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Economic Institutions: Formation and Classification

  • Bhumika Dutta
  • Nov 27, 2021
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Considering the situation of any country, every person in the population lives in a society. 


Society needs to balance out its production and distribution to make effective use of all the available resources. 


The economy must look after the basic needs of the entire population, including food, clothing, and shelter. Now, the question is, what comprises the economy of the society?


About Economy


The economy is a social institution that assures the preservation and order of society through the manufacture, distribution, and consumption of products and services. 


The economy is divided into three sectors:


  • Primary production, which is responsible for extracting raw materials and resources from the environment, 

  • Secondary production, which processes those raw materials into finished products, and 

  • Tertiary production, which includes all commercial services such as transportation, communication, education, real estate, entertainment, sports, and so on. 


All of the above-mentioned aspects of the economy are handled by economic institutions. 


Property rights, honest governance, political stability, a stable legal system, and competitive and free markets are what economists mean when they use this word. These institutions are responsible for the management of those scarce resources. Let us learn more about Economic Institutions now.


(Must read: Capital in economics)


What is an Economic Institution?


According to economists' study, the evolution of economies has been mostly inconsistent, with some evolving faster than others. 


Economic Institutions are government or private institutions and organizations that gather and evaluate economic data. It can also refer to foundations that supply a product or service that is important to the country's economy. 


Examples of economic institutions are The Internal Revenue Service (IRS), the U.S. Federal Reserve, and the National Bureau of Economic Research. 


 Also, economic institutions are well-established systems and structures that are parts of the culture or society, such as competitive marketplaces, the banking system, children's allowances, customary tipping, and a property rights system.


The economy has always existed, but economic institutions have re-emerged at the focus of attention in development economics after a lengthy period in which their presence and smooth operation was assumed in neoclassical economic theories, as described in this source.



How are Economic Institutions formed?


Institutions evolve in two ways: formally via conscious design or informally through frequent encounters between persons or organizations that create anticipated norms of behavior.


In the second situation, the institution may be established by the government or by a commercial firm or civil society initiative. In both circumstances, institutions are developed and evolve in response to the uncertainty, risk, and information costs of living and transacting in an imperfect world.


Whatever the institution's origins, the more broadly it is recognized, the better it will operate, and such acceptance achieves its pinnacle when the norm is accepted as legally enforceable by the state. 


Not all institutions require government support, but some must remove uncertainty and offer a legal basis for the standards under consideration. 


Institutions are valued for the predictability they offer to the system; as a result, rapid change and testing with established standards are typically discouraged. 


Furthermore, specific institutions can bestow rights and benefits on specific groups of people in society, who would use their influence to block changes that might jeopardize their advantages.


(Suggested reading: Positive and Normative Economics)



What are Economic systems?


An economic system is a societal structure for the production and exchange of goods and services, as well as the distribution of resources. 


Property ownership is an important component of economic structure since it determines who owns and controls the means of production. 


During the Industrial Revolution, there were three primary economic systems:


  1. Capitalism:


It is a type of economic system that promotes individual ownership and competition. 


Private individuals or organizations will control the money and production, and the primary purpose will be to make a profit via commerce. 


Everyone has the opportunity to prosper or fail, and only the strongest will survive.



  1. Communism:


Communism is based on collective ownership and a planned economy in which the government controls all decisions. 


Karl Marx established this system in 1848 when he published "The Communist Manifesto." 


In communism, everyone gets the same outcomes, no matter how hard or how little they work.



  1. Socialism:


Socialism falls somewhat between capitalism and communism, where all the means of production are in the hands of the government but people are not paid equal wages. 


They get paid based on several factors like qualification, the difficulty of the job, social need, etc.


 In socialism, high taxes are imposed on the rich to provide more government services. 


(Related reading: Capitalism vs Socialism)



Classification of Economic Institutions:


The following are the classifications of economic institutions according to this blog written by econlib:


  1. Property Rights:


A property right is the only authority to decide how a resource is utilized, regardless of whether the resource is held by the government or by people. 


With state-administered force and social ostracism, society endorses the uses chosen by the holder of the property right.


Some examples of property rights are Land tenure, inheritance law, patents, copyright, etc.



  1. Political Behavior:


People need to compete for basic resources everywhere due to their scarcity. Markets are one method of organizing and channeling competition. Another example is politics. 


People utilize both markets and politics to direct resources toward their preferred goals. Political action, on the other hand, is opposed to voluntary trade in markets. 


In a democracy, organizations can do far more in politics than they might in the commercial sector.


Some of them are critical to the overall welfare of the community, such as the management of health-threatening air pollution from a variety of sources that affect millions of people, or the provision of national defense.



  1. Law and Economics:


Economics has made significant contributions to our knowledge of the law, but the law has also made significant contributions to our understanding of economics


Courts deal with the realities of economic abstractions like property and contract regularly. 


Thus, studying law allows economists to have a better understanding of some of the principles underpinning economic theory.



  1. Free Market:


All trades in primitive societies are done through barter or direct exchange. 


Two people trade two directly useful things, but as society evolves, a step-by-step process of mutual benefit results in the selection of one or two generally beneficial and valued commodities on the market as a medium of indirect exchange. 


This money-commodity is therefore sought after not just for its reason, but also to allow re-exchange for another desired commodity.



  1. Federal Reserve system:


Since its inception in 1913, the Federal Reserve System (the Fed) has served as the United States' central bank. 


A central bank's primary function is to manage the availability of money and credit to the economy.



Role of Economic Institutions in Economic growth:


The work done by these economic institutions can help determine economic growth in the following ways:


  1. People with sufficient capital will be more eager to invest if the economic institution guarantees their property rights. 


If investing becomes reasonably easy and activities such as trading, acquiring credit, and maintaining a sufficient part of earnings without excessive taxation become simpler, a large number of firms or more informal economic organizations will emerge.


  1. Power is the purposeful influence over people's ideas, feelings, and behaviors, whereas authority is the formal power to act. Economic riches confer power and 


Wealth is a huge power that allows people to influence many agencies, organizations, and resources.


  1. Secure intellectual property rights are expected to encourage private investment in innovative research and development. Any country's technological situation will benefit from this.


  1. When institutions allow transactions and cooperation between individuals, whether within formal firms or less formal co-operatives, the economic organization is likely to be more effective and efficient, offering the benefits of specialization and economies of scale where they apply.


  1. The primary role of economic institutions is to meet the human needs for which they were created. In this regard, all sectors of the economy play a significant role. 


Individuals' economic existence depends heavily on their ability to find work. Employees' requirements will be met if they are well compensated.


(Recommended reading: Scope of Managerial Economics)


In the end, Economic institutions play a vital role in the economic growth of any country. Without proper institutions, the country may experience an economic downfall. 


Summing this article up, we have talked about the economy and economic institutions, along with the formation and classification of economic institutions. We have also discussed the role of these institutions in the economic development of any country.

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