constant occasion for the help of his brethren. action will be not be socially tolerated by others and
—Adam Smith, 1776 this lack of acceptance will result in some form of so-
cial sanction. Third, because of an economic sanction
associated with the deviation, such as a fine, imprison-
I
mmigrants in California raise credit through rotat- ment, or denial of future business, often with added
ing credit associations rather than from banks. social stigma attached to the economic punishment.
Small traders in Mexico use informal mechanisms Formal institutions focus on the third incentive and
rather than courts to resolve disputes. Bankers in Japan thus can be ineffective if this economic sanction is
seal deals with a handshake rather than a legal con- weak.
tract.1 All three groups rely on institutional arrange- Norm-based institutions can supplement or sup-
ments far removed from the formal constructs of gov- plant laws and formal rules. They may substitute for
ernments and modern organizations. In all societies formal institutions where the latter do not exist or are
systems based on social norms or networks—alterna- not accessible or where they fail to facilitate business
tively referred to as informal institutions and some- transactions. In these cases informal institutions allow
times as “culture”—are a central means of facilitating those sharing norms or culture to behave predictably,
market transactions.2 Such norm-based institutions are lowering the risks in a transaction (chapter 1).4 Cor-
especially critical for the poor, who often lack formal rupt environments, for example, are often the result of
alternatives. ineffective formal institutions that coexist with weak
Transactions that rely on informal institutions are social deterrence, sometimes called a “culture of cor-
regulated by a set of expectations about other people’s ruption” (chapter 5).5 In such situations incentives for
behavior. These expectations derive from a common un- corruption rise as peers also become corrupt, leading
derstanding of the rules of the game and the penalties to a vicious cycle of socially undesirable behavior.
for deviation and are based on shared beliefs and shared For geographically isolated and poor market partic-
identities of network members. Such norm-based be- ipants, formal institutions are not easily accessible.
havior is not always confined to small groups but is also These groups are more likely to use informal mecha-
evident on a broader scale. One example is tax compli- nisms to improve information flows and enforce con-
ance, when individuals in society tend to act more hon- tractual arrangements. For much of the world’s poor,
estly if they sense that other people’s behavior is similar informal institutions play a primary role in making
and when there is a social penalty for deviation.3 business easier.6
But informal mechanisms are used not only by those mechanisms, formal rural credit schemes that explic-
in poorer environments. Social networks grounded in itly use elements of local norms of solidarity, and in-
class, caste, tribe, and neighborhoods—as well as school stitutions such as affirmative action that try to reduce
background and membership in clubs—can be as im- discrimination.
portant for cementing deals in corporate towers as in This chapter draws on established research and new
rural markets. Work is habitually helped by the use of analysis in the social sciences as well as studies of the de-
conventions, personal relationships, and shortcuts that velopment experience to elucidate the role of informal
complement codified rules in large corporations as well institutions and their interactions with formal insti-
as small firms.7 In these markets informal institutions tutions. Finally, it provides insights for policymakers
tend to complement formal ones. building new institutions by addressing three questions:
For policymakers, building new formal institutions How do informal institutions aid market transactions?
that complement existing informal institutions is a Why do informal institutions facilitate transactions for
challenge. When inadequate attention has been paid to some and not for others? And how can the interaction
norms and culture, formal institutions have not deliv- of informal and formal institutions be used to ensure a
ered desired outcomes. But many successful institu- dynamically supportive market environment?
tional arrangements have flourished precisely because
Informal institutions in markets:
of their ability to harness, or adapt to, prevailing norms.
their utility and shortcomings
An important issue is that new laws or organizations
can make some market participants worse off than they This section first illustrates when and where norms
were under norm-based institutions. In extreme cases lower transaction costs in markets and facilitate activity.
new institutions may not bring many benefits while It then discusses examples of situations where norms,
destroying old norms that have benefited market ac- though aiding transactions, can be exclusionary or less
tivities. Thus, in some situations, replacing informal in- efficient than formal institutions. This includes cases
stitutions with formal institutions may not be the where norms restrict entry and so reduce competition.
preferred policy (as is the case with community-based
land tenure in some regions, discussed in chapter 2). When norms and networks help
That is even more likely if, as in many poorer countries, market-based activity
the preconditions for effective and efficient formal in- Informal institutions develop to spread risk and to raise
stitutions are not met. relative returns from market transactions. They do this
Connecting communities through trade can bring by improving information flows, defining property
about a demand for formal institutions to complement rights and contracts, and managing competition.
norm-based institutions. Norm-based institutions be- Informal institutions for sharing information within
come less effective as the number of trading partners groups. Well-established informal mechanisms for
grows and they become more socioculturally diverse. information-sharing have been used all over the world.
