Douglass C. North Nobel Laureate in 1993 wrote many papers about institutions. In his Nobel Prize lecture he admitted that how institutional change actually happens is one of the biggest mysteries in Economics. The importance of institutions in economic growth was well established long before now.
In his paper “Institutions” wrote in 1991, he defines institutions as “humanly devised constraints that structure political, economic and social interaction. They consist of both informal constraints (sanctions, taboos, customs, traditions, and codes of conduct), and formal rules (constitutions, laws, property rights)”. Their main objective are “to create order and reduce uncertainty in exchange.” […] “they define the choice set and therefore determine transaction and production costs and hence the profitability and feasibility of engaging in economic activity”.
Why did institutions emerge?
North argues that institutions and rules were necessary when transactions between strangers happened repeatedly. As societies evolved, they experienced divisions of labour and growth in trade. These two factor increased the likelihood of repeated transactions with strangers and the need for common rules. “Cooperation is difficult to sustain when the game is not repeated (or there is an endgame), when information on the other players is lacking, and when there are large numbers of players”.
Why are they important for growth?
Because institutions reduce transaction and production costs per exchange so that the potential gains from trade are realizeable. Both political and economic institutions are essential parts of an effective institutional matrix.
Some economists have recently argued that the most important institution for economic growth are those involved in private property regulations.