If political economy has one master variable, it is institutions. They are why two countries with the same geography, resources, and technology can diverge by a factor of thirty in income per head. This module defines them precisely, sets out the dominant theory of how they shape growth, and confronts the hard problem of proving any of it.
What an institution is
North's definition
Douglass North (1990): institutions are 'the humanly devised constraints that structure political, economic, and social interaction' — the rules of the game. They include formal rules (constitutions, laws, property rights, contracts) and informal constraints (norms, conventions, codes of conduct). Crucially, institutions are distinct from organisations: institutions are the rules; organisations (firms, parties, unions, the KRA) are the players who act within them and try to change them.
The distinction matters because reform often confuses the two. Building a new anti-corruption agency (an organisation) does little if the underlying rules and norms (the institutions) still reward corruption. The agency becomes one more player in a game whose payoffs haven't changed.
Why institutions matter for growth: transaction costs
North's mechanism is transaction costs. Production and exchange require contracts to be written and enforced, property to be secure, and disputes to be settled. Where institutions do this cheaply and predictably, agents invest, specialise, and trade. Where they don't, every transaction carries the risk of expropriation or default, so agents stay small, deal only with kin, demand cash up front, and forgo the gains from specialisation. The economy stays poor not because it lacks resources but because its rules make complex exchange too risky.
Inclusive vs extractive institutions
Daron Acemoglu and James Robinson (Why Nations Fail, 2012) sharpened the framework into a binary. Inclusive institutions secure property rights broadly, enforce contracts impartially, and let people enter occupations and markets freely — so a wide population has incentives to invest and innovate. Extractive institutions concentrate power and direct resources from the many to a narrow elite — so the population has no incentive to invest, and the elite has no incentive to allow the creative destruction that threatens its rents.
The property-rights channel
The core empirical claim is that secure, broadly-held property rights are the proximate cause of investment and growth. If I cannot be confident I will keep the returns to my effort — because the state, a chief, or a neighbour can take them — I will not make the effort. Inclusive institutions make that confidence credible for everyone; extractive ones make it credible only for the elite.
Proving it: the colonial-origins strategy
The obvious objection is reverse causation: rich countries can afford good institutions, so does the correlation run from institutions to wealth or the other way? Acemoglu, Johnson, and Robinson (2001) answered with one of the most cited instruments in economics. Where Europeans faced high mortality (malaria, yellow fever), they could not settle, so they set up extractive institutions to expropriate; where mortality was low, they settled and built inclusive institutions resembling home. Settler mortality two centuries ago plausibly affects income today only through the institutions it created — making it a valid instrument that isolates the causal effect of institutions on growth.
The critiques are serious
Glaeser, La Porta, Lopez-de-Silanes & Shleifer (2004) argued the colonists brought human capital, not just institutions, and that early measures capture policy choices that can reverse — so the instrument may violate the exclusion restriction. Albouy (2012) challenged the mortality data itself. The honest position: institutions clearly matter, but the precise magnitude from any single identification strategy is contested. Treat the binary 'inclusive vs extractive' as a powerful lens, not a measured constant.
The Botswana exception
Botswana is the framework's showcase. At independence in 1966 it was among the poorest countries on earth, landlocked, with a few kilometres of paved road and a diamond endowment that elsewhere is a curse. It became one of the fastest-growing economies in the world for three decades. Acemoglu, Johnson, and Robinson attribute this to relatively inclusive pre-colonial Tswana institutions (the kgotla assembly constraining chiefs) that survived light-touch British administration, combined with a post-independence elite whose own cattle wealth depended on secure property rights — so they chose to entrench rather than expropriate. Geography and diamonds were constants; institutions were the variable.
Exercise
Hernando de Soto argued that the poor in developing countries hold trillions in 'dead capital' — land and homes they occupy informally but cannot use as collateral because they lack formal title. Kenya has run large-scale land-titling programmes on this logic. (1) State the institutional argument for titling in North's terms. (2) The empirical results of titling programmes across Africa have been mixed at best. Using the institutions-vs-organisations distinction and the idea of informal constraints, explain why issuing a title document (the formal rule) may not deliver the predicted investment and credit effects. (3) What complementary institutions must exist for a title to actually function as North's theory predicts?