Moreover, because informal institutions often function Armenian traders in the 17th and 18th centuries, and
by restricting access to new members, they can be inac- Chinese immigrant trading communities until today,
cessible for many market participants and may hinder shared valuable trading information among themselves
competition in markets. Widespread income growth to ease transactions. Less sophisticated devices are used
and poverty reduction require formal institutions that by members of small business and trading groups all
can serve as bridges between separate groups. These can over the world, from street vendors in Peru, to mutual
help support more complex transactions and widen the aid groups in Benin, to wealthier members of clubs and
set of opportunities and agents that can benefit from business associations. In each case, an informal network
various market transactions. communicates information about business opportuni-
Experimenting with innovative elements that recog- ties, barriers, and potential partners to fellow group
nize the presence and effect of norms creates more ef- members.
fective formal institutions. Policies that allow parallel The information networks in these groups can lower
operation of informal and formal institutions increase the riskiness of transactions, as members gain informa-
options for market participants. Examples are courts tion about the quality of partners and the business envi-
that operate in parallel with informal enforcement ronment. In developing countries formal alternatives—
the costs of coordination.8 Individual Personal (for example, Reputation loss and
guilt) resulting exclusion
This type of informal information exchange is based
Retaliation by partner from future trans-
on trust. Close familial bonds and friendships permit in transaction actions of the kind
information sharing. Things are different when groups where cheating
Sanctioned punish- occurred.
are larger. Trust among kinfolk and strongly bound eth- ment by an outside
nic groups is built through multiple or repeated inter- mediator
actions, which allow each group member to assess the Community Direct sanction from Exclusion from other
other for reliability in adhering to contracts. Ghanaian community social transactions
fishmongers in Accra, for example, share business in-
formation even among competitors. This sharing of in-
formation is helped by multiple bonds: the women live
in the same neighborhood and sell in the same market, nity. One of the key instruments is the knowledge that a
they share a common ethnicity, and their husbands (the reputation for untrustworthiness would exclude people
fishermen) are business partners as well.9 from future transactions.12 Informal contract enforce-
Different types of information may be exchanged ment mechanisms are self-enforcing—the costs of deviat-
within networks. Agents may have specific information ing are high even in the absence of formal contract en-
about their counterparts, gained through previous inter- forcement mechanisms.13 Such incentive structures may
actions. In the absence of specific information, their only be devised in a variety of ways—some at an individual
recourse is generic information, such as shared value sys- level, some at a community level, and some involving the
tems (stemming from shared ethnicity, say, or common informal use of outside mediators or enforcers. Broadly
socioeconomic circles) or indirect “symbolic” denoters speaking these incentive mechanisms can be divided into
of quality or honesty (such as whether male or female, six groups, summarized in table 9.1.14
white or black, or the same or different ethnicity).10 In a world where information—about the other
The groups that have access to information may be party in a transaction and about the transaction itself—
formed in many different ways. For example, in mar- is imperfect, there needs to be a way for the aggrieved
kets in Africa, women market traders form close-knit parties to resolve their differences amicably. In devel-
groupings that offer mutual support, with even direct oped markets participants can use formal institutions
competitors selling for a member if she is sick. Their such as the justice system and the police. But the use of
bond exists even though they may be of different tribal formal mechanisms for dispute resolution may be un-
affiliations because their group is bound together by common in many communities, where official dispen-
their common gender.11 A second binding element is sation of justice may be regarded as too costly or ineffi-
their repeated interactions that build up specific knowl- cient. It may also be unavailable, if, for example, the
edge about one another. This helps cement the trust, courts are too far away. In industrial countries efficient
letting the group know who among them can be relied court systems also offer an incentive to develop pri-
on to use the information. Specific knowledge thus also vately negotiated solutions to disputes, whether through
helps determine the boundaries of the group sharing formal channels, such as trade associations, or informal
the information. (chapter 6). Studies of the United States, for example,
Informal institutions for dispute resolution or contract have found that private solutions to dispute resolution
enforcement within groups. Some informal institutions predominate. In richer countries, formal institutions
also define property rights and enforce contracts. In complement informal ones; informal rules can be very
modern-day rural Indonesia, for example, an informal effective as they have formal laws as the backup. In de-
system inhibits participants in business or credit transac- veloping countries market participants use informal
tions from defaulting on fellow members of the commu- mechanisms as substitutes.
In some instances, use of formal mechanisms is min- cretion over the reform of formal institutions, these
imal. Among a sample of Malagasy traders, for exam- shortcomings can be more easily remedied.
ple, a study found that a vast majority never used for- Limits on entry and exclusion from informal institu-
mal mechanisms at all.15 In other situations informal tions. A persistent problem in many poorly designed
enforcement mechanisms may explicitly reinforce for- formal institutions, as discussed throughout this Re-
mal ones. This, for example, is the case for the Grameen port, is that they may not be available to all interested
Bank in Bangladesh. Repayment rates are kept rela- parties. Informal institutions, by their very nature, suf-
tively high for small business loans to women not just fer from this problem as well. Information flows about
through formal credit histories, but also through ex- business opportunities may be available only to mem-
plicit social mechanisms. Group members are urged to bers of a group, with outsiders excluded because of lin-
select one another with an eye to as much homogene- guistic or cultural barriers (box 9.1). Also, because
ity as possible. Then, loan eligibility of each member in information is usually shared during the process of
a group is made subject to the credit history of the intracommunity social occasions, even among today’s
other members of the group, creating a strong element ethnic business communities, it may be difficult for
of peer pressure.16 outsiders to gain access.
The short-run mechanisms in table 9.1 have their Sociocultural barriers to using informal mechanisms
direct counterparts in the formal sphere as well. There, can be costly in multicultural or multiethnic societies.
the punitive act comes from the state, usually a fine, In parts of Africa there are often scores—and sometimes
imprisonment, or both, imposed by a court of law. Me- hundreds—of societies that were institutionally au-
diation is also a common, and often effective, alter- tonomous until recently.17 One example is The Gam-
native to a drawn-out judicial process (chapter 6). For bia. Within its more than 4,000 square miles, main eth-
informal contracts, loss of reputation is especially im- nic communities include groups such as the Madinko,
portant if the partner in the transaction is one of few Fula, Wolof, Jola, and Serahuli, each with endogamous
in the particular line of business. This may be a village profession-based “castes” among them. Other signifi-
moneylender, or the sole supplier of inputs for a farmer cant examples are the Mauritanian Moorish and Leba-
in a remote area, or a community member. In more nese trading communities.18 In such situations formal
competitive markets, where business partners outside institutions may be the only way to lower the costs of
the group are available, informal mechanisms become doing business for all concerned. Similar conditions,
less effective. They are also less useful during economic among them barriers to using cultural traditions that
or political upheavals and similar situations, where the build trust, exist for minority groups. A case in point is
composition of communities is volatile. the Korean minority in Japan, which is excluded from
Such multidimensional and long-term punishment the bonding iemoto groups that help build trust and ease
structures are effective so long as the individual needs to transactions even in today’s Japan.19 The same is true for
remain part of the community. But their utility dimin- those indigenous people in many countries throughout
ishes when the relevant group involved in transactions the world who live culturally separate existences from
is large and is spread across different communities or re- the mainstream.
gions, as when lower transport costs or changes in poli- Issues of access can be important even for those who
cies increase the range of trading partners. benefit from norm-based practices in some transac-
tions. Reliance on their own networks alone can mean
When norm-based institutions may not be enough that other possible businesses and potentially high-
Reliance on informal institutions alone is not enough yielding projects, governed by different institutional
for the growth of inclusive markets. Some groups may arrangements, are unavailable. The situation in box 9.2
be excluded from the use of such institutions. Also, illustrates how reliance on networks alone implies that
such institutions may limit the scale of operation, or more efficient producers may be denied access to credit.
they may have multiple objectives. In some cases the Therefore, the very mechanisms that promote lower
problems of, for instance, no access or multiple objec- transaction costs for participants can discriminate
tives are common to poorly designed formal institu- against those denied access to the networks. In such
tions as well. But because policymakers have more dis- cases there is a clear need for good formal institutions.
more ethnic groups in a given economy, each with its history decides his creditworthiness, while the lender
own set of customs and norms for doing business, the has recourse to specialized courts of law to enforce the
complexity of the coordination problem also mush- formal loan contract.
rooms. As group size grows, information processing In contrast, credit transactions within the commu-
and enforcement within the group also become diffi- nity are carried out through an institution—the com-
cult. Again, a shared set of formal institutions may be munity network—built to facilitate an array of eco-
the solution. nomic activity. This includes information about a
With more alternative trading opportunities outside person’s creditworthiness and possible social sanctions
the community, the number and diversity of potential on default. But it also incorporates mutual insurance
trading partners grow, and the relative benefit from schemes where a borrower, at a different time, may lend
staying in the network declines. In this situation, a to today’s lender or help him with information or con-
trader may find it less costly to violate a community nections in a totally different business matter. So a bad
norm because any sanctions (such as loss of shared in- credit history may be discounted, or the punishment
formation) that can be imposed by the group are less for default may not be as strong, as when impersonal
effective. With increased competition and other trad- formal institutions operate.
ing partners, the trader may find it feasible to exit the One problem is that poorer borrowers may not feel
community and exist comfortably without dealing obliged to repay richer lenders and instead may see
again with those the trader has cheated. default as part of an implicit mechanism to equalize
Norm-based mutual insurance networks are an ex- wealth among the kin or community.22 In a survey of
ample. Small communities use these to protect mem- 58 firms in Ghana, no credit sales were made to kin be-
bers from individual economic shocks by sharing excess cause the potential creditors worried that they would
resources such as food, labor, and land (where land is not be able to compel relatives to pay.23
abundant). Such systems are extremely valuable as a Such concerns, reinforced by cultural values about
means of protecting every member of the community egalitarianism and fairness, can also hinder the process
against misfortune. But as communities grow larger, of development, although they serve a social purpose.
commitments become more difficult to coordinate and A study in Cameroon, for example, found that village
deviations harder to punish. Moreover, a feature of mu- development committees in the north worked inef-
tual insurance mechanisms is that they come with a ficiently because of concerns that no single person
built-in set of incentives that may inhibit the commu- should benefit from the development work more than
nity from encouraging economic experimentation, others.24 In a village in the Republic of Congo another
entrepreneurship, and processes where individuals study found that fishermen who got new technology
compete among themselves. This is usually because of because of a fishery development project gave up using
concern that excessive riches will allow the individual the new nets because fellow community members were
to “opt out” of the mutual insurance systems essential not able to share in the improved incomes.25
for the community’s survival.21 In more complex econ- As policymakers set up formal and more specialized
omies, therefore, such mutual insurance systems have institutions, however, the equity-enhancing roles of the
been formalized under often more efficient systems informal institutions they displace often cannot be re-
of explicit taxes and transfers. created. In these cases the policy choice is made more
Multiple objectives of informal institutions. Well-func- difficult because the creation of a more efficient formal
tioning formal institutions are designed to solve a fo- institution can undermine long established risk-miti-
cused economic problem in the most efficient way pos- gating or redistributive functions played by norm-based
sible. But norm-based practices almost always have structures.
multiple objectives. Take the example of a credit trans-
Building and adapting formal institutions
action. Institutions that address, among other things,
two key elements of uncertainty—the borrower’s abil- Formal institutions are either superfluous or counter-
ity to repay the loan and his propensity to default— productive when transactions take place within small
mitigate the riskiness of the deal. Different formal in- communities and in larger communities with a shared
stitutions would act separately to mitigate the two risks; set of effective informal institutions. But as economies
for example, a formal record of the borrower’s credit develop, formerly distant communities become more
formal institutions may not be valued by the user at and to manage market risks, they may also exclude po-
first, meaning that it will take time for them to suc- tential entrants and partners. Formal institutions are
ceed. Socioeconomic norms develop through social important because they can deal with a larger group of
learning and imitation and are slow to change (much participants and because, if well designed, they can
slower than formal institutions, which can be altered serve to include more people rather than exclude them.
by some combination of market demand, political will, Imposing a formal legal system on an environment
and administrative capacity). It may be desirable to in- where informal contract enforcement has been the norm
troduce formal alternatives gradually with some experi- can either raise the transaction costs of dispute resolu-
mentation to identify the most effective institutional tion considerably (formal legal procedures are often
form (box 9.5 gives an example from Kenya). costly) or weaken the implicit contracts that governed
relations until that time (without significantly strength-
Conclusions
ening the effectiveness of alternatives). Such considera-
Market activities are supported by a complex blend of tions need to be kept in mind when examining the de-
informal and formal institutions. In many poor regions velopment of formal systems. When formal institutions
of the world, and particularly for many poor people, replace one of the functions provided by informal ones
informal institutions such as community networks are (such as efficiency in a particular transaction) but not
the only ones that are relevant, because access to formal others (such as risk sharing), policymakers need to be
institutions is relatively scarce. Moreover, in many situ- aware of the effect of their choices not just on economic
ations, even if governments could establish formal in- outcomes, but also on political and social effects; they
stitutions, the costs of doing so, relative to the benefits, can then either modify the pace of change or design
may be high. Informal institutions can be superior to complementary institutions. Take, for example, any pol-
formal alternatives, either because they are more effi- icy that serves to weaken community ties, such as those
cient at achieving the objective or because they embody that support out-migration or the breaking up of com-
features that formal institutions are unable to provide. munities in order to resettle them to otherwise better
But in other cases, informal institutions may prevent areas. These actions could weaken the informal enforce-
further market development, as when closed networks ment mechanisms for contracts, and alternative formal
restrict the scale and breadth of possible transactions. institutions for contract enforcement may be needed.
In developing markets, informal institutions tend to Finally, the greater use of formal institutions requires
substitute for the lack of formal systems, whereas in de- the removal of overly onerous regulatory barriers that
veloped markets informal and formal institutions tend help foster informal economic activity (chapters 1 and
to complement each other. 7). A second, and critical, set of policies relates to liter-
While informal institutions provide people with a acy and education—without which sophisticated for-
way to access and benefit from market opportunities mal institutions may be unusable